Deferred compensation arrangements that are not “tax-favored” retirement plans under Code Sections 401(a), 403(b), or (in the case of a governmental employer) 457(b) are generally referred to as “nonqualified” plans. So long as a nonqualified plan is “unfunded” (meaning the amounts deferred remain the property of the employer, and subject to the employer’s general creditors, until paid), the amounts deferred are generally not taxable until they are “paid or otherwise made available” to the employee. This principle of taxation is sometimes referred to as the doctrine of constructive receipt, since the amounts deferred become taxable only when they are actually or “constructively” received by the employee.
However, in a major trap for the unwary, nonqualified deferred compensation arrangements of both state/local governments and tax-exempt organizations are subject to more restrictive rules under Code Section 457(f). Under those rules, unless the plan in question qualifies as an “eligible” 457(b) plan (where deferrals are limited to $18,000 per year, and distributions cannot be made prior to age 70½ or severance from employment), the amounts deferred are taxable when the participant’s right to payment of the compensation is no longer subject to a “substantial risk of forfeiture.” Therefore, for any arrangement subject to this provision, compensation that is no longer subject to a substantial risk of forfeiture (or that never was subject to forfeiture) is immediately taxable, even if the participant does not have actual (or constructive) receipt of the compensation.
Code Section 457(f)(3) provides that compensation is subject to a substantial risk of forfeiture if the employee’s rights to such compensation are conditioned upon the future performance of substantial services. The only regulations under Code Section 457(f), which were published in July of 2003, do not provide any additional detail on what constitutes a substantial risk of forfeiture. However, the IRS has for several decades issued private letter rulings holding that a “substantial risk of forfeiture” for purposes of Section 457(f) is essentially the same as a “risk of forfeiture” under Section 83 (dealing with the transfer of property in exchange for services). Under the Section 83 regulations, a substantial risk of forfeiture exists only if rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or upon the occurrence of a condition related to a purpose of the transfer if the possibility of forfeiture is substantial. Thus, under Section 83 (and presumably Section 457(f)), amounts deferred have been considered subject to forfeiture if the individual’s right to the amount is contingent on a promise not to compete, or is contingent on the performance of the individual or the company.
However, in 2009, Code Section 409A added an additional layer of regulation for nonqualified plans (limiting payment to certain specified “distributable events,” and generally prohibiting any acceleration of, or delay in, the payment of deferred compensation). Failure to comply with the requirements of 409A (in either form or operation) results in early taxation of amounts deferred, a 20% tax penalty, and an additional interest penalty. The amount includible in income (if there is a 409A violation in a given year) is the excess of (i) the total amount deferred under the arrangement, over (ii) the portion of that amount, if any, that is either subject to a substantial risk of forfeiture or has been previously included in income. However, Code Section 409A includes a more restrictive definition of “substantial risk of forfeiture” than the definition under Section 83. In particular, the 409A definition does not recognize forfeiture risks that are contingent on agreements not to compete, and does not recognize extensions of the forfeiture period. In addition, the 409A regulations do not recognize a risk of forfeiture where the participant makes “elective” deferrals of current compensation.
In 2007, the IRS issued guidance (Notice 2007-62) indicating its “intent” to conform the definition of “substantial risk of forfeiture” under Section 457(f) to the definition set forth in Code Section 409A. So, for almost 9 years, governmental and tax-exempt employers (and their advisors) have had to deal with uncertainty regarding what constitutes a “substantial risk of forfeiture” for purposes of Section 457(f), and therefore when amounts deferred under such arrangements are actually taxable.
On June 21, 2016, the IRS issued proposed regulations that address how Section 457(f) nonqualified deferred compensation plans of governmental and tax-exempt employers are taxed. The proposed regulations clarify when deferred amounts are includible in income, and the actual amount to be included in income (when the risk of forfeiture lapses). They also address the interaction between Code Sections 457(f) and 409A. Fortunately, the proposed rules are not as restrictive as they could have been (based on the “intent” expressed in Notice 2007-62), as some of the rules are identical to the rules that apply under Section 409A, while others are slightly different. For example, the definition of “substantial risk of forfeiture” under the proposed 457(f) regulation is not identical to the definition under Code Section 409A. The proposed rules (which will not be effective until the first calendar year that begins after they are finalized, but which taxpayers may rely on before that date) provide that:
- The definition of “deferral of compensation” is basically the same as under Code Section 409A (i.e., a legally binding right during a taxable year to compensation that, pursuant to the terms of the plan, is or may be payable in a later taxable year).
- A “substantial risk of forfeiture” for purposes of Section 457(f) means that the participant’s entitlement to the amount deferred is either:
- Conditioned on the performance of substantial future services;
- Conditioned on the occurrence of a condition related to a purpose of the compensation, if the possibility of forfeiture is substantial; or
- In limited circumstances, subject to an agreement not to compete. (Note: the 409A definition of “risk of forfeiture” does not include this option.)
- A “short-term” deferral (which is exempt from 457(f)) is defined in the same manner as a “short-term deferral” under Code Section 409A, except that it uses the 457(f) definition of “substantial risk of forfeiture.”
- “Bona fide” severance pay plans (which are also exempt from 457(f)) are defined in a manner that is similar, but not identical, to the definition of “separation pay” plan under Code Section 409A.
- “Involuntary” termination of employment (which can be an early payment event without voiding an otherwise substantial risk of forfeiture) also includes voluntary termination for “good reason,” where “good reason” is defined in a manner that is similar, but not identical, to the definition under Code Section 409A.
- Even though deferrals at the election of the participant are never considered to be subject to forfeiture under Code Section 409A, such elective deferrals may be treated as subject to a substantial risk of forfeiture under Section 457(f), but only if several requirements are satisfied, including the requirement that the present value of the amount payable upon the lapse of the risk of forfeiture must be “materially” (at least 25%) greater than the amount the employee would otherwise be paid but for the election to defer. In addition, the deferred compensation cannot be conditioned on the occurrence of a condition related to a purpose of the compensation (i.e., it must generally be conditioned on an agreement to perform at least two years of future services).
- In order for a non-compete agreement to constitute a substantial risk of forfeiture, the agreement must be in writing and enforceable under applicable law, the employer must make reasonable efforts to verify compliance with all non-compete agreements to which it is a party, and the employer must have a substantial, bona fide interest in preventing the employee from competing. In addition, the employee must have a bona fide interest in engaging (and the ability to engage) in the prohibited activity.
These rules, once finalized, will provide much-needed clarity to governmental and tax-exempt employers as they enter into employment agreements, bonus arrangements, and incentive compensation plans with their executives and other key employees. The ability to defer taxation on compensation that is contingent on the employee’s agreement not to compete is particularly helpful, as is the clarification on the types of arrangements (such as short-term deferrals and bona-fide severance pay plans) that are exempt from Code Section 457(f). The IRS has scheduled a public hearing on the proposed regulations for October 18, 2016. Given the date of the hearing, it is likely that the regulations will not be finalized until 2017, and therefore will not be fully effective until 2018. However, as noted above, taxpayers are entitled to rely on the proposed rules until the applicability date.