Proposed rules for tax-exempt organizations and governmental agencies with deferred compensation plans

Issue May/June 2017 May 2017 By Patricia Ann Metzer

Section 457(f) is a special Tax Code provision that deals with the taxation of certain deferred compensation arrangements for workers employed by tax-exempt organizations, such as hospitals and universities, and state and local governments. It covers arrangements that do not meet the special qualification requirements in other parts of Section 457.

Under the statute, any worker covered by a plan to which Section 457(f) applies will have current income at the time his/her employer unconditionally agrees to pay compensation to him/her in the future, or when an initially forfeitable promise to pay compensation to him/her in the future ceases to be forfeitable. Workers in the private sector are treated more favorably under a different Tax Code provision-Section 409A. For them, under a properly drafted and administered program, deferred compensation will not become taxable until it is actually paid, although the failure to satisfy 409A's requirements will trigger not only current income but also a 20 percent excise tax.

There are some helpful statutory provisions that, if applicable, will remove some deferrals from coverage under the current inclusion rules in Section 457(f). By its terms, the provision does not apply to qualified retirement and annuity plans, property transfers to which Tax Code Section 83 applies, and nonqualified trusts covered by Tax Code Section 402(b). Also, 457(f) does not affect bona fide vacation, sick leave, disability pay, severance pay and death benefit plans, because they are treated as not providing for a deferral of compensation.

In the past, the Internal Revenue Service has provided very little guidance on how to interpret Section 457(f) - most significantly on when a deferred benefit ceases to be forfeitable and what is a bona fide severance pay plan.

Intending to fill in the gaps, the government has now proposed regulations under Section 457(f). This article summarizes questions addressed by the proposed regulations and the government's proposed positions. Many provisions are based on previously finalized regulations under Section 409A.

In general, what is Section 457(f) deferred compensation?

A worker's compensation will be deemed to have been deferred if, under the terms of a plan, he/she currently has a legally binding right to the compensation but it is or may be payable in a later calendar year. Facts and circumstances are critical. A legally binding right will not exist if the employer has the unilateral right to reduce or eliminate compensation once it has been earned by performing services.

Compensation not initially treated as deferred compensation can turn into a deferral at a later date. As an example, the proposed regulations cite a retiree health care plan that is amended to allow participants to receive future cash payments instead of health benefits.

Even if technically "deferred compensation," some deferrals fall outside the scope of Section 457(f) due to some useful exceptions in the proposed regulations. These are taken from the final regulations under Section 409A. A deferral of compensation will not occur to the extent a plan provides:

A short-term deferral - due not more than 2-½ months after the end of the worker's or employer's tax year in which the compensation vests, applying the definition of a substantial risk of forfeiture under the 457(f) regulations,

"Recurring part-year compensation" that does not exceed the annual qualified retirement plan limit ($270,000 for 2017) - like the annual salary of a permanent teacher who provides services during a school year comprised of 10 consecutive months but whose salary is paid over no more than 13 months after the start of his/her service period,

Expense reimbursements, medical benefits, and in-kind benefits due in connection with a worker's termination of employment, whether or not involuntary,

Payments under an indemnification plan, or to purchase an insurance policy, covering expenses incurred or damages payable by a worker on account of a bona fide claim against him/her or his/her employer,

Settlements or awards to resolve bona fide legal claims based on wrongful termination, employment discrimination, the Fair Labor Standards Act, or worker's compensation statutes, and

Taxable educational expenses for an employee.

What types of plans are not covered by Section 457 - and hence not by 457(f)?

An important part of the proposed regulations is the discussion of certain plans to which none of the provisions of Section 457 apply - because the Tax Code itself excludes them. The definitions provided are instructive. All excepted plans must be bona fide.

Vacation and Sick Leave Plans

The primary purpose of a bona fide vacation or sick leave plan is to provide workers with paid time-off due to vacation, sickness or other personal reasons. A number of relevant facts and circumstances are listed in the proposed regulations. Positive factors include a plan's availability to more than a limited number of employees, the payment of benefits promptly upon a worker's termination of employment, and the fact that ordinarily benefits would have been used up in the normal course while the worker was employed.

