The Proposed 457(f) and 409(A) Regulations: A Closer Look
In a recent Top of Mind, we reviewed the potential revival of 457(f) plans due to the recently published proposed regulations. However, there was another set of proposed regulations that could impact such plans as well; namely, the 409A regulations, which apply to all deferred compensation plans (corporate, as well as tax-exempt) and were released at the same time as the 457(f) regulations. In addition, the 457 regulations addressed plan types other than 457(f) as well (namely, 457(b) plans). In this article, we will take a closer look at both sets of regulations and their impact on the deferred compensation marketplace.
THE PROPOSED 409A REGULATIONS - KEY PROVISONS
- There are indeed two sets of rules that apply to 457(f) plans — One of the first clarifications provided in the proposed regulations is that the rules under 409A apply “separately and in addition to the rules under 457.” Thus, both the 409A regulations and the 457 regulations would apply to 457(f) plans when finalized. So the regulatory environment for 457(f) plans remains complex, though important clarifications regarding the interaction between 457(f) and 409A werewere provided in the proposed 457 regulations.
- A common feature for employee stock options is NOT deferred compensation— A common feature of stock options is that the exercise price of the option will be less fair market value if an employee is terminated for cause or violates a noncompete/nondisclosure agreement, in order to avoid a scenario of an employee taking action with respect to stock that might be detrimental to the employer. However, until now, such a feature would have triggered deferred compensation under 409A. The proposed regulations clarify that such a feature would not subject a stock option to 409A.
- Granting stock options (or other rights, such as stock appreciation rights) to an employee as part of pre-employment contract negotiation is NOT deferred compensation — A quirk under 409A was the fact that the exemption from 409A for stock rights arrangements only applied to active employees. Again, the proposed regulations eliminate this quirk, allowing employers to provide options to prospective employees, a common tactic to attract key employees.
- Involuntary separation pay agreements are NOT deferred compensation, plans even if the employee works less than a year — In another 409A quirk, compensation in an employee’s prior year of service was needed to calculate whether an involuntary separation pay agreement was exempt from 409A. But what if an employee worked less than a year? The proposed regulations address this anomaly by stating that, in such cases, compensation in the year of termination can be used to calculate whether the arrangement was exempt from 409A, as opposed to prior year compensation (which would not exist for the employee in question).
- College and university faculty, and other employees who do not work a full twelve months out of the year, do NOT create deferred compensation plans if they choose to spread their compensation out over a 12-month period for cash flow or other reasons — As crazy as it may sound, the prior regulations under 409A actually created a deferred compensation plan subject to 409A in this scenario! The IRS quickly moved to address this problem under Notice 2008-62, but that Notice placed a cap of $18,000 on the amount of the pay that was deferred from one year to another (which obviously created an issue for higher education faculty, since they are paid for the academic year and the “deferred” amount could easily exceed $18,000). The proposed regulationsremoving
- In general, payments that are no longer taxable under 457(f) due to their no longer being subject to a “substantial risk of forfeiture” are taxable under 409A as well — This eliminated a prior conflict between 457(f) and 409A, where taxation under 457(f) was not considered to be a taxable payment under 409A and was, thus, taxable under one set of rules, but not the other. Since it was unknown as to what set of rules took precedence, this guidance is welcomed and eliminates any uncertainty. Note that there are some limited exceptions to the rule; for example noncompete triggers that are not structured in a manner to create a substantial risk for forfeiture under 457(f) will create a taxable payment under 457(f), but not under 409A.
- Rules that apply to payments upon death also apply to payment upon the beneficiary’s death, and the time period for payment has been extended to allow for issues such as probate — These changes are self-explanatory; the deadline for payment is extended to December 31st following the calendar year of death.
THE PROPOSED 457 REGULATIONS - KEY PROVISIONS
- Nothing terribly new for 457(b) plans —Though the 457 proposed regulations cover 457(b) as well as 457(f) plans, there is not much in the proposed regulations about which a 457(b) plan sponsor should be concerned. The only provisions that affect 457(b) in the proposed regulations were to update 457(b) to reflect changes in the law (e.g., adding Roth as an option for governmental plans, incorporating HEART act provisions related to qualified military service, etc.) So for 457(b) plan sponsors, essentially nothing to see here.
- Additional guidance as to how certain leave payment plans (severance pay, vacation/sick/leave pay, etc.) need to be constructed in order to avoid 457(f)— For those entities that sponsor such plans, the regulations should be required reading to confirm that such plans are structured so as to be exempt from 457(f),
which would defeat the purpose of offering such plans.
- An exemption from 457(f) for “short term deferral” plans was carried over from 409A — This means that certain types of short-term deferrals are NOT subject to 457(f) (or 409A) at all. These arrangements are generally defined as bonuses or other compensation arrangements where the compensation is paid no later than the 15th of the third month following the later of the employee’s or employer’s tax year in which the compensation is no longer subject to a substantial risk of forfeiture.
- We finally know (I think) what constitutes a substantial risk of forfeiture under 457(f) — This is important, since compensation can only be deferred until it is no longer subject to what is called a “substantial risk of forfeiture,” at which point the compensation is no longer deferred and is taxable to the employee. Section 457(f) has been historically obtuse as to what a “substantial risk of forfeiture” actually means. In addition, 409A brought its own definition of “substantial risk of forfeiture” to the table, creating confusion as to whether that definition would take precedence over the 457(f) definition, or vice versa. Fortunately, the proposed 457(f) regulations clarify the definition that applies to 457(f) plans, and it is NOT the 409A definition. The new definition states that substantial services must be provided in the future (in other words, the hours worked must be significant relative to the compensation provided) and that a condition which is related to a purpose of the compensation must occur in order for a substantial risk of forfeiture to exist. Examples of what constitutes a substantial risk of forfeiture include involuntary termination, termination for “good reason” (a “safe harbor” definition of good reason is provided), and certain covenants not to compete that satisfy the requirements of the regulations.
- The death of the use of rolling risks of forfeiture in 457(f) plans has been greatly exaggerated — When IRC section 409A and its related regulations came into being, it was thought that this might be the beginning of the end for the use of so-called “rolling risks" for forfeiture in 457(f) plans. This historically popular feature allowed an executive to extend the date that the expiration of the substantial risk of forfeiture would have been scheduled to occur, thus further delaying the taxation of deferred compensation. The proposed 457(f) regulations make it clear that rolling risks of forfeiture continue to be permitted, but that substantial future services must generally be performed for at least two years (among other restrictions), and that the present value of the deferred compensation must be at least 125% of the compensation that the employee would have received had the agreement not been extended. The proposed regulations also provide flexibility as to timing, allowing agreements to be extended if a written agreement is executed at least 90 days prior to the expiration of the existing substantial risk of forfeiture.
- Employee elective deferrals of current compensation are permitted — It was previously uncertain whether elective deferrals were permitted, but again the new proposed regulations provide important clarification that such deferrals are indeed allowed. Agreements to defer compensation must be in place prior to the initial calendar year of compensation deferral, with an exception for new hires, where the agreement must be in place within 30 days of hire.
The 409A and 457 proposed regulations make all deferred compensation arrangements much more practical to administer, and, if finalized, may reverse the rapid decline in 457(f) plans since the enactment of Code Section 409A. Those who sponsor (or who wish to sponsor) deferred compensation plans should follow the progress of these regulations closely.
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.
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