Action Item: On June 22, 2016, the Internal Revenue Service (“IRS”) issued long-awaited proposed regulations under Section 457 of the Internal Revenue Code that could significantly impact the deferred compensation and severance arrangements of many charities, trade associations, and other tax-exempt organizations. Tax-exempt employers should review their existing employment contracts, deferred compensation agreements, and incentive compensation plans to identify potentially problematic areas.

Background—why should a tax-exempt employer care about the new Section 457 regulations?

Amounts set aside under a Section 457 eligible deferred compensation plan, which is a plan that is made available only to a limited group of management or highly-compensated employees and which provides for contributions within prescribed limits, are taxed to employees when the employees receive payment of the deferred compensation.

A number of years ago, Congress changed the tax law to provide that deferred compensation payable to an employee of a tax-exempt organization, which is not deferred under a Section 457 eligible deferred compensation plan, is taxed to the employee when the compensation vests, not when it is paid to the employee. Most legally binding promises by a tax-exempt organization to pay compensation in a future year are treated as deferred compensation. There is a narrow, but important exception, to this definition for future payments that are made no later than the 15th day of the third month of the year following the year in which the deferred compensation vests.

Among a number of other topics addressed in the proposed regulations, the IRS has set forth the requirements that must be satisfied in order to prevent severance pay and vacation or sick pay, offered by a tax-exempt organization, from being treated as deferred compensation that is taxable upon vesting.

How do the proposed regulations impact severance pay?

Although there are others exceptions (including, for example, window programs in connection with downsizings), one of the most important exceptions to the definition of deferred compensation is severance pay.

In order to qualify as severance pay, the payment must be in connection with an involuntary termination of employment that is due to the employer’s independent exercise of authority and not due to the employee’s explicit or implicit request. Importantly, the proposed regulations provide that the term involuntary termination of employment also includes resignations for “good reason” that fall within IRS benchmarks.

The proposed regulations layer on two significant additional requirements that a tax-exempt organization must meet for severance pay to avoid treatment as deferred compensation.

First, the amount of the severance pay cannot exceed two times the employee’s “annual rate of pay.” One matter not addressed by the proposed regulations is the meaning of annual rate of pay, which leaves open the question of whether bonus payments are to be taken into account in making the calculation. The second additional requirement is that the entire amount of the severance pay must be paid, pursuant to a written requirement, no later than the last day of the second calendar year following the calendar year in which the employee terminates employment.

The effect of failing to satisfy either of the additional requirements is that payments that would clearly only be made upon an involuntary termination of employment would nevertheless be treated as deferred compensation rather than severance pay, with the result that the value of the payments would be fully taxable to the employee at the time the employee’s employment terminates, without regard to the period over which the payments are to be made.

Under what circumstances will paid leave be treated as deferred compensation?

The proposed regulations state that vacation pay or sick pay may be treated as deferred compensation, if it has certain attributes. Among the factors that the IRS will consider in evaluating whether leave pay is deferred compensation are: whether the amount of leave that can be accumulated is more than could reasonably be expected to be used in the normal course, absent unusual circumstances; whether the amount of leave is broadly available to the employer’s employees; the circumstances under which an employee can carry over unused leave to subsequent years and exchange it for cash; and whether unused leave payable upon a termination of employment is payable in a lump sum or over time.

If, for example, a tax-exempt employer had an agreement with one of its officers to allow the officer to accumulate vacation pay and carry it over without limit and receive a payment of the entire amount upon a termination of employment for any reason, the risk exists that at the end of each year the IRS would treat the officer as taxable on the annual increase in the value of the accumulated vacation pay.

Is deferred compensation “vested” if it is forfeitable upon violation of a noncompete?

An issue that has long existed is to what extent the taxation of deferred compensation of an employee of a tax-exempt employer can be delayed by making the compensation forfeitable if the employee competes with the employer.

The proposed regulations set forth several factors that the IRS will take into consideration in determining whether a noncompete restriction is sufficiently consequential to make the deferred compensation that is subject to the restriction credibly forfeitable and, as such, unvested. These factors include: whether the specific restriction is legally enforceable; whether the employer makes reasonable ongoing efforts to verify the employee’s compliance with the restriction; whether the facts demonstrate that the employer has a bona fide substantial interest in preventing the employee from competing; and whether the employee has the ability to engage in the prohibited competition.

It is worth noting that the proposed regulations do not allow a delay in the taxation of deferred compensation on the basis of an agreement by an employee not to solicit customers or employees of the employer. Presumably, the IRS did not view nonsolicitation restrictions to create a sufficient risk of losing one’s deferred compensation to avoid the compensation from being viewed as vested This is especially important given the growing trend against the enforceability of covenants not to compete.

What should tax-exempt employers do now?

The regulations apply to any compensation deferred after the regulations become final, even if the deferral at that time occurs pursuant to a plan or agreement that is already in place. Accordingly, tax-exempt employers should review their existing employment contracts, deferred compensation agreements, and incentive compensation plans to identify potentially problematic areas. This review might also include an evaluation as to whether any leave arrangements are likely to run afoul of the standards in the proposed regulations that treat such arrangements as deferred compensation.

Employers, if they so choose, may rely upon the proposed regulations now. That might be helpful, for example, if a tax-exempt employer would like to use the proposed regulations’ definition of resignation for good reason to feel comfortable that an amount payable upon a resignation for good reason qualifies as severance pay.

Finally, the proposed regulations caution that “no implication is intended regarding application of the law before these proposed regulations become applicable.” This admonition serves as a reminder to a tax-exempt employer that is currently relying upon an aggressive position—such as, to take an extreme example, that a noncompete restriction applicable to a 95 year old retiree defers the timing of taxation of deferred compensation payable to the retiree—would likely have a difficult time defending that position under existing law, without regard to the proposed regulations.