Disability Pay Plan

A bona fide disability pay plan provides benefits only when a participant is disabled. One of three definitions of disability must be met: the participant must be unable to engage in any substantial gainful activity due to a medically determinable physical or mental impairment that can be expected to result in death or last for not less than 12 continuous months, must, for the same reason, be receiving income replacement benefits for not less than three months under an employer sponsored accident and health plan or must be determined to be totally disabled by the Social Security Administration or the Railroad Retirement Board.

Death Benefit Plan

The term "death benefit" is defined by reference to the employment tax regulations, under which benefits provided only upon death may be viewed as having been provided under a death benefit plan. The proposed regulations make only one modification. Death benefits may be provided through insurance, in which case the value of term life insurance coverage that is included in income is not a prohibited lifetime benefit.

Severance Pay Plan

The most anticipated definition in the proposed regulations deals with bona fide severance pay plans. In the past, workers and employers most often sought to have their deferred compensation arrangements characterized as severance pay plans because Section 457(f) does not apply to them.

Severance is addressed in other regulations promulgated under the Tax Code and the Employee Retirement Income Security Act of 1974. The proposed 457(f) regulations borrow from them, but it is important to keep in mind that the Section 457(f) rules have not been copied verbatim from these other regulations. As a general matter, a bona severance pay plan must meet three requirements: benefits can be payable only on involuntary severance from employment, the amount due can be no more than twice the worker's annualized pay for the calendar year preceding the calendar year of severance (the dollar cap in the final 409A regulations does not apply) and the benefit, per a written plan document, must be paid in full no later than the last day of the second calendar year after the year in which the severance occurs. Benefits under so-called "window programs" and voluntary early retirement incentive plans are automatically treated as separation pay plans if the regulatory prerequisites can be met.

What does "involuntary" mean? Essentially, a severance is involuntary if an employer exercises its unilateral authority to terminate a worker's services when the worker was willing and able to continue to work and did not implicitly or explicitly request a severance. When a worker quits for "good reason," the severance will be treated as involuntary if it can be demonstrated that unilateral action on the employer's part caused a material negative change in the worker's relationship with the employer. In this context, it is good to be able to show that payments due because of a severance for "good reason" are equal (i) in amount to, (ii) payable in the same form as, and (iii) due at the same time as, benefits payable when an actual involuntary severance occurs. If the conditions of a regulatory a safe harbor can be met, "good reason" will be presumed to exist.

When is a benefit not subject to a substantial risk of forfeiture and hence taxable?

Taxation will not be immediate if a worker's benefits, when granted, are subject to a "substantial risk of forfeiture." This concept appears in other Tax Code provisions. However, the proposed 457(f) regulations interpret the concept differently.

Entitlement must be conditioned on the future performance of substantial services or the occurrence of a condition related to a purpose of the compensation. In every case, the possibility of forfeiture must be substantial. Facts and circumstances will determine whether a substantial risk of forfeiture exists. As an example of a good forfeiture condition, the government cites involuntary severance from employment without cause where the possibility of forfeiture is substantial.

The proposed regulations take the position that, in the right case, compensation will be treated as forfeitable when payment is conditioned on not competing with the employer, so long as there is an enforceable written non-competition agreement, the employer makes reasonable ongoing efforts to verify compliance, and at the time the agreement becomes binding, it can be demonstrated that the employer has a substantial and bona fide interest in preventing the services, and the worker has a bona interest in engaging in the prohibited competition and the ability to do so.

Another helpful aspect of the proposed regulations is their recognition of rolling risks of forfeiture. As a general rule, an employer cannot extend a forfeiture condition after a worker becomes legally entitled to compensation. But the proposed regulations provide that, under certain defined circumstances, an employer can. As a threshold matter, the present value of the amount made subject to the new forfeiture condition must be materially greater than the present value of the amount the worker would have received absent the extended risk of forfeiture. Materially greater is defined to mean more than 125 percent. Two other conditions must also be met. First, the worker must perform substantial services (or refrain from competing) for at least two years after he/she could have received the compensation, unless there is an intervening death, disability, or involuntary termination of employment without cause. Second, a written agreement must be entered into at least 90 days before the existing substantial risk of forfeiture would have lapsed.

