Congress and the Internal Revenue Service have changed the landscape of the taxation of deferred compensation for all employers. Tax-exempt employers who offer 457(f) plans and 403(b) plans—a common practice among exempt health care industry clients—face additional requirements. Important changes are required by the end of 2008 to both deferred compensation plans (including 457(f) plans) and 403(b) plans. These changes—and the implications for both taxable and tax-exempt employers—are highlighted below.
Changes Applicable to All Employers
Deferred Compensation Arrangements. If deferred compensation programs are not designed in a manner that complies with Section 409A,1 participants in those programs are subject to income tax acceleration on deferred amounts, a 20% additional tax, as well as possible interest and penalties. Section 409A became effective in 2005, but, under transition rules, employers have until the end of 2008 to amend their deferred compensation plan documents to conform with the requirements of Section 409A. To avoid the consequences of noncompliance, deferred compensation must be provided under written arrangements that comply with Section 409A by January 1, 2009.
Under Section 409A, the definition of “deferred compensation arrangement” is extremely broad and applies to all employers—not only public or for-profit companies. Any compensation that is earned in one year but could be paid in another year could be subject to Section 409A. As a result, all compensation arrangements and agreements should be reviewed. The following are examples of the types of arrangements that should be reviewed and updated, if necessary:
- Employment Agreements
- Indemnification Agreements
- Split Dollar Life Insurance
- Consulting Agreements
- Severance Plans and Agreements
- Bonus or Incentive Plans and Agreements
- Supplemental Retirement Plans
- Transaction Bonus or Change in Control Payments (including Section 457(f) plans)
- Reimbursement Arrangements
- Gross-Up Provisions
This updating of deferred compensation arrangements may involve negotiating with executives and requesting participant consent, as well as obtaining board or compensation committee approvals. Prompt action is necessary to avoid potential adverse tax consequences.
Changes Applicable to Tax-Exempt Employers
457(f) Plans. Section 457(f)2 applies to nonqualified deferred compensation plans of tax-exempt as well as state and local government employers. Such plans that provide income deferrals above certain limits are called “ineligible” plans and are subject to Section 457(f). This includes many deferred compensation arrangements for executives of tax-exempt organizations.
Under Section 457(f), deferred amounts are includible in income in the first year in which there is no “substantial risk of forfeiture.” Some common design features of 457(f) plans, such as use of a non-compete to defer taxation past termination of employment, or other extensions of the vesting period (“rolling vesting”), may violate the requirements of Section 409A and could result in adverse tax consequences to participants in plans that maintain these features. Similarly, common “change in control” definitions in 457(f) plans may not satisfy the requirements of Section 409A.
All Section 457(f) plans should be reviewed and, if necessary, amended by December 31, 2008 either to comply with 409A or to qualify for an exemption from 409A coverage .
403(b) Plans. Organizations that are tax-exempt under Section 501(c)(3), including religious and charitable organizations, tax-exempt hospitals and public schools, often provide Section 403(b)3 plans under which employees may defer compensation into a tax-deferred annuity or mutual fund custodial account.
Internal Revenue Service regulations, which are effective beginning in 2009, impose significant additional compliance requirements on 403(b) plans. These include a written plan document, clear identification of all responsibilities for plan administration, and new rules for the administration of multiple 403(b) accounts maintained for the same individual. In some cases, the effect of these rules may be to make the 403(b) plan subject to the Employee Retirement Income Security Act of 1974 (“ERISA”), where that was previously not the case.
Any employer which offers or contributes to a 403(b) plan for employees should take immediate steps to ensure that the plan is in compliance with the new Section 403(b) regulations.