Flexibility Offered for Deferred Compensation Plans of Tax-Exempt Organizations, Government Agencies

Ballard Spahr LLP

The U.S. Treasury Department has issued two sets of proposed regulations, under Sections 457 and 409A of the Internal Revenue Code, relating to deferred compensation plans of state and local governments and tax-exempt organizations such as health systems, universities, foundations and other nonprofit entities.

Over the past decade, we have seen the federal government tighten the restrictions on deferred compensation, primarily with the enactment of Section 409A of the Internal Revenue Code. In 2007, the IRS announced that Treasury would be proposing regulations to further restrict the deferred compensation plans that could be offered to employees of state and local governments and tax-exempt organizations. Nine years later, Treasury has proposed those regulations, but they unexpectedly provide (or preserve) some flexibility for government and tax-exempt employers.

In general, deferred compensation provided to employees of state and local governments and tax-exempt organizations is subject to taxation under Section 457(f) (unless provided through a "qualified" plan under Section 401(a), 403(b) or 457(b)). Under Section 457(f), deferred compensation is taxable to the employee when it is no longer subject to a substantial risk of forfeiture (SRF) (i.e., it becomes vested). This is very different from the deferred compensation rules applicable to for-profit entities, where deferred compensation is subject to taxation only when it is actually or constructively received, even though it may have become vested at an earlier date.

Highlights of the new proposed regulations include the following:

  • A non-compete provision can continue to be an SRF (notwithstanding the 2007 IRS announcement that suggested otherwise) if the following conditions are satisfied: receipt of the compensation must be expressly conditioned on the employee refraining from future services pursuant to a written non-compete agreement enforceable under applicable law; the employer must consistently make reasonable efforts to verify compliance with all non-compete agreements to which it is a party; and the facts and circumstances must show that the employer has a substantial and bona fide interest in preventing the employee from performing the services and that the employee has a bona fide interest in engaging, and an ability to engage, in the prohibited services.
  • "Rolling" vesting is still permitted, subject to certain conditions. The period for which a deferred compensation amount is deferred may be extended if the present value of the deferred compensation is materially greater (125 percent or more) than the value due upon the original lapse of the SRF; the extended SRF must be based on the future performance of substantial services or adherence to a non-compete agreement (it cannot be based solely on a condition related to the purpose of the compensation); the SRF must be extended for at least an additional two years; and the extension must be made in writing at least 90 days in advance of the lapse of the original SRF.
  • Section 457(b) plans maintained by state and local government entities may include Roth contribution features.
  • Bona fide severance plans, which are exempt from the Section 457(f) deferred compensation rules, are defined in a manner similar to separation pay plans under section 409A. In general, severance will be exempt from Section 457(f) if it is payable only upon an involuntary severance from employment (or upon a voluntary termination for "good reason" or a window program), it is limited to no more than two times the employee's annualized compensation, and all payments are made by the end of the second calendar year following the year in which the severance from employment occurs.
  • Guidance is provided in defining bona fide vacation and sick leave plans, which are exempt from the Section 457(f) deferred compensation rules. In general, a vacation or sick leave program will be exempt from Section 457(f) if the amount of leave can reasonably be expected to be used by the individual during employment; there are reasonable limits on accruals and the ability to exchange accumulated leave for cash or taxable benefits; there are limits on the amount and frequency of in-service distributions of cash in exchange for accumulated leave; and the program is provided to a broad-base of employees.

Treasury has requested comments on all aspects of the proposed section 457 regulations (and the corresponding section 409A regulations). A public hearing on the proposed section 457 regulations is scheduled for October 18, 2016.

All state and local government employers, and all tax-exempt employers, should review their deferred compensation, severance, and paid-time off arrangements in light of the new proposed regulations. Some adjustments to the arrangements may be needed to maintain compliance, but there also may be opportunities to take advantage of the unexpected flexibility contained in the proposed regulations.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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