These same provisions are available to workers and employers who want to introduce a risk of forfeiture where one was not previously present. Then, the required agreement must normally be entered into before the start of the calendar year in which any services giving rise to the compensation subject to the new condition are performed.

When a deferral first becomes taxable, how much is includible in income?

Determining the taxable amount when deferred compensation first vests, can be difficult. The proposed regulations tax the present value of deferred compensation on the first date on which there is a legally binding right to it, or, in the case of a forfeitable amount, the first date on which the substantial risk of forfeiture lapses. Under the basic rule, each payment due must be multiplied by the probability that any relevant contingency will be satisfied, and discounted using an assumed rate of interest to reflect the time value of money. Contingencies that cannot be taken into account include death (except in the case of a benefit forfeitable upon death), the unfunded status of a plan, possible future changes in the law, and investment risk. Special provisions deal with formula amounts, payment restrictions, and alternative times and forms of payment.

Fortunately, the proposed regulations provide a more administrable rule for a plain vanilla "account balance plan," under which a worker will receive the principal amount credited to an unfunded account in his/her name, plus all earnings credited to that account until the payment date, determined using a fixed rate of return. If the rate of return is reasonable, the worker will be taxed on the amount actually credited to the account when his/her benefit first vests. To be able to apply this provision, an employer must determine earnings using either an interest rate permitted under the employment tax regulations dealing with the current taxability of deferred compensation for FICA purposes or a return based on a predetermined actual investment, again in accordance with the employment tax regulations.

When benefits are ultimately paid, will an additional tax be due?

Once a deferred amount has been taxed under Section 457(f), an additional tax will be imposed only when the benefit is actually paid or made available at a later time.

First, it is worth noting that the proposed regulations discuss some less obvious circumstances under which deferred compensation will be deemed to have been paid or made available. These include a transfer or cancellation of a deferral in exchange for benefits under a tax exempt welfare benefit plan or any other benefit excludible from gross income. Under these circumstances, the worker will be deemed to have constructively received cash.

When deferred compensation is actually or constructively paid or made available to a worker, a worker will realize additional income - determined by taking into account the amount on which he/she was previously was taxed. The rules in Tax Code Section 72 apply here, treating the deferred compensation plan like an annuity contract. The proposed regulations give an individual an "investment in the contract," which can be recovered tax-free ratably over the payout period. The proposed regulations make it clear that a worker will have an investment in the contract for this purpose only if he/she actually reported the proper amount of income when his/her deferral first became subject to tax.

What happens if previously taxed benefits are never paid?

It is not beyond the realm of possibility that a worker will pay tax on deferrals under Section 457(f) that he/she never receives. The proposed regulations allow a worker to deduct a previously taxed amount that is never paid if he/she can be demonstrate that the compensation is permanently forfeited under a plan's terms or otherwise permanently lost. A permanent loss does not include an investment loss or an actuarial reduction in benefits if the worker retains the right to any payment under the plan. Essentially a benefit must become wholly worthless.

The bad part about this provision is that the deduction will be subject to the statutory limitations on miscellaneous itemized deductions.

How does 457(f) relate to Section 409A?

Another Tax Code provision dealing with the taxation of deferred compensation, Section

409A, addresses when deferral elections must be made, and when and how payments under certain deferred compensation arrangements must occur. Unfortunately, Sections 457(f) and 409A can both apply. This means that a footfall under 409A can trigger an additional 20 percent excise tax under Section 409A when deferrals not taxed under Section 457(f) are or become subject to 409A - for example, if 457(f) benefits are accelerated. The moral here is that, when putting together and administering a deferred compensation program for its workers, a tax-exempt organization or state or local government may need to satisfy the requirements of 409A to the extent they are different from those in 457(f).

When do the provisions in the proposed regulations take effect?

The provisions in the proposed 457(f) regulations, when finalized, will generally apply to compensation deferred for calendar years beginning after the Treasury Decision adopting the provisions is published in the Federal Register. The effective date is not entirely prospective. The final regulations will affect deferred amounts to which a legally binding right arose in prior calendar years that were not previously included in income.

There are special deferred effective dates for collectively bargained and governmental plans. Also, before the regulations are finalized, taxpayers may rely in them.