The IRS recently issued proposed regulations under Internal Revenue Code Section 409A for deferred compensation arrangements that apply to all employers. The IRS also recently proposed regulations under Internal Revenue Code Section 457 for deferred compensation plans of tax-exempts and governmental entities. In addition to traditional deferred compensation arrangements, certain employment agreement provisions, severance arrangements, equity grants and expense reimbursement arrangements, and other similar arrangements, may be impacted.
Proposed regulations under Section 409A
There are extensive existing final regulations and proposed regulations under 409A, and the recently issued proposed regulations modify both and clarify specific issues.
Restrictions with respect to nonvested amounts
Perhaps the most significant change is a restriction on the ability to correct 409A violations relating to nonvested amounts, and to otherwise change payment terms for nonvested amounts. Based on provisions of the existing proposed regulations and other IRS guidance under which amounts that remain nonvested throughout a calendar year are not subject to taxation under 409A, many plan sponsors and practitioners have taken the position that there is wide latitude to correct 409A violations affecting nonvested amounts without tax consequences. Moreover, some plan sponsors and practitioners have permitted changes in time and form of payment, that would otherwise be impermissible under 409A, for nonvested amounts.
The new proposed regulations provide that if the IRS has prescribed a particular correction method (in its existing 409A correction guidance), a plan sponsor must follow that substantive method (though not the procedural requirements, such as payment of taxes and IRS reporting), even for nonvested amounts. Moreover, nonvested amounts will be taxed if an impermissible change in time or form of payment is made without a reasonable, good faith basis that the original plan provision was flawed or if the plan sponsor has a pattern or practice of permitting impermissible changes of substantially similar errors. The IRS has provided examples of when a plan sponsor will be deemed to have engaged in a pattern or practice of impermissible changes in time or form of payment.
These changes apply now and eliminate an area of flexibility that has existed under Section 409A.
Other provisions of the new proposed Section 409A regulations
In addition, the new proposed 409A regulations make other changes, including the following:
- 409A-exempt stock rights can provide for payment based on less than full fair market value upon termination of employment for cause or other adverse action within the control of the service provider (such as violation of a noncompetition obligation).
- 409A-exempt stock rights can be issued to entities (in addition to individuals).
- 409A-exempt stock rights can be granted within 12 months before employment begins (i.e., grants need not wait until employment begins).
- 409A-exempt stock rights and incentive stock options may be cancelled in a change of ownership of the stock or substantially all of the assets of a corporation in exchange for payments made at the same time and in the same manner as payments are made to shareholders or the corporation, as applicable, provided all such payments for the stock rights and options are made within 5 years of closing.
- The 409A separation pay exemption is clarified for newly-hired employees.
- The 409A exemption for recurring part-year compensation – such as is common among educational institutions that pay employees over 12 months for 10 months of work - applies for individuals with total compensation up to the limitation on recognizable compensation for qualified retirement plan purposes ($265,000 for 2016, indexed for inflation).
- The timing rules for payments to beneficiaries are liberalized, to allow payment of any amount due during the calendar year of death to be made by the end of the next following calendar year.
- "Short term deferral" treatment is preserved when payment is delayed to avoid violating securities or other laws.
- The types of legal fees/expenses for which reimbursement is exempt are expanded.
The proposed regulations modify the existing final regulations to provide the following clarifications:
- A nontaxable transfer of nonvested property for which a Section 83(b) election has not been made or grant of stock options is not considered a payment under Section 409A.
- A contribution to a nonqualified trust is not considered a payment under Section 409A until it is includible in taxable income.
- A stock sale treated as an asset sale under Section 338 of the Code does not give rise to a separation from service, unlike a true asset sale.
- Under the general plan termination rule, all plans of the same type must be terminated (not only those covering a particular participant).
Generally, the items that constitute changes to the current final regulations are proposed to be effective when finalized, but can be relied upon before then. However, the four clarifications listed directly above are effective immediately (because the IRS does not view them as changes to the current rules).
Proposed regulations under Section 457
Section 457 governs deferred compensation plans maintained by most tax-exempt and governmental entities.
The IRS has proposed revisions to the existing Section 457(b) regulations (issued in 2003) to reflect law changes over the past 13 years, including Roth contributions for governmental 457(b) plans, HEART Act conforming changes, and other items.
The proposed regulations deliver on a promise made by the IRS almost ten years ago to issue more formal guidance addressing Section 457(f) plans.
