For many years, the IRS has promised to issue regulations for Sec. 457(f) plans, largely because taxpayers and practitioners sorely needed detailed guidance addressing certain issues. Finally, the IRS issued proposed regulations (REG-147196-07) in June 2016, and they provide helpful guidance and even some welcome news. The regulations are effective for calendar years beginning after the date the IRS publishes final regulations, but taxpayers may rely on the proposed regulations in the interim.
A Sec. 457(f) plan is a deferred compensation plan sponsored by a state or local government or by a tax-exempt entity. The rules regarding Sec. 457(f) plans get a lot of attention because an employee's benefits are subject to income tax upon vesting, even if they are paid later, a situation that usually is viewed as unfavorable. Employers and employees that do not realize they have a Sec. 457(f) plan or do not realize that the amounts have vested and are therefore currently taxable can be in for a shock. Besides taxes on the vested amounts, employees can be subject to interest and penalties for not paying the taxes on time.
This item provides background information on Sec. 457(f) plans and highlights certain aspects of the proposed regulations that have received considerable attention. Those aspects are guidance on exemptions from Sec. 457(f) and on when an employee becomes vested in a Sec. 457(f) plan.
As noted earlier, a Sec. 457(f) plan is a deferred compensation plan. The proposed regulations define deferred compensation as an arrangement under which "the participant has a legally binding right during a calendar year to compensation that, pursuant to the terms of the plan, is or may be payable to (or on behalf of) the participant in a later calendar year" (Prop. Regs. Sec. 1.457-12(d)(1)(i)). Many types of arrangements fall within this definition, but not all of them are Sec. 457(f) plans.
The rules specifically exempt certain arrangements from treatment as a Sec. 457(f) plan, and then treat as a Sec. 457(f) plan any arrangement that falls within the definition of deferred compensation that is not specifically exempt. In other words, Sec. 457(f) is the default. Benefits under exempt arrangements are not subject to income tax until the benefits are paid. A Sec. 457(f) plan is the only plan under which the benefits are subject to income tax upon vesting, even if they are not paid out at that time.
Exempt arrangements include qualified retirement plans such as defined benefit and Sec. 401(k) plans. Exempt arrangements also include Sec. 403(b) plans and Sec. 457(b) plans. These plans are easy to identify because a written plan document states their type. They can also be identified by specific characteristics. For example, a Sec. 457(b) plan imposes an annual contribution limit (for 2017, $18,000, plus a $6,000 catch-up contribution for governmental employees age 50 or older). Sec. 457(f) plans, in contrast, have no contribution limits or distribution restrictions.
The proposed regulations bring good news by adding new exemptions and clarifying certain existing ones. The exemptions now include "short-term deferrals," vacation leave, sick leave, severance pay, disability pay, death benefit plans, and some additional, narrower exemptions. The exemptions in the proposed regulations that have received the most attention are short-term deferrals and severance pay.
The short-term deferral exemption is a welcome addition. Under it, an arrangement is exempt from Sec. 457(f) as long as the amounts under the arrangement are not paid under any circumstances later than the 15th day of the third calendar month following the later of the end of (1) the calendar year in which vesting occurs or (2) the employer's fiscal year in which vesting occurs.
Example 1: A university with a fiscal year that ends on June 30 granted an employee a bonus that vested on July 15, 2016, but will not be paid until July 15, 2017. If this arrangement is subject to Sec. 457(f), the present value of the bonus would have become subject to income tax when it vested. In contrast, if the arrangement is exempt from Sec. 457(f), it will not be subject to income tax until it is paid. The last day of the calendar year in which vesting occurred was Dec. 31, 2016. The payment deadline for exemption from Sec. 457(f) based on the calendar year is March 15, 2017 (the 15th day of the third calendar month following Dec. 31, 2016). The last day of the fiscal year in which vesting occurred is June 30, 2017. The payment deadline for exemption from Sec. 457(f) based on the employer's fiscal year is Sept. 15, 2017 (the 15th day of the third calendar month following June 30, 2017). The later of the two payment deadlines is Sept. 15, 2017. Since the payment will be made on July 15, 2017, which is earlier than Sept. 15, 2017, the bonus is exempt from Sec. 457(f).
The severance pay exemption is not new. It has been in the statute for many years. However, neither the statute nor any prior regulations define severance pay. The proposed regulations provide a comprehensive definition that reduces previous uncertainty. Generally, under the proposed regulations, severance pay is paid in connection with an involuntary separation from service, the amount paid is limited to two times compensation (using annualized compensation based on the employee's annual rate of pay for the calendar year preceding the year in which the employee has the severance from employment), and the amount is paid by the end of the second calendar year following severance from employment. If the severance pay arrangement qualifies for the exemption, amounts are not subject to income tax until they are paid. In contrast, if the severance pay arrangement does not qualify for the exemption (e.g., the severance from employment is voluntary or the amount or period exceeds the limits), then the pay is subject to income tax upon vesting, which is likely to be at the time of the severance from employment.
