IRS Issues Regulations Affecting Compensation Arrangements at Tax-Exempt Organizations

by McDermott Will & Emery
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On June 21, the IRS issued long awaited proposed regulations under Section 457 of the Internal Revenue Code that affect a broad range of compensation arrangements at tax exempt organizations. If a compensation arrangement is subject to Section 457(f), the employee is immediately taxed upon earning a vested right to receive “deferred compensation” that might not be paid until years later. These regulations address important issues under Section 457(f) that were identified by the IRS back in 2007, including whether severance pay is subject to Section 457(f), if changes to a vesting schedule could delay when deferred compensation is taxable and if covenants not to compete would be respected as bona fide vesting conditions.

A severance pay arrangement will be treated as deferred compensation under Section 457(f) under the proposed regulations unless (1) the total amount of severance pay is limited to two times total annual compensation; (2) payments are completed within two full calendar years following termination of employment; and (3) the events triggering the right to severance pay are limited to a bona fide involuntary termination, which may include certain types of “good reason” terminations of employment by an employee and failure to renew an employment agreement.

There have been questions as to whether vesting conditions imposed after a compensation arrangement has been established will be respected for tax purposes. In that event, the time for income taxation under Section 457(f) is delayed until the new vesting requirement is met. If certain requirements are met, the proposed regulations provide that additional vesting conditions will be taken into account when determining the time of taxation under Section 457. These conditions include that the deferred amount subject to a new vesting date has to be more than 25 percent greater than the old amount with the former vesting date, the delay in vesting has to be at least two years (except in the case of death, disability or a qualifying involuntary termination), and the change in vesting is entered into sufficiently in advance of the original vesting date under special timing rules.

The proposed regulations also allow for noncompetes to be used as vesting conditions under Section 457(f), but only if:

  • The right to payment is expressly conditioned on satisfying the noncompete;
  • The noncompete has to be evidenced by an enforceable written agreement between the employer and employee;
  • The employer has to make reasonable ongoing efforts to verify compliance with the noncompete;
  • When the noncompete agreement becomes binding, the facts and circumstances have to show that both the ability to compete and the harm of competition are genuine and substantial;
  • The noncompete must be enforceable under applicable law; and
  • The employer must show that the likelihood of enforcement of the noncompete is substantial.

There had been concern that the IRS might not allow any form of noncompete to be a substantial risk of forfeiture under Section 457(f).

These regulations are generally scheduled to go into effect as of January 1 of the calendar year after being finalized. These rule changes under Section 457(f) will affect amounts deferred amounts in earlier years that were not taxed before the Section 457(f) effective date. The IRS has stated that no implication is intended regarding the proper interpretation of Section 457(f) for prior periods. The IRS will be accepting comments on the proposed regulations until early this fall. Taxpayers may rely on these proposed regulations until the applicability date—doing so is likely to be an appropriate compliance approach in many situations.

Click here for a copy of the Section 457 proposed regulation. We will be issuing a detailed review of these regulations. In the meantime, please contact one of the authors or your regular McDermott Will & Emery lawyer if you have questions about the Section 457 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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