Notably, the IRS has proposed for these regulations to apply to existing 457(f) plans and arrangements, without a broad grandfathering rule. The IRS has, however, requested comment on potential transitional rules.
Here is an overview of the new proposed regulations:
Substantial Risk of Forfeiture
The existence of a substantial risk of forfeiture is of central importance under 457(f), because deferred amounts become subject to taxation on the date the substantial risk of forfeiture lapses. The proposed regulations confirm that a substantial risk of forfeiture may take several forms:
- A requirement to perform substantial future services.
- The occurrence of a condition related to the purpose of the compensation (e.g., achievement of performance goals), if the possibility of forfeiture is substantial.
- Involuntary termination without cause or constructive discharge.
- Notably, the proposed regulations allow noncompetition agreements to serve as the basis for a substantial risk of forfeiture if (1) vesting is expressly conditioned on a written noncompetition agreement that is enforceable under law, (2) the employer consistently attempts to verify compliance with all of its noncompetition agreements, (3) when established, the employer has a substantial and bona fide interest in preventing competition, and (4) the employee is able to compete, and has a bona fide interest in doing so.
For all purported risks of forfeiture, the proposed regulations require that the condition be likely to be enforced. In this regard, the IRS will evaluate the past practices of the employer in enforcing forfeitures, the level of influence and control of the participant, and likelihood that the condition is legally enforceable.
Elective Deferrals and Vesting Date Extensions (Rolling Vesting)
The IRS will honor voluntary elections to defer compensation under a 457(f) plan, and to extend an existing vesting date, if the following conditions are satisfied:
- The present value of the amount payable in the future must be more than 125% of the present value of the amount deferred. Practically, this means that there must be additional employer contributions on account of the deferral election (excluding compensation for continued performance of services), or an above-market earnings crediting rate (crediting of actual earnings does not result in excess present value).
- The risk of forfeiture must be based on a requirement to perform substantial future services, or comply with a non-competition agreement (subject to the qualifications noted above), but cannot be based solely on occurrence of a condition, such as an organizational performance goal.
- The deferral election or vesting date postponement must be for a minimum period of two years (absent an intervening event, such as death, disability or involuntary termination, upon which vesting may be accelerated).
- For elective deferrals, the election must be made before the calendar year in which services are performed. For vesting date extensions, the election must be made at least 90 days before the original vesting date.
Determination of Taxable Amount upon Vesting
Upon vesting, the taxable amount cannot reflect discounts due to (1) the unfunded status of plan, (2) the risk of investment loss, (3) the risk that the plan sponsor will be unable or unwilling to pay, or certain other factors.
For defined benefit arrangements, the plan sponsor must use reasonable actuarial assumptions to determine the taxable amount upon vesting. Otherwise, the IRS may recalculate the taxable amount using an interest rate and mortality table specified in the regulations.
Employee Deduction for Loss
If an employee is subjected to taxation on an amount upon vesting but is ultimately paid less than that amount (including due to investment losses), the employee may deduct the difference at the time of final payment from the plan. However, the deduction will generally be subject to limitations (such as the Schedule A limitations on miscellaneous itemized deductions).
Plans Exempt from Section 457(f)
Bona Fide Severance Pay Plans
The proposed regulations require that a severance plan meet the following parameters to qualify for the Section 457(f) exemption:
- Payment may be made only upon actual involuntary termination of employment (when the employee is otherwise able and willing to continue in service), constructive discharge (in accordance with specified safe harbor standards or other appropriate facts and circumstances), or a voluntary window program;
- Total payments do not exceed 200% of the employee's annualized compensation; and
- Payments do not extend beyond the last day of second calendar year following calendar year of employment termination.
Bona Fide Vacation Leave and Sick Leave Plans
The proposed regulations provide the following criteria for evaluating whether vacation leave and sick time plans are "bona fide," and therefore exempt from Section 457(f), or alternatively, disguised deferred compensation:
- Whether amount of leave could reasonably be expected to be used in normal course.
- The extent to which there are limits on the ability to exchange unused leave for cash.
- The amount and frequency of in-service distributions of cash.
- Whether payment for unused leave is made promptly upon termination or paid over time.
- Whether plan is broadly available or available only to certain employees.
Disability Pay Plans
The proposed regulations provide that an exempt disability pay plan is one that pays benefits only in the event of long-term disability (under one of three alternative definitions provided in the regulations).
Death Benefit Plans
The proposed regulations provide that death benefits are exempt to the extent they exceed the lifetime benefits payable under the plan.