The proposed regulations make two exceptions to the rule that the severance must be involuntary. The first is a situation where the severance from employment is voluntary, but it is due to a material negative change in the employee's relationship with the employer, referred to as severance for "good reason." The second is severance pay made available for a limited time under a window program. In these situations, the severance pay is exempt from Sec. 457(f) treatment as long as the amount and time limits described above are satisfied.
In addition to helpful guidance regarding exemptions, the proposed regulations provide guidance regarding what constitutes vesting. Since vesting triggers income taxation in a Sec. 457(f) plan, it is important to understand exactly when it occurs. The regulations brought good news by providing that a noncompetition agreement can cause vesting—and, therefore, income taxation—to be delayed until the noncompetition agreement expires.
Example 2: A university coach's contract provides that if she works until age 65, she will be paid $100,000 per year for 10 years following retirement, as long as she does not take a coaching position at a Division I school at any time during the 10-year payment period. If the coach is deemed to be vested upon retirement at age 65, the payments are taxable when she turns 65. In contrast, if the noncompetition provision causes her not to be vested for Sec. 457(f) purposes, the payments will not be subject to income tax until they are received, since the university would not make the payments if she accepted a prohibited position.
The proposed regulations provide that a noncompetition provision can indeed delay vesting for Sec. 457(f) purposes, as long as the noncompetition provision is enforceable, the employer makes reasonable ongoing efforts to verify compliance, the employer has a substantial and bona fide interest in preventing the employee from performing the prohibited services, and the employee has a bona fide interest and ability to engage in the prohibited competition. Thus, in Example 2, it appears that the payments would be subject to income tax only as they are paid, rather than at age 65. However, suppose at around the time the coach turned age 65, she became disabled and was no longer able to work. In that situation, the payments would be treated as vested at age 65 because she would no longer be able to engage in the prohibited competition. As a result, the present value of the payments would be subject to income taxation at age 65. In addition, a portion of the payments over and above the present value would be subject to income taxation as the payments are received under the rules of Sec. 72.
The regulations also address vesting with respect to an employee's voluntary election to defer compensation. Suppose an employee who has made the maximum contribution to his Sec. 401(k) or 403(b) plan wants to defer $50,000 of his 2017 salary to 2020. If his employer maintains a Sec. 457(b) plan, the employee will probably defer $18,000 into that plan (and if he is 50 or older and his employer is a state or local government, he can defer an additional $6,000 as a catch-up contribution). The remaining amount would have to be deferred into a Sec. 457(f) plan.
To defer the income taxation until he receives the payment in 2020, the employee would have to agree to work at his employer until 2020 and forfeit the payments if he leaves prior to 2020. For many years, there has been an open question whether the IRS would view this as truly subject to a vesting condition for purposes of Sec. 457(f). The proposed regulations answer this question. Under the regulations, the deferred amount would be treated as vested in 2017 and therefore subject to income tax in 2017 unless the employer makes a matching contribution equal to more than 25%. In addition, the employee must have made the deferral election by Dec. 31, 2016, since the proposed regulations require voluntary deferral elections to be made before the beginning of the calendar year in which any services that give rise to the compensation are performed. Finally, the proposed regulations require the employee to extend the vesting period for at least two years.
The regulations also address vesting period extensions. Suppose an employee vests in a $1 million payment in 2017 but does not like the idea of having to pay the income tax in 2017. Thus, the employee wants to extend the vesting to a later year to delay paying the income taxes. Whether the IRS would recognize such an extension for purposes of determining when amounts become subject to income tax has been an open question.
The proposed regulations answer this question by stating that the extension of a vesting period will delay the income taxation only if the decision to extend the vesting period is made at least 90 days before the original vesting date, the vesting period is extended at least two years, and the employee receives a materially greater amount upon the later vesting date than he or she would have received upon the original vesting date. "Materially greater" is defined as more than 125% and is measured on a present-value basis. In other words, the present value of the new amount must be more than 125% of the present value of the old amount.
In summary, the proposed regulations provide helpful guidance for Sec. 457(f) plans. Some provisions, in particular, have received considerable attention. For the first time, short-term deferrals are exempt. Also, the proposed regulations define severance pay for purposes of determining whether the pay is exempt. In addition, they open the way for noncompetition provisions to be viewed as a legitimate vesting condition and recognize both voluntary salary deferrals and vesting period extensions, as long as certain requirements are satisfied. As a result of the proposed regulations, state and local governments and tax-exempt employers, along with their employees, now can be more certain of the tax treatment of deferred compensation amounts.
Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.