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Proposed Section 457(f) Regulations

As part of the American Jobs Creation Act of 2004, a new Section 409A was added to the Internal Revenue Code.  Section 409A generally provides that, unless certain requirements are met, amounts deferred under a nonqualified deferred compensation plan for all taxable years are currently includible in gross income to the extent not subject to a substantial risk of forfeiture.

While much of the focus on Section 409A has been with respect to taxable employers, it was recognized that there was an intersection of the standards articulated in Section 409A with the existing provisions under Section 457(f) which specifically covers ineligible (i.e., not subject to Section 457(b)) nonqualified deferred compensation arrangements of tax exempt employers.

For example, both Section 409A and Section 457(f) use the concept of “substantial risk of forfeiture” in terms of determining when income is to be recognized and both sections have specific rules regarding the treatment of severance payments.

On June 22, 2016, the IRS issued the long awaited proposed regulations under Internal Revenue Code Section 457(f) (the “Section 457(f) Proposed Regulations”) which provides some guidance in reconciling these two sections.  While a comprehensive summary of the proposed regulations will be posted to our website in the future, here are five immediate takeaways to keep in mind:

  1. The definition of “Substantial Risk of Forfeiture” under the Section 457(f) Proposed Regulations generally follows the definition under Section 409A (and the regulations under that section) but provides additional flexibility in connection with non-compete arrangements and extensions of a substantial risk of forfeiture (commonly referred to as a “rolling risk of forfeiture”).  Of course, in California, non-compete arrangements are only enforceable in limited circumstances so for most tax exempt employers (and employees), this additional flexibility will not be available.
  2. Severance pay plans will be exempt from Section 457(f) if they follow requirements similar to those specified in the Section 409A regulations. The one important departure point from the Section 409A regulations is that the amount under the Section 457(f) Proposed Regulations payable to an employee under the plan or arrangement must not exceed two times the employee’s annualized compensation, whereas the limit under Section 409A is the lesser of two times the employee’s annualized compensation or two times the qualified plan compensation limit for the year of termination ($265,000 X 2 = $530,000 for 2016).
  3. Short term deferrals are taxed in the year of payment. Under Section 409A, amounts that are paid to an employee within 2 ½ months after the end of the employer’s taxable year are not treated as deferred compensation subject to Section 409A (the result of this is that the compensation is treated as income to the employee in the year of payment).  Under Section 457(f), compensation is treated as income when it vests (i.e., is no longer subject to a substantial risk of forfeiture).  Thus, there was an open question as to what year to include compensation if, for example, a tax exempt employee was vested in the amount on 12/31, but was not paid out until 3/15 of the following year.   The Section 457(f) Proposed Regulations settle this question by providing that amounts paid by 3/15 should be considered taxable in the year of payment, even though they may have vested in the prior taxable year.
  4. The Section 457(f) Proposed Regulations also contain guidance on the present value calculation for amounts that are vesting under Section 457(f). There are a number of nuances in these calculations and some of the techniques previously used to maximize benefits under Section 457(f) and 409A (specifically, deferred investment gains on vested account balances that are subject to 409A time and form of payment rules) may not be as advantageous.
  5. Besides the severance pay plan exemption mentioned above, the Section 457(f) Proposed Regulations also provide guidance for other arrangements exempt from Section 457(f), such as disability pay plans, death benefits and sick and vacation benefits.

As presently drafted, the Section 457(f) Proposed Regulations do not grandfather existing arrangements and would thus arguably apply both on a prospective and retroactive basis.  Whether the final regulations continue with this approach remains to be seen.

Posted in Tax Laws.