There have been a number of significant regulatory developments in the area of deferred compensation. This Part I considers various regulatory proposals and other amendments under consideration. Part II, which will appear in the fall issue of ABA Tax Times, discusses the Department of Labor’s new fiduciary rule and the five lawsuits challenging the rule.
I. New Proposed Regulations Under Code Section 409A
Before 2004, nonqualified deferred compensation was often the wild west of tax planning. The contours of permissible practice were determined by general tax concepts (constructive receipt, economic benefit, equivalence of cash) that were often difficult to apply and that were often ignored by those marketing deferred compensation plans. When Congress enacted Code section 409A in 2004, the change brought order to the area along with great complexity.
On June 22, 2016, Treasury and the Service published proposed regulations1 to clarify or modify specific provisions of the final regulations under section 409A. The document also (i) withdraws a specific provision of a December 8, 2008 proposed regulation2 regarding the calculation of amounts includible in income under section 409A(a)(1) and (ii) replaces that provision with revised proposed regulations. Comments and requests for a public hearing must be received by September 20, 2016. Taxpayers may rely upon the proposed regulations immediately.
The preamble explains the government’s purpose in revising the regulations:
The Treasury Department and the IRS have concluded that certain clarifications and modifications to the final regulations and the proposed income inclusion regulations will help taxpayers comply with the requirements of section 409A. These proposed regulations address certain specific provisions of the final regulations and the proposed income inclusion regulations and are not intended to propose a general revision of, or broad changes to, the final regulations or the proposed income inclusion regulations. The narrow and specific purpose of these proposed regulations should be taken into account when submitting comments on these proposed regulations.
A. Preamble’s Summary of the Proposals
The Preamble states that the proposals:
(1) Clarify that the rules under section 409A apply to nonqualified deferred compensation plans separately and in addition to the rules under section 457A.3
(2) Modify the short-term deferral rule to permit a delay in payments to avoid violating Federal securities laws or other applicable law.4
(3) Clarify that a stock right that does not otherwise provide for a deferral of compensation will not be treated as providing for a deferral of compensation solely because the amount payable under the stock right upon an involuntary separation from service for cause, or the occurrence of a condition within the service provider’s control, is based on a measure that is less than fair market value.5
(4) Modify the definition of the term “eligible issuer of service recipient stock” to provide that it includes a corporation (or other entity) for which a person is reasonably expected to begin, and actually begins, providing services within 12 months after the grant date of a stock right.6
(5) Clarify that certain separation pay plans that do not provide for a deferral of compensation may apply to a service provider who had no compensation from the service recipient during the year preceding the year in which a separation from service occurs.7
(6) Provide that a plan under which a service provider has a right to payment or reimbursement of reasonable attorneys’ fees and other expenses incurred to pursue a bona fide legal claim against the service recipient with respect to the service relationship does not provide for a deferral of compensation.8
(7) Modify the rules regarding recurring part-year compensation.9
(8) Clarify that a stock purchase treated as a deemed asset sale under section 338 is not a sale or other disposition of assets for purposes of determining whether a service provider has a separation from service.10
(9) Clarify that a service provider who ceases providing services as an employee and begins providing services as an independent contractor is treated as having a separation from service if, at the time of the change in employment status, the level of services reasonably anticipated to be provided after the change would result in a separation from service under the rules applicable to employees.11
(10) Provide a rule that is generally applicable to determine when a “payment” has been made for purposes of section 409A: “a payment is made, or the payment of an amount occurs, when any taxable benefit is actually or constructively received”, including the inclusion of an amount in income under section 457(f)(1)(A). 12
Under the proposed rules, for example, a deferred amount subject to Code Section 457(f) (relating to tax-exempt and governmental employers) will be a “payment” on the vesting date (the date on which it is generally taxable under section 457(f)) and not the actual payment date for purposes of determining (i) whether the arrangement is exempt from section 409A as a “short-term deferral” and (ii) (if it is not exempt) whether it satisfies section 409A’s timing of payment rules. A transfer of unvested property (e.g., restricted stock) is not a “payment” unless the service provider makes a section 83(b) election to include the value in current income. Treasury and the Service request comments on whether rules similar to those applicable to amounts included in income under section 457(f) should be adopted for amounts included in income under section 457A.
