Proposed Regulations Create (Some) Executive Compensation Design Opportunities for Tax-Exempt Employers
It has been a long time coming (nine years to be exact), but the Treasury Department has at last published proposed regulations that harmonize important concepts governing deferred compensation arrangements under Code Section 409A and Code Section 457. The proposed regulations contain no major surprises that would shake up the world of deferred compensation for tax-exempt employers. But the proposed regulations do provide important new rules under Code Section 457 that: (1) explain the meaning of "substantial risk of forfeiture"; (2) develop existing regulations regarding plans that are not subject to Code Section 457; and (3) help calculate amounts to be included in income under the Code Section 457 tax regime. The new proposed regulations provide greater clarity regarding these important concepts and can be said to offer new opportunities to tax-exempt employers in designing certain types of executive compensation arrangements (or perhaps, more accurately, resurrect design elements that have fallen into disuse).
Code Section 457 governs the nonqualified deferred compensation plans of state and local governments, as well as tax-exempt employers (other than churches). Code Section 457 divides such plans into two categories. "Eligible" plans, those that meet the requirements of Code Section 457(b) – which limits annual contributions and provides rules regarding the timing of deferral elections and benefit distributions – enjoy favorable income tax treatment, including an exemption from the restrictions of Code Section 409A. Deferred compensation plans that do not meet those requirements (referred to as "ineligible" plans) are taxed under the somewhat more restrictive regime of Code Section 457(f) explained below. Certain types of welfare benefit type plans and programs are exempt from Code Section 457, including "bona fide" severance pay, sick pay, and vacation pay plans. The new proposed regulations focus on Section 457(f) deferred compensation plans and exempt plans.
Substantial Risk of Forfeiture Clarified
Compensation deferred under a Code Section 457(f) arrangement is included in the income of the employee in the first year in which it ceases to be subject to a substantial risk of forfeiture. (Compensation that is never subject to a substantial risk of forfeiture is includable in income immediately when the employee gains a legally binding right to the compensation.) The concept of substantial risk of forfeiture has always been at the heart of Code Section 457(f) income tax regime and proposed regulations provide helpful guidance in determining the meaning and application of the term.
Code Section 457(f)(3) states that a person's right to compensation is subject to a substantial risk of forfeiture if his or her right to receive the compensation is "conditioned upon the future performance of substantial services." The proposed regulations expand upon that simple statement in ways that are generally consistent with the regulations under Code Section 409A. The proposed rules provide that a substantial risk of forfeiture exists only if "entitlement to the amount is conditioned on the future performance of substantial services, or the occurrence of a condition that is related to a purpose of the compensation if the possibility of forfeiture is substantial." Whether an amount is "conditioned on the future performance of substantial services" is determined based on all the relevant facts and circumstances. And whether a condition is "related to a purpose of the compensation" is determined by assessing the linkage to the employee's performance of services as well as the achievement of the employer's tax-exempt purpose and organizational goals (and only if the likelihood that the forfeiture will occur is substantial). The proposed regulations confirm that if a payment of compensation is conditioned upon an involuntary severance from employment without cause such a condition will be considered a substantial risk of forfeiture (if the possibility of forfeiture is substantial).
The proposed regulations depart from the Code Section 409A approach, however, by approving the use of covenants not to compete as a risk of forfeiture device, albeit in a highly restrictive manner. The use of non-competes to defer the taxation of compensation under Code Section 457(f) has for years been a source of controversy for practitioners, and most have shied away from that approach since the IRS announcement (in 2007) that regulations under Code Section 457 would likely follow the approach taken under Code Section 409A, which expressly rejects the use of non-competes to defer the taxation of compensation.
Under the proposed regulations, compensation that is to be paid only upon compliance with a non-compete can be considered subject to a substantial risk of forfeiture if three important requirements are satisfied:
- The right must be expressly conditioned upon compliance of a noncompete and must be contained in a written agreement that is enforceable under applicable law;
- The employer must consistently make reasonable efforts to verify compliance with the noncompete; and
- Facts and circumstances must show both that the employer has a substantial interest in preventing the employee from providing competing services and that the employee has the ability to and a substantial interest in engaging in competition by providing the prohibited services.
These requirements may be too restrictive to have broad appeal among tax-exempt employers, but when presented with the right fact pattern (e.g., a supplemental retirement program for a highly prized athletic coach, professor, physician, development officer, or investment officer) the use of a properly designed non-compete could provide a valuable new feature for deferred compensation arrangements.
Another area that has often vexed professionals working in the area has been the efficacy of "rolling vesting" structures, which have historically been viewed with disfavor by the IRS. A rolling vesting feature gives an employee the right to agree to voluntarily extend the risk of forfeiture applicable to deferred compensation and thereby extend the taxation date. For those who have shied away from rolling risk of forfeiture arrangements, the new proposed regulations may offer some (and only some) comfort. The proposed regulations would allow for a rolling risk of forfeiture feature if the following conditions are met:
- The new deferral, more accurately the amount subject to the new risk of forfeiture, must be materially greater than (i.e., having a present value that is at least 125% of) the amount that would have been vested prior to the application of the new forfeiture risk;
- The period during which the new risk of forfeiture must apply must be at least two years later than the original vesting date was scheduled to lapse; and
- The agreement allowing for the risk of forfeiture must be in place prior to the beginning of the year in which the services are rendered and the agreement extending the risk of forfeiture must be made at least 90 days before the current risk of forfeiture was scheduled to lapse. (For those practitioners who were comfortable with rolling risks of forfeiture, the common practice was to require that the election to extend the risk could be made at least a year and a day before the end of the current vesting period.)
