By Joan Vines, CPA
The Internal Revenue Service (IRS) released proposed regulations that provide guidance for the nonqualified deferred compensation arrangements of tax-exempt organizations in June. The regulations, which have been anticipated by the industry since 2007, address the interplay between Internal Revenue Code Section 457 and Section 409A, which govern the nonqualified deferred compensation arrangements of all employers, including tax-exempt organizations. The newly proposed Section 457 regulations provide plan design opportunities specifically for tax-exempt employers, which could aid in the recruitment and retention of key executives.
The proposed regulations provide comprehensive guidance for nonprofit employers and offer several options for employers structuring deferred compensation plans. Section 457(f) requires the immediate taxation of nonqualified deferred compensation upon vesting. Its newly proposed regulations contain plan design features that effectively delay the vesting event, thereby avoiding immediate taxation and providing much-needed clarity to when compensation is subject to or exempt from Section 457(f).
The proposed regulations become effective upon finalization, but may be relied upon in the meantime.
The new regulations distinguish between for-profit and nonprofit deferred compensation requirements with changes specific to six aspects—risk of forfeiture, salary deferrals, noncompete agreements, short-term deferrals, severance pay and other welfare plans.
Rolling Risk of Forfeiture
The proposed regulations permit an upcoming vesting date, as well as the point of taxation, to be extended, provided:
- The extension is made at least 90 days before the vesting date;
- The extended vesting is conditioned upon the employee’s provision of substantial services for at least two years (absent an intervening event such as death, disability or involuntary severance from employment); and
- The present value of the amount to be paid at vesting must be more than 125 percent of the amount the employee otherwise would have received in absence of the extended vesting date.
BDO Insight: Section 409A similarly disregards an extended risk of forfeiture, unless the present value of the deferral is materially greater than the amount otherwise payable absent such extension. However, Section 409A does not provide a bright line test to determine “materially greater” and does not require a two-year, service-based minimum extension. The Section 457 proposed regulations are more rigid with respect to tax-exempt employers. Where an employer is exempt from U.S. taxation, the employee derives a tax benefit from the deferral while the employer is indifferent. The additional payout required under the Section 457 proposed regulations is designed to constrain tax-motivated deferrals by employees. A tax-exempt employer may not be as willing to agree to the additional vesting period if the payout is significantly higher. For instance, an employer might prefer to pay $100,000 in 2018, rather than potentially more than $125,000 in 2020.
Under prior guidance, current compensation, including salary, commissions and certain bonuses, was considered vested and therefore ineligible for deferral under Section 457(f). However, the proposed regulations permit current compensation to be deferred under Section 457(f), provided the following rules are met:
- The deferral election must be made in writing before the beginning of the calendar year in which any services that give rise to the compensation are performed (or within 30 days after a new employee’s hire date for pay attributable to services rendered after the deferral election);
- Payment of the deferred amounts must be conditioned upon the employee’s substantial services for at least two years (absent an applicable intervening event); and
- The present value of the amount to be paid at vesting must be more than 125 percent of the amount the employee otherwise would have received in absence of the deferral.
BDO Insight: The two-year minimum deferral period applies separately to each payroll deferral. Additionally, an employer match of more than 25 percent may be required to satisfy the 125 percent rule for salary deferrals.
Under prior guidance, the vesting schedule for deferred compensation served as a retention mechanism, requiring the employee’s continuous services through the vesting date as a condition to receive the amount. Under the newly proposed regulations, vesting may also serve as an enforcement mechanism for a noncompete covenant, requiring an employee to refrain from providing services to a competitor for a specified period. Provided the noncompete is a written, bona fide and enforceable covenant, the vesting period may be extended through the end of the restrictive period, allowing tax-exempt employers to make post-employment payments during such period. In addition, deferred compensation payable upon a voluntary termination is no longer treated as fully vested at all times if the amounts could be forfeited in accordance with the terms of a bona fide noncompete covenant.
BDO Insight: Among other factors applied to determine a bona fide noncompete covenant, the facts and circumstances must show that the employer has a substantial interest in preventing the employee from performing the prohibited services. To the extent the compensation paid to the employee for entering into a noncompete agreement exceeds the value of such agreement, (measured, for example, by the economic damages the organization would incur from an employee’s violation of that covenant), then the restrictive covenant may not be a bona fide noncompete agreement for purposes of Section 457. A valuation of the noncompete agreement may be in order to support an extension of the vesting date to the end of the restrictive period.
The proposed regulations provide that Section 457(f) does not apply to an arrangement in which payment is made within the “2 ½ month short-term deferral period” under Section 409A, which is generally March 15 of the first calendar year following the year of vesting.
BDO Insight: The Section 457 proposed regulations apply the Section 409A definition of short-term deferral, but substitute its own definition for “substantial risk of forfeiture.” Accordingly, a short-term deferral under Section 457 may not constitute a short-term deferral under Section 409A as is the case of a plan with a noncompete vesting provision. Technically, income taxes are due upon vesting under Section 457(f). However, the proposed regulations make clear that short-term deferrals are not subject to Section 457(f), thereby allowing income taxes to be collected upon distribution, which is administratively convenient where there is a gap between the vesting and distribution dates.
The proposed regulations provide that Section 457(f) does not apply to severance pay in connection with an involuntary separation from service (including a voluntary termination by the employee for a pre-established, good reason condition that has not been remedied by the employer) or pursuant to a window program or an early retirement incentive plan. Payments under such “bona fide severance pay plans” must not exceed two times the employee’s annualized compensation for the preceding calendar year (or the current calendar year if the employee had no compensation from the employer in the preceding year) and payment must be made by the last day of the second calendar year following the calendar year in which the severance occurs.
BDO Insight: Pay due to an involuntary separation from service or participation in a window program is similarly exempt from Section 409A in limited amounts (the lesser of two times the employee’s annual rate of pay for the preceding year or two times the compensation limit set forth under Section 401(a) (17) for the year of separation).
Other Welfare Plans
The proposed regulations clarify that Section 457(f) does not apply to bona fide death benefit, disability pay, sick leave and vacation leave plans.
BDO Insight: Section 409A similarly exempts such welfare plans from its deferred compensation rules.
What Should I Do Now?
Prior to the finalization of these regulations, tax-exempt organizations can take immediate action to align current deferred compensation procedures with the recent changes. Nonprofits, foundations and universities should review their current arrangements, severance plans and welfare benefit plans in light of these proposed regulations, and develop a plan to implement the necessary updates. Additionally, nonprofit executives should be proactive and take steps to effectively communicate with their employees in regards to the changes.