(11) Modify the rules applicable to amounts payable following death.13
(12) Clarify that the rules for transaction-based compensation apply to stock rights that do not provide for a deferral of compensation and statutory stock options.14
(13) Provide that the addition of the death, disability, or unforeseeable emergency of a beneficiary who has become entitled to a payment due to a service provider’s death as a potentially earlier or intervening payment event will not violate the prohibition on the acceleration of payments.15
(14) Modify the conflict of interest exception to the prohibition on the acceleration of payments to permit the payment of all types of deferred compensation (not only certain types of foreign earned income) to comply with bona fide foreign ethics or conflicts of interest laws.16
(15) Clarify the provision permitting payments upon the termination and liquidation of a plan in connection with bankruptcy.17
(16) Clarify other rules permitting payments in connection with the termination and liquidation of a plan.18
(17) Provide that a plan may accelerate the time of payment to comply with Federal debt collection laws.19
(18) Clarify and modify section 1.409A-4(a)(1)(ii)(B) of the proposed regulations regarding the treatment of deferred amounts subject to a substantial risk of forfeiture for purposes of calculating the amount includible in income under section 409A(a)(1). The 2008 proposed regulations permit the correction of certain plan provisions that fail to comply with section 409A. The new proposed regulations clarify and modify the anti-abuse rule of the proposed regulations to preclude certain changes.
(19) Clarify various provisions of the final regulations to recognize that a service provider can be an entity as well as an individual.20
B. Effective Dates
The provisions of the proposed regulations amending the final regulations are proposed to be applicable on or after the date on which they are published as final regulations. For periods before this date, the existing final regulations and other applicable guidance apply (without regard to the proposed regulations). Taxpayers may, however, rely on the proposed regulations before they are published as final regulations and, until final regulations are published, the IRS will not assert positions that are contrary to the positions set forth in the proposed regulations.
Certain provisions of the proposed amendments to the final regulations are not intended as substantive changes to the current requirements, as clarified in the Preamble:
[T]he Treasury Department and the IRS have concluded that the following positions may not properly be taken under the existing final regulations: (1) That the transfer of restricted stock for which no section 83(b) election is made or the transfer of a stock option that does not have a readily ascertainable fair market value would result in a payment under a plan; (2) that a contribution to a section 402(b) trust includible in income under section 402(b) to fund an obligation under a plan would not result in a payment under a plan; (3) that a stock purchase treated as a deemed asset sale under section 338 is a sale or other disposition of assets for purposes of determining when a service provider separates from service as a result of an asset purchase transaction; or (4) that the exception to the prohibition on acceleration of a payment upon a termination and liquidation of a plan pursuant to section 1.409A-3(j)(4)(ix)(C) applies if the service recipient terminates and liquidates only the plans of the same category in which a particular service provider participates, rather than all plans of the same category that the service recipient sponsors.
The proposed income inclusion regulations are proposed to be applicable on or after the date on which they are published as final regulations. Until the Treasury Department and the IRS issue further guidance, taxpayers may rely on the proposed income inclusion regulations, as modified by the new proposed regulations, for purposes of (i) calculating the amount includible in income under section 409A(a)(1) (including the identification and treatment of deferred amounts subject to a substantial risk of forfeiture) and (ii) the calculation of the additional taxes under section 409A(a)(1). The IRS will not assert positions, with respect to periods before the date final regulations are published, that are contrary to the positions set forth in the amended proposed income inclusion regulations.
Taxpayers may rely on either the rules in the new proposed regulations or the rules in Notice 2008-62 relating to recurring part-year compensation for the taxable year in which the proposed regulations are published as final regulations and all prior taxable years.
