Bona fide severance pay plan
Substantial risk of forfeiture
What can employers do now?
In June 2016 the Internal Revenue Service (IRS) issued comprehensive proposed regulations on the application of Section 457 of the Internal Revenue Code to certain deferred compensation plans of state and local governments and tax-exempt entities – the first official guidance to be issued since IRS Notice 2007-62.(1)
A bona fide severance pay plan is not treated as providing for the deferral of compensation and thus is not subject to Section 457.(2) The proposed regulations outline the criteria that a plan must meet in order to be a bona fide severance pay plan for the purpose of the exclusion provided by Section 457(e):
- The benefits provided under the plan must be payable only on a participant's involuntary severance from employment or pursuant to a window programme or voluntary early retirement incentive plan.
- The amount payable to a participant must not exceed two times the participant's annualised compensation based on the annual rate of pay for the calendar year preceding the calendar year in which the participant has a severance from employment, subject to certain adjustments.
- Pursuant to the plan's written terms, the severance benefits must be paid no later than the last day of the second calendar year following the calendar year in which the severance from employment occurs.
As anticipated by IRS Notice 2007-62, these criteria are analogous to those for separation pay plans under Internal Revenue Code Section 409A, which may also apply to certain plans separately and in addition to any applicable requirements under Internal Revenue Code Section 457. However, the criteria are not identical; the proposed regulations do not limit annualised compensation to the amount that may be taken into account under Internal Revenue Code Section 401(a)(17). In addition, the proposed regulations do not include exceptions for:
- collectively bargained separation pay plans;
- foreign separation pay plans and reimbursements; and
- certain other separation payments.
Substantial risk of forfeiture
Deferred compensation subject to Section 457 is generally includible in gross income under Section 457(f) on the later of:
- the date on which the employee obtains the legally binding right to the compensation; or
- if the compensation is subject to a substantial risk of forfeiture, the date on which the substantial risk of forfeiture lapses.
The proposed regulations generally provide that a substantial risk of forfeiture exists only:
- if entitlement to the deferred compensation is conditioned on the future performance of substantial services; or
- if the possibility of forfeiture is substantial, on the occurrence of a condition that relates to a purpose of the compensation.
However – subject to specific criteria – according to the proposed regulations the following arrangements may also provide for a substantial risk of forfeiture:
- a non-competition requirement;
- an initial deferral of current compensation;
- an extension of an existing substantial risk of forfeiture.
IRS Notice 2007-62 originally anticipated that some of these scenarios would not constitute a substantial risk of forfeiture. In allowing for them, the proposed regulations may also differ from the rules under Section 409A of the Internal Revenue Code, which provide, among other things, that:
- an amount is not subject to a substantial risk of forfeiture merely because it is conditioned on refraining from the performance of services; and
- an extension of a period during which compensation is subject to a substantial risk of forfeiture is disregarded when determining whether deferred compensation is subject to a substantial risk of forfeiture.
In general, the proposed regulations apply to compensation deferred under a plan for calendar years beginning after the date on which they are published in final form in the federal register. Taxpayers may rely on the proposed regulations until the applicability date, although no implication is made regarding application of the law before the applicability date. In the meantime, state and local governments and tax-exempt entities that sponsor deferred compensation plans subject to Section 457 may wish to:
- review existing plans in light of the proposed regulations and consider whether current or prospective revisions are appropriate;
- draft new plans in compliance with the proposed regulations, including provisions for the flexibility to amend the draft plans when the final regulations are issued; and
- determine whether a plan is also subject to Section 409A and, if so, how to ensure documentary and operational compliance with both regimes.
For further information on this topic please contact Joanne C Youn at Caplin & Drysdale, Chartered by telephone (+1 202 862 5000) or email ([email protected]). The Caplin & Drysdale, Chartered website can be accessed at www.caplindrysdale.com.
(1) This update follows the February 2009 client alert "Bona Fide Severance Plan and Substantial Risk of Forfeiture under Section 457".
(2) Although these criteria are similar to those under longstanding Department of Labour regulations for determining whether a severance pay plan is considered a pension plan, a distinct determination must be made for employers that are otherwise subject to Title I of the Employee Retirement Income Security Act.