The guidance regarding effective non-competes and rolling vesting opens narrow pathways to new design opportunities for tax-exempt employers who can meet the strict requirements set out in the proposed regulations.
Application of Short-Term Deferral Exception Under Section 457(f)
One of the most important and widely used exceptions under Code Section 409A is the "short-term deferral" exception. Under the short-term deferral exception, compensation is not considered deferred if the amount is paid to the employee on or before the later of (a) the 15th day of the third calendar month following the employee's first taxable year in which the right to payment is no longer subject to a substantial risk of forfeiture (e.g., March 15 of the following calendar year), or (b) the 15th day of the third month following the end of the employer's first taxable year in which the amount is no longer subject to a substantial risk of forfeiture. The proposed regulations confirm that the same concept will apply under Code Section 457(f), such that compensation that would qualify for the short-term deferral exception under Code Section 409A will not be considered a deferral of compensation under Code Section 457(f). As noted above, however, the definition of substantial risk of forfeiture under the proposed regulations is broader than that under Code Section 409A so the reverse may not be true. In other words, an amount that is considered a short-term deferral for purposes of Code Section 457(f) may not necessarily be eligible for the short-term deferral exception under Code Section 409A. While the availability of the short term deferral exception under Code Section 457(f) is helpful, it may not as a practical matter alter the design of deferred compensation programs for executives and tax-exempt organizations. The conservative design approach for many years has called for a payment of vested deferred compensation within 30 or at most 60 days after the occurrence of the vesting event. The proposed regulations are unlikely to significantly alter this approach.
Confirmation of Exceptions under Code Section 457(f)
The proposed regulations provide helpful guidance regarding the types of arrangements that are not subject to the restrictions of Code Section 457, including Code Section 457(f). Specifically, the proposed regulations include rules for determining whether a plan constitutes a bona fide death benefit plan, a bona fide disability pay plan, or a bona fide sick leave and vacation leave plan, all of which historically have been exempt under Code Section 457(f) but now benefit from greater clarity. Perhaps most importantly the proposed regulations provide useful guidance with respect to the treatment of bona fide severance pay plans, which, in general, aligns with the "separation pay plan" exception under Code Section 409A. Specifically, an arrangement that meets the following requirements will be considered a bona fide severance pay plan for purposes of Code Section 457:
- Benefits provided under the arrangement must be payable only upon a participant's involuntary severance from employment, pursuant to a window program, or pursuant to a voluntary early retirement incentive plan;
- The amount payable must not exceed two times the participant's annualized compensation, determined based on the employee's annual rate of pay for the year preceding the year in which severance occurred or for the current calendar year if the employee had no compensation during the preceding year (note that this exception is broader than the Code Section 409A exception because it is not subject to the maximum dollar limit applicable under the separation pay exception under Code Section 409A); and
- The severance benefits must be paid no later than the last day of the second calendar year following the calendar year in which the severance from employment occurs.
The proposed regulations confirm that an involuntary severance from employment will include a severance for "good reason" provided that the conditions for good reason termination are specified in advance in writing. The proposed regulations provide a safe harbor definition of "good reason" that is substantially similar to the safe harbor under Code Section 409A and that includes such important conditions as a material diminution in the employee's base compensation, authority, duties, or responsibility, a material diminution in the budget over which the employee has authority, a material change in the geographic location in which the employee must provide services, or any other action or omission that constitutes a material breach by the employer of the terms of an agreement to which the employee is subject. In addition, consistent with the general rules under Code Section 409A, the good reason safe harbor requires that severance from employment occur within a period of no longer than two years after the initial existence of the good reason condition, the amount, time, and form of payment must be the same as the amount, time and form of payment that would have occurred under a true and voluntary severance from employment, and the employee must give written notice to the employer of the condition giving rise to good reason within 90 days after the initial existence of the condition and the employer must have at least 30 days to remedy the condition.
Window programs and voluntary early retirement incentive plans can be considered bona fide severance pay plans so long as they meet applicable requirements. Consistent with current regulations, a window program will generally be treated as a bona fide severance pay plan if it provides separation pay in connection with a severance from employment that is often for a limited period of time (generally not longer than 12 months). A voluntary early retirement incentive plan will be treated as a bona fide severance pay plan solely with respect to the additional payments or benefits that are provided in coordination with a tax qualified defined benefit plan.
Determining the Amount Included in Income
Under Code Section 457(f) the amount of deferred compensation includable in income is equal to the present value of the amount of compensation deferred plus earnings. The proposed regulations provide guidance for the determination of the present value of compensation to be included in income. While these rules are generally consistent with the analogous provisions under Code Section 409A, it is important to note that the amount to be included under Code Section 457(f) is determined as of the date on which the amount becomes subject to tax. Conversely, the calculation date applicable under Code Section 409A is the end of the service provider's taxable year. The proposed regulations also contain guidance for determining the amounts subject to tax both for account and nonaccount based plans as well as reimbursement arrangements and split dollar life insurance programs.
Effective Dates and Action Items
Although the new rules will not officially take effect until the first calendar year after the date on which the final regulations are published, taxpayers may generally rely on the proposed regulations until publication of the final regulations. Comments on the proposed regulations are due later this summer and hearings are scheduled for September. At this point no one is expecting substantial changes to these rules before they are finalized.
With that in mind, tax-exempt employers should begin to review existing deferred compensation arrangements to ensure that documents and administrative procedures are consistent with the requirements of the new proposed regulations. Tax-exempt employers should also consider the design opportunities presented by the new proposed regulations. In particular, in appropriate cases, tax-exempt employers may find it useful to reconsider the application of rolling vesting or noncompete provisions in the case of deferred compensation arrangements for certain key executives where the facts and circumstances requirements support the application of those features.