C. Comment
The proposed regulations are generally helpful in clarifying areas that were previously uncertain. This is particularly important in view of the severe penalties for failing to comply with section 409A. Nevertheless, we now have more than 10 years of experience with the section, and it is time for Congress to review the scope and requirements of the statute with a view to simplification. Congress in its review, or the Treasury and IRS in finalization of these proposals, should develop safe harbors that allow for correction of inadvertent violations without severe penalties.
II. New Proposed Regulations for 457 Plans
A. Background
Code section 457, originally enacted in 1978, contains additional requirements for most deferred compensation arrangements of governmental employers21 and private tax-exempt employers. If a plan of an eligible employer is subject to section 457, and satisfies the requirements of section 457(b) (including an annual limit on the amount deferred), then it is an “eligible plan” and benefits are generally taxed on actual or (for a non-governmental plan) constructive receipt. If a plan of an eligible employer is subject to section 457, and does not satisfy the requirements of section 457(b), then it is an “ineligible plan” and the compensation deferred under the plan is includible in the gross income of the participant or beneficiary under section 457(f)(1)(A) on the date (the “applicable date”) that is the later of (i) the date the participant or beneficiary obtains a legally binding right to the compensation or (ii) if the compensation is subject to a substantial risk of forfeiture at that time, the date the substantial risk of forfeiture lapses.22 An ineligible section 457 plan is also required to comply with section 409A.
Section 457(e) includes definitions and special rules for purposes of section 457 and describes plans that either are not subject to section 457 or are treated as not providing for a deferral of compensation under section 457.23 Section 457(e)(11) provides that certain plans are treated as not providing for a deferral of compensation: (i) any bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, or death benefit plan, (ii) any plan paying solely length of service awards to certain bona fide volunteers (or their beneficiaries), and (iii) certain voluntary early retirement incentive plans.24 Section 457(e)(12) provides that section 457 does not apply to certain non-elective deferred compensation of nonemployees.
There are significant additional differences between governmental and non-governmental 457 plans. For example, tax-free rollovers may be made between eligible governmental 457 plans and IRAs or qualified plans. Further, eligible governmental 457 plans must, and non-governmental plans may not, be funded.
On July 11, 2003, the Treasury Department and the IRS issued final regulations under section 457 (2003 final regulations).25 The 2003 final regulations reflect the changes made to section 457 through 2002. In Notice 2007-62, and at regular intervals since then, Treasury and IRS have promised substantive further guidance on areas of uncertainty under section 457. On June 22, 2016, Treasury and IRS published proposed amendments to the regulations under section 457.26
These new regulations would resolve many of the previous uncertainties. The proposed regulations make changes to the 2003 final regulations to reflect statutory changes to section 457 since 2003. In addition, the proposed regulations (i) provide guidance on certain issues under sections 457(e)(11) and 457(e)(12) that are not addressed in the 2003 final regulations, and (ii) provide additional guidance under section 457(f). The rules under section 457 apply to plan participants and beneficiaries without regard to whether the related services are provided by an employee or independent contractor.27
Comments on the proposed regulations, and an outline of topics to be discussed at a public hearing scheduled for October 18, 2016, must be received by September 20, 2016.
B. Regulatory Amendments to Reflect Statutory Changes to Section 457
1. Qualified Roth Contribution Program
The proposed regulation section 1.457-4 revises subsections (a) and (b) to reflect the change that allows an eligible governmental plan to include a qualified Roth contribution program. The proposed regulations also amend section 1.457-7(b)(1), which provides guidance regarding the circumstances under which amounts are included in income under an eligible governmental plan, to specify that qualified distributions from a designated Roth account are excluded from gross income.
2. Distributions for Qualified Accident and Health Insurance Premiums
The proposed regulation section 1.457-7(b) amends the rules for the taxation of eligible governmental plan distributions to reflect the change with respect to certain amounts distributed to an eligible public safety officer.
