United States: Proposed 457(F) Regulations: Opportunities And Challenges

Introduction

  • Welcome and surprising opportunities with respect to tax-exempt and governmental entities' "ineligible nonqualified deferred compensation" arrangements in 2016 regulations.
  • 2016 regulations significantly expanded 457(f) plan sponsors' ability to do the following without immediate taxation to participants:

    • Permit elective deferrals
    • Use noncompetition agreement
    • Make larger severance payments than otherwise permitted under 409A
  • Presentation addresses those issues and

    • Rules and limitations of the short-term deferral exception
    • The interaction of the 2016 regulations with existing regulations under Section 409A of the Internal Revenue Code
    • Other types of arrangements potentially affected by the 2016 regulations (e.g., vacation pay, flexible allowance plans)
    • Best practices

Agenda

  • Short-Term Deferral Exception
  • Elective Deferral Feature
  • Rolling Risks of Forfeiture
  • Noncompetes and Impact on Taxation
  • Interplay between 409A and 457(f)
  • Arrangements to Monitor
  • Next steps

Short-Term Deferral Exception –New!

  • Prior to Proposed Regulations, an amount earned and vested in one year was taxable in that year – no exceptions!
  • Now, deferred compensation does not exist if it meets the "short term" deferral definition provided by Code Section 409A, but substituting the new definition of "substantial risk of forfeiture" under the Proposed Regulations for that of the Code Section 409A risk of forfeiture.
  • The service provider must actually or constructively receives such payment on or before the last day of the applicable 2½ month period
  • This means that the typical annual bonus can be fully vested in one year, but paid out and taxable early in the next year
  • "An amount of compensation is 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."
  • Proposed regulations clarify that substantial means substantial – minor amount of required services will not work!

Elective Deferral Feature

  • Elective deferrals very rare prior to 2016 regulations

    • In 2007 guidance, IRS stated: "a rational participant normally would not agree to subject a right to amounts that may be earned and payable as current compensation, such as salary payments, to a condition that subjects the right to the same payments to a real possibility of forfeiture."
    • No reason to defer receipt of compensation if taxation occurs when substantial risk of forfeiture expires
  • 2016 regulations permit elective deferrals if the following conditions are met:

    • The deferral election must be made in writing before the beginning of the calendar year in which the services will be performed and the compensation will be earned;
    • The present value of the amount to be paid when the substantial risk of forfeiture lapses must be materially greater defined as more than twenty-five percent (25%) of the amount the executive otherwise would have received absent the substantial risk of forfeiture; and
    • The executive must provide substantial services for at least two (2) additional years or must agree not to compete for at least two (2) additional years.
  • Example:

    • Hospital's CFO receives compensation of $500,000/yr. She wants to defer $200,000 of her 2018 compensation.
    • She elects to defer $200,000 by December 31, 2017 to be received in a lump sum in 2021.
    • Hospital provides a $60,000 "matching contribution", also received in 2021
  • Downside: If she terminates employment other than due to an involuntary termination without cause, death or disability, she forfeits her right to receive any portion of the payment

Rolling Risk of Forfeiture – It's Back!

  • Tips:
  • Identify initial elective deferral vs rolling risk of forfeiture
  • Keep track of dates required to "Roll"
  • 25% match is substantial – excessive compensation?
  • "Roll" as long as possible so "re-Roll" not required
  • If possible, use covenant not to compete as the risk of forfeiture. For example, at initial deferral, distribution is one year following separation from service contingent on non-compete satisfied through that date. In that case, employee can separate when ever he or she wants.
  • Question #10 of IRS Notice 2005-1 then articulated the following:

  • "...Any addition of a substantial risk of forfeiture after the beginning of the service period to which the compensation relates, or any extension of a period during which compensation is subject to a substantial risk of forfeiture, in either case whether elected by the service provider, service recipient or other person (or by agreement of two or more of such persons), is disregarded for purposes of determining whether such compensation is subject to a substantial risk of forfeiture. An amount is not subject to a substantial risk of forfeiture merely because the right to the amount is conditioned, directly or indirectly, upon the refraining from performance of services." (emphasis added)
  • Additionally, IRS Notice 2007-62 then stated:
  • "This notice announces the intent of the Treasury Department (Treasury) and the Internal Revenue Service (Service) to issue guidance under § 457, which applies to nonqualified deferred compensation plans of state and local governments and tax-exempt entities, concerning the definitions of a bona fide severance pay plan under § 457(e)(11) and concerning the definition of substantial risk of forfeiture under § 457(f)(1)(B). This notice also describes the guidance that the Treasury and the Service anticipate issuing, which in many respects would be similar to the rules in the recent final regulations under § 409A, and requests comments on the issues intended to be addressed by such guidance." (emphasis added)
  • The Proposed Regulations now clarify that noncompetes can be utilized as a substantial risk of forfeiture in the following situations:

    1. The executive's right to the compensation must be specifically conditioned in writing on the refraining from performing future services and the noncompete must be enforceable under applicable law;
    2. The tax-exempt entity must make reasonable efforts to verify the executive's compliance with the noncompete; and
    3. Regardless of any other factors, the facts and circumstances must demonstrate that the tax-exempt entity has a "bona fide interest" in ensuring that the executive is prevented from performing services and that the executive has a "bona fide interest" in his/her ability to engage in performing services.
  • Challenges

    • Developing procedures to appropriately monitor and document executive activities post-termination.
    • The "bona fide interest" requirements may pose a new challenge with respect to aging executives (e.g., may be harder to demonstrate that older executives have a legitimate interest in continuing to work or have a true financial need to work). These criteria will be evaluated from both the executive's viewpoint and the tax-exempt entities' viewpoint.
    • Solution: Since many executives receiving severance pay are likely subject to noncompetition restrictions anyway, the tax-exempt entity can piggyback off of these prior procedures, but strengthen them for Code Section 457(f) compliance purposes. Periodic written verification from the executives will be critical, but independent monitoring by the tax-exempt entity beyond this will likely be necessary as proof of reasonable efforts (e.g., monitoring Facebook pages, Google searches, etc.).
  • Opportunity Presented

    • Ability to continue tax deferral post-termination is viewed as valuable by many executives (notwithstanding that they are an unsecured creditor of the tax- exempt entity).
    • Further, nonpayment of deferred amounts for violation of the noncompete does provide significant leverage for the tax-exempt entity. Because the substantial risk of forfeiture will not lapse until the end of the noncompetition period, it offers a significant reprieve period following an executive's departure.
    • Potentially provide longer deferral periods versus time-based vesting currently being used.

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Proposed 457(F) Regulations: Opportunities And Challenges

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