IRS Issues Proposed Regulations Under Code Section 457(f)
Considerations for Tax-Exempt Organizations
In June 2016, the IRS issued long-awaited proposed regulations under Section 457(f) of the Internal Revenue Code of 1986, as amended. While the proposed regulations will generally apply to compensation deferred under a plan for calendar years beginning after the date of publication of the final regulations, taxpayers may rely on the proposed regulations until finalized. The proposed regulations contain some anticipated provisions as well as some favorable departures from what the IRS originally indicated would be included, thus presenting some planning opportunities for tax-exempt organizations that sponsor these plans. Of course, employers need to keep in mind the rules under Code Section 409A that also apply to deferred compensation plans, and the proposed regulations that the IRS issued to better coordinate Code Section 409A with Code Section 457(f).
Substantial Risk of Forfeiture
By way of brief background, Code Section 457(f) plans are generally referred to as “ineligible plans” where the amounts deferred are subject to tax when they are no longer subject to a substantial risk of forfeiture, regardless of when paid. The proposed regulations provide that an amount is generally subject to a substantial risk of forfeiture only if entitlement to the amount is conditioned on the future performance of substantial services, or upon the occurrence of a condition that is related to a purpose of the compensation if the possibility of forfeiture is substantial. This definition is similar to the definition under Code Section 409A. Whether an amount is conditioned on the future performance of substantial services is based on all of the relevant facts and circumstances, an amount is not subject to a substantial risk of forfeiture if the facts and circumstances indicate that the forfeiture condition is unlikely to be enforced. Further, a condition is related to a purpose of the compensation only if the condition relates to the employee's performance of services for the employer or to the employer's tax exempt activities or organizational goals.
“Short-term deferrals” are not subject to Section 457(f)
The proposed 457(f) regulations adopt the “short-term deferral exception” concept from Code Section 409A. Under the proposed regulations, a deferral of compensation does not occur (and therefore the compensation is not subject to Section 457(f)), if certain conditions are met: that the compensation is required to be paid and is actually or constructively paid on or before the 15th day of the third month following the end of the employee’s or the employer’s tax year (whichever is later) in which the employee’s right to the payment is no longer subject to a substantial risk of forfeiture.
Covenants Not to Compete May be Used to Create a Substantial Risk of Forfeiture
There has been uncertainty as to whether noncompete provisions provide a substantial risk of forfeiture under Code Section 457(f) (they do not provide a substantial risk of forfeiture under Code Section 409A). The proposed regulations set forth the following parameters for covenants not to compete:
- The right to the payment must be expressly conditioned on the employee refraining from performing future services pursuant to an enforceable written agreement. (Note that this requirement likely will be difficult to satisfy in states where noncompetition agreements are unenforceable.)
- The employer must make reasonable ongoing efforts to verify compliance with all of the noncompetition agreements to which it is a party.
- At the time that the noncompete becomes binding, the facts and circumstances must show: (a) the employer has a substantial and bona fide interest in preventing the employee from performing the prohibited services; and (b) the employee has a bona fide interest in engaging, and ability to engage, in the prohibited services.
A Substantial Risk of Forfeiture May be Applied to Elective Deferrals of Current Compensation
Rules similar to those regarding rolling risks of forfeiture apply to initial deferrals of compensation. Differences include, for example, the scenario where an employee makes a salary deferral election, in which case the deferred benefit must be materially greater than the amount of compensation that would otherwise have been paid (e.g., pursuant to an employer match) and must be conditioned upon the future performance of substantial services or being bound by a noncompetition agreement. Further, payment must be deferred (generally) for at least two years. This will require tracking deferrals of periodic payroll amounts, individually. Finally, the written deferral agreement must be entered into before the beginning of the calendar year in which any services that give rise to the compensation are performed, or 30 days after commencement of employment, in the case of new employees.
A Rolling Risk of Forfeiture Feature May be Used to Add to or Extend a Substantial Risk of Forfeiture
The proposed regulations address so-called “rolling risks of forfeiture”. According to the proposed regulations, additional deferrals or extensions based on substantial risks of forfeiture must satisfy all of the following requirements:
- The present value of the amount subject to the additional or extended substantial risk of forfeiture must be more than 125% of the present value of the amount that the participant would have received absent the additional/extended risk of forfeiture.
- The employee must be required to perform substantial services in the future, or refrain pursuant to a noncompete agreement, for a minimum of two years after the date that the employee would have received compensation.
- The parties must agree in writing to any addition or extension of substantial risks of forfeiture. An initial addition must be entered into before the beginning of the calendar year. An extension must (generally) be entered into at least 90 days before an existing risk of forfeiture would have lapsed.
457(f) plans will have a new set of rules that define income inclusion based on a present value calculation that is similar to the rule proposed under Section 409A. Present value for 457(f) purposes will be determined according to the “applicable date” which is defined as the later of
- The first date on which there is a legally binding right to the compensation; or
- The first date on which the substantial risk of forfeiture lapses.
By comparison, the present value calculation under Code Section 409A is determined according to the end of the participant’s taxable year.
The proposed regulations have been long-awaited and provide clarification on several fronts. Employers should inventory their current plans and consider the impact of the proposed regulations on those plans and planning opportunities for the future.