3. Rules Related to Qualified Military Service
Proposed regulation section 1.457-2(f) implements the requirements of section 457(g)(4), which provides that an eligible governmental plan must meet the requirements of section 401(a)(37). In addition the proposed regulations amend section 1.457-6(b)(1) to provide a cross reference to the rules under section 414(u)(12)(B), providing that leave for certain military service is treated as a severance from employment for purposes of the plan distribution restrictions that apply to eligible plans.
C. Certain Plans That Are Not Subject to Section 457 or Are Not Treated as Providing for a Deferral of Compensation Under Section 457
1. In General
Section 1.457-2(k) of the 2003 final regulations defines the term “plan” for purposes of section 457 and identifies (i) certain plans that are not subject to section 457 and (ii) certain plans that are treated as not providing for a deferral of compensation for purposes of section 457. The new proposed regulations remove these provisions from that section and move the provisions regarding most of these plans to section 1.457-11. That regulation also provides additional guidance on:
- bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, and death benefit plans, as described in section 457(e)(11)(A)(i), which are treated as not providing for a deferral of compensation for purposes of section 457; and
- plans paying solely length of service awards to bona fide volunteers (or their beneficiaries), as described in section 457(e)(11)(A)(ii), that also are treated as not providing for a deferral of compensation for purposes of section 457.28
The proposed regulations also provide guidance in a new section 1.457-12 on plans described in section 457(f)(2), to which section 457(f)(1) does not apply.
2. Bona Fide Severance Pay Plans
The proposed regulations provide that a plan must meet certain requirements to be a bona fide severance pay plan that is treated as not providing for the deferral of compensation (and therefore not subject to section 457).29 The benefits provided under the plan must be payable only (i) upon a participant’s involuntary severance from employment or (ii) pursuant to a window program or voluntary early retirement incentive plan. There are also limitations on the amount paid and the time of payment. An employee’s voluntary severance from employment may be treated as an involuntary severance from employment if the severance from employment is for good reason.
3. Ineligible Plans Under Section 457(f)
Generally, the amount that is includible in gross income on the applicable date is the present value, as of that date, of the amount of compensation deferred, including any earnings as of that date on amounts deferred under the plan. Any earnings credited thereafter are includible in gross income when paid or made available to the participant or beneficiary and are taxable under section 72. For purposes of section 72, the participant (or beneficiary) is treated as having an investment in the contract equal to the amount actually included in gross income on the applicable date.
The proposed regulations provide general rules for determining the present value of compensation deferred under an ineligible plan.30 The regulations also include specific rules for determining the present value of compensation deferred under account balance plans. The rules for determining present value in the proposed regulations are similar to the rules for determining present value in the proposed section 409A regulations.31
The proposed regulations also set forth rules for calculating the present value of compensation deferred under an ineligible plan that is not an account balance plan. The present value of an amount deferred under such a plan as of an applicable date is the value, as of that date, of the right to receive payment of the compensation in the future, taking into account the time value of money and the probability that the payment will be made. Any actuarial assumptions used to calculate the present value must be reasonable as of the applicable date, determined based on all of the relevant facts and circumstances.
4. Definition of Deferral of Compensation
In general, a plan provides for a deferral of compensation if a participant has a legally binding right during a taxable year to compensation that, pursuant to the terms of the plan, is or may be payable in a later taxable year.32 However, the proposed regulations generally provide that a participant does not have a legally binding right to compensation to the extent that it may be unilaterally reduced or eliminated by the employer after the services creating the right have been performed.
a. Short-Term Deferrals
The proposed regulations provide that a deferral of compensation does not occur with respect to any amount that would be a short-term deferral under section 1.409A-1(b)(4), substituting the definition of a substantial risk of forfeiture provided under the proposed regulations for the definition under section 1.409A-1(d).33
b. Recurring Part-Year Compensation
To simplify the rule set forth inNotice 2008-62, and recognizing that educational employers frequently structure their pay plans to include recurring part-year compensation, the proposed regulations modify the recurring part-year compensation rule for purposes of section 457(f).34 The proposed regulations provide that a plan or arrangement under which an employee receives recurring part-year compensation that is earned over a period of service does not provide for the deferral of compensation if (i) the plan or arrangement does not defer payment of any of the recurring part-year compensation to a date beyond the last day of the 13th month following the first day of the service period for which the recurring part-year compensation is paid, and (ii) the amount of the recurring part-year compensation (not merely the amount deferred) does not exceed the annual compensation limit under section 401(a)(17) ($265,000 for 2016) for the calendar year in which the service period commences. A conforming change is included in the new proposed regulations under section 409A.
