The Treasury Department has released long-awaited proposed regulations governing deferred compensation arrangements for tax-exempt and governmental entities (Exempt Entities). Under section 457(f) of the Internal Revenue Code (the Code), Exempt Entities are restricted to providing deferred compensation only through tax-qualified arrangements, such as Code section 401(k), 403(b), 457(b) plans or traditional pension plans. Most other compensation earned in one calendar year and paid in another calendar year, even compensation not traditionally considered “deferred compensation,” is taxable to employees of Exempt Entities when the compensation is first no longer subject to a “substantial risk of forfeiture.” This has handcuffed Exempt Entities in their ability to provide deferred compensation arrangements similar to those provided by taxable employers.
The proposed regulations loosen the handcuffs in many key areas including the following:
- Pay NOT Considered Deferral of Compensation. Rules are provided to help determine when certain pay (e.g., severance pay or sick leave and vacation pay) will not be treated as providing for the deferral of compensation including:
- Bona Fide Severance Pay Rules. Many existing severance pay arrangements are subject to Code section 457(f) rules, resulting in taxation of all of the future severance payments upon termination of employment (or earlier), regardless of the fact that some of the severance payments will be made in a year later than the year of the employee’s termination. The proposed rules include exceptions for severance pay that largely parallel the exception for separation pay under Code section 409A.
- Bona Fide Sick Leave and Vacation Pay Rules. Definitions have been provided helping determine what constitutes bona fide vacation pay and bona fide sick leave, which are generally not subject to Code section 457(f).
- Payment Upon Termination for Good Reason. Under the proposed regulations, a payment conditioned upon involuntary severance from employment without cause, including a voluntary termination for good reason, may be subject to the substantial risk of forfeiture rule if the possibility of forfeiture is substantial.
- Covenant Not to Compete as a Substantial Risk of Forfeiture. The proposed regulations provide detailed standards and operational rules for using violation of a covenant not to compete as the basis for a substantial risk of forfeiture. Essentially, any deferral period dependent solely on a non-compete will effectively be limited by the non-compete enforceability limitations under state law (which seldom exceed two years even in non-compete friendly jurisdictions). NOTE: Most arrangements that currently use a non-compete probably do not meet the detailed new standards.
- Rolling Risk of Forfeiture Allowed, but Costly and Complicated. It is now possible to extend the date a risk of forfeiture is scheduled to lapse to a later date (frequently referred to as a “rolling risk of forfeiture”), resulting in a delay in the taxation of the deferred compensation, but only if certain restrictive conditions are met. At a minimum, this requires an increase in the value of the deferred compensation by 125% and a delay of at least two years. However, such extensions will not necessarily be recognized for Code section 409A purposes, meaning that an extended risk of forfeiture could cause an arrangement to become subject to the requirements of Code section 409A (if it is not already) or, in some cases, cause the arrangement to violate the requirements of Code section 409A.
Taxpayers May Rely on Proposed Regulations
While these proposed regulations will not be effective until they are published as final regulations, taxpayers may rely upon the proposed regulations in the meantime. Since the proposed regulations address many unanswered issues (e.g., rolling risk of forfeiture, non-competes, good reason), a review of existing arrangements subject to Code section 457(f) may be warranted.
What Should Exempt Entities Do Next?
Exempt Entities should survey their existing compensation arrangements to determine the effect of the proposed regulations and whether these arrangements should be revised. For new compensation arrangements, or new grants under existing arrangements, Exempt Employers may wish to conform to the proposed regulations because of the additional clarity they provide. While the proposed regulations provide more flexibility, Exempt Employers should be prepared to spend more resources for administration of their compensation arrangements.