5. Interaction of Section 457 With Section 409A35
The proposed regulations provide that the rules under section 457(f) apply to plans separately and in addition to the requirements under section 409A.36 Thus, a deferred compensation plan of an eligible employer that is subject to section 457(f) may also be a nonqualified deferred compensation plan that is subject to section 409A. 37
6. Substantial Risk of Forfeiture
The proposed regulations provide that an amount is generally subject to a substantial risk of forfeiture for purposes of section 457(f) only if entitlement to that amount is conditioned on (i) the future performance of substantial services, or (ii) the occurrence of a condition that is related to a purpose of the compensation if the possibility of forfeiture is substantial.38 Also, an amount is not subject to a substantial risk of forfeiture if the facts and circumstances indicate that the forfeiture condition is unlikely to be enforced. A special rule applies to determine whether initial deferrals of current compensation may be treated as subject to a substantial risk of forfeiture and whether a substantial risk of forfeiture can be extended.
Whether an amount is conditioned on the future performance of substantial services is based on all of the relevant facts and circumstances, such as whether the hours required to be performed during the relevant period are substantial in relation to the amount of compensation.
If a plan provides that entitlement to an amount is conditioned on an involuntary severance from employment without cause, the right is subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial. For this purpose, a voluntary severance from employment that would be treated as an involuntary severance from employment under a bona fide severance pay plan (that is, a severance from employment for good reason) is also treated as an involuntary severance from employment without cause.39 Compensation is not considered to be subject to a substantial risk of forfeiture merely because it would be forfeited if the employee accepts a position with a competing employer unless certain conditions are satisfied.
Additional conditions apply with respect to the ability to treat initial deferrals of current compensation as being subject to a substantial risk of forfeiture. Similarly, an attempt to extend the period covered by a risk of forfeiture, often referred to as a rolling risk of forfeiture, is generally disregarded under the proposed regulations unless certain conditions are met.
The Treasury Department and the IRS request comments on whether special provisions for newly eligible employees are needed, and if so whether the rules under sections 1.409A-1(c)(2) and 1.409A-2(a)(7) of the regulations would be a useful basis for similar rules under section 457(f) and how an aggregated single plan (versus multiple plans) should be defined for this purpose to ensure that the rules are not subject to manipulation.
D. Proposed Applicability Dates
Generally, the regulations are proposed to apply to compensation deferred under a plan for calendar years beginning after the date of publication of the rules as final regulations, including deferred amounts to which the legally binding right arose during prior calendar years that were not previously included in income during one or more prior calendar years. No implication is intended regarding application of the law before the proposed regulations become applicable. Taxpayers may rely on the proposed regulations until the applicability date.40
There are special applicability dates for collectively bargained plans and governmental plans, to the extent that legislation is required to amend a governmental plan. For all plans, with respect to the rules regarding recurring part-year compensation, for periods before the applicability date of the regulations, taxpayers may rely on either the rules set forth in the proposed regulations or the rules set forth inNotice 2008-62.
E. Comment
The proposed regulations are helpful in resolving uncertainty in certain important areas (e.g., the definition of a bona fide severance pay plan and the definition of substantial risk of forfeiture). In some respects, the proposed regulations are less restrictive than many experts had feared, e.g., in accepting that a covenant not to compete may result in a substantial risk of forfeiture in certain cases and the limited allowance of rolling risks of forfeiture.
The long-awaited issuance of regulations may indicate that the IRS will increase audit activity with respect to section 457 plans. Sponsors must ensure that plan documentation is adequate, that the terms of the plan documents are being followed in operation, and that the plan complies with the requirements of the law and regulations. Given the prevalence of section 457 plans, it would be very helpful if the IRS extended the Employee Plans Compliance Resolution System to include them. ■
3 Prop. Reg. §1.409A-1(a)(4).
4 Prop. Reg. § 1.409A-1(b)(4)(ii).
5 Prop. Reg. § 1.409A-1(b)(5)(iii)(A).
6 Prop. Reg. § 1.409A-1(b)(5)(iii)(E).
7 Prop. Reg. § 1.409A-1(b)(9)(iii)(A).
8 Prop. Reg. § 1.409A-1(b)(11).
9 Prop. Reg. § 1.409A-1(b)(13).
10 Prop. Reg. § 1.409A-1(h)(4).
11 Prop. Reg. § 1.409A-1(h)(5).
12 Prop. Reg. § 1.409A-1(b)(4)(i)(B), 1.409A-1(q).
13 Prop. Reg. § 1.409A-3(d)(2).
14 Prop. Reg. § 1.409A-3(d)(2)(iv).
15 Prop. Reg. § 1.409A-3(j)(1), (2).
16 Prop. Reg. § 1.409A-3(j)(4)(iii)(B).
17 Prop. Reg. § 1.409A-3(j)(4)(ix)(A).
18 Prop. Reg. § 1.409A-3(j)(4)(ix)(C).
19 Prop. Reg. § 1.409A-3(j)(4)(xiii)(B).
20 The proposed regulations clarify §§ 1.409A-1(b)(5)(vi)(A), 1.409A-1(b)(5)(vi)(E), 1.409A-1(b)(5)(vi)(F), and 1.409A-3(i)(5)(iii) of the final regulations.
21 An eligible employer described in section 457(e)(1)(A) means a State, a political subdivision of a State, or any agency or instrumentality of a State or political subdivision of a State (a governmental entity). It does not include the federal government or any agency or instrumentality of the federal government.
22 Prop. Reg. § 1.457-12.
23 Plans described in certain statutes that are not incorporated into the Code are not subject to § 457. See §§ 1107(c)(3)(B), 1107(c)(4), and 1107(c)(5) of the Tax Reform Act of 1986, as amended, and §§ 1101(e)(6), 6064(d)(2), and 6064(d)(3) of the Technical and Miscellaneous Revenue Act of 1988.
24 Announcement 2000-1, 2000-1 CB 294 (January 1, 2000) provides transitional guidance on the reporting requirements for certain broad-based, nonelective deferred compensation plans maintained by State or local governments.
27 § 457(e)(2) provides that the performance of services for purposes of § 457 includes the performance of services as an independent contractor and that the person (or governmental entity) for whom these services are performed is treated as an employer.
28 See § 457(e)(11)(B) for special rules relating to length of service award plans.
29 IRC § 457(e)(11)(A)(i); Prop. Reg. §1.457-11(d).
30 See Prop. Reg. §1.457-12(c), including the 9 Examples in §1.457-12(c)(1)(iv)(D).
31 One difference between these regulations and the proposed § 409A regulations is that income inclusion under § 457(f) and § 1.457-12(a)(2), and the present value calculation under the proposed regulations, is determined as of the applicable date, whereas income inclusion under § 409A, and the present value calculation under the proposed § 1.409A-4, is determined as of the end of the service provider’s taxable year.
32 Prop. Reg. §1.457-12(d).
33 Prop. Reg. §1.457-12(d)(2).
34 Prop. Reg. §1.457-12(d)(3).
35 See Prop. Reg. §1.457-12(d)(5).
36 See also § 1.409A-1(a)(4).
37 Prop. Reg. § 1.457-12(d)(5)(iii) provides an example of the interaction of §§ 409A and 457(f).
38 See Prop. Reg. §1.457-12(e), including the 4 Examples.
39 See § III.B.2 of the preamble for a discussion of circumstances under which a severance from employment for good reason may be treated as an involuntary severance from employment for purposes of § 457(e)(11)(A)(i).
40 Prop. Reg. §1.457-13(a).