The IRS has issued proposed regulations dealing with deferred compensation arrangements of state and local governments or tax exempt organizations subject to IRC §457 in REG-147196-07. The regulations deal with numerous issues related to such programs, but most interest is concentrated on how the rules apply “substantial risk of forfeiture” for programs subject to IRC §457(f).
457 plans are divided into “eligible” plans (§457(b) plans) and ineligible plans (§457(f) plans). Eligible plans work much like traditional qualified retirement plans in terms of when an employee is taxed on the amounts, taking place only when the amounts are distributed to the employee. However, participants in §457(f) plans pay tax when the amounts are no longer subject to a substantial risk of forfeiture, regardless of when the participant will actually receive any funds from the plan.
Eligible plans are subject to restrictions much like qualified retirement plans, specifically capping the maximum amount of annual elective deferrals. The ineligible plans function to allow the granting of additional benefits beyond those limits, but under less favorable rules generally.
As you might guess, for such plans the question of what constitutes a “substantial risk of forfeiture” is a big issue. The IRS had previously indicated in Notice 2007-62 that it thought that substantial risk of forfeiture for these plans should be defined similarly to how it is defined for §409A.
Specifically the Notice provided:
The Treasury and the Service further anticipate issuing guidance regarding a substantial risk of forfeiture for purposes of § 457(f)(3)(B) under rules similar to those set forth under § 1.409A-1(d).
Section 1.409A-1(d) provides that a right to an amount of compensation is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the performance of substantial future services or the occurrence of a condition that is related to a purpose of the compensation and the possibility of forfeiture is substantial.
The Notice also contained other provisions that suggested the final regulations would negatively interpret other provisions related to such plans.
The proposed regulations modify the “substantial risk of forfeiture” in a number of ways that are less restrictive than what Notice 2007-62 suggested would be found in the regulations.
One of the key changes relates to the IRS accepting the position that restrictions on an employee working for another organization can be treated as a substantial risk of forfeiture for the period when the non-compete applies if certain conditions are met.
As the preamble notes:
The proposed regulations provide that 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. First, the right to the compensation must be expressly conditioned on the employee refraining from the performance of future services pursuant to a written agreement that is enforceable under applicable law. Second, the employer must consistently make reasonable efforts to verify compliance with all of the noncompetition agreements to which it is a party (including the noncompetition agreement at issue). Third, at the time the noncompetition agreement becomes binding, the facts and circumstances must show that the employer has a substantial and bona fide interest in preventing the employee from performing the prohibited services and that the employee has a bona fide interest in engaging, and an ability to engage, in the prohibited services. The proposed regulations identify several factors that are relevant for this purpose.
The proposed conditions that would apply in order for a noncompetition agreement to be treated as a substantial risk of forfeiture are:
- The right to payment of the amount is expressly conditioned upon the employee refraining from the future performance of services pursuant to an enforceable written agreement.
- The employer makes reasonable ongoing efforts to verify compliance with noncompetition agreements (including the noncompetition agreement applicable to the employee).
- At the time that the enforceable written agreement becomes binding, the facts and circumstanc es demonstrate that the employer has a substantial and bona fide interest in preventing the employee from performing the prohibited services and that the employee has bona fide interest in, and ability to, engage in the prohibited competition. Factors taken into account for this purpose include the employer's ability to show significant adverse economic consequences that would likely result from the prohibited services; the marketability of the employee based on specialized skills, reputation, or other factors; and the employee's interest, financial need, and ability to engage in the prohibited services.
The proposed regulations also note that that if it is clear the parties do not intend to actually enforce the agreement, it will not be considered a substantial risk of forfeiture.
The regulations also provide for specific conditions that must be met for an employee to defer taxation on amounts the employee elects to defer into a §457(f) ineligible plan. The preamble notes:
Specifically, the proposed regulations permit initial deferrals of current compensation to be subject to a substantial risk of forfeiture and also allow an existing risk of forfeiture to be extended only if all of the following requirements are met. First, the present value of the amount to be paid upon the lapse of the substantial risk of forfeiture (as extended, if applicable) must be materially greater than the amount the employee otherwise would be paid in the absence of the substantial risk of forfeiture (or absence of the extension). The proposed regulations provide that an amount is materially greater for this purpose only if the present value of the amount to be paid upon the lapse of the substantial risk of forfeiture, measured as of the date the amount would have otherwise been paid (or in the case of an extension of the risk of forfeiture, the date that the substantial risk of forfeiture would have lapsed without regard to the extension), is more than 125 percent of the amount the participant otherwise would have received on that date in the absence of the new or extended substantial risk of forfeiture. (No implication is intended that this standard would also apply for purposes of § 1.409A-1(d)(1).)
Second, the initial or extended substantial risk of forfeiture must be based upon the future performance of substantial services or adherence to an agreement not to compete. It may not be based solely on the occurrence of a condition related to the purpose of the transfer (for example, a performance goal for the organization), though that type of condition may be combined with a sufficient service condition.
Third, the period for which substantial future services must be performed may not be less than two years (absent an intervening event such as death, disability, or involuntary severance from employment).
Fourth, the agreement subjecting the amount to a substantial risk of forfeiture must be made in writing before the beginning of the calendar year in which any services giving rise to the compensation are performed in the case of initial deferrals of current compensation or at least 90 days before the date on which an existing substantial risk of forfeiture would have lapsed in the absence of an extension. Special rules apply to new employees. The proposed regulations do not extend these special rules for new employees to employees who are newly eligible to participate in a plan. The Treasury Department and the IRS request comments on whether special provisions for newly eligible employees are needed in the context of arrangements subject to section 457(f), and if so whether the rules under §§ 1.409A-1(c)(2) and 1.409A-2(a)(7) 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.
The regulations deal with a number of other specific matters related to both eligible and ineligible 457 plans, so CPAs working with such plans should review the entire 22 pages of proposed regulations and explanation published in the Federal Register contained In the link above.
Since these are proposed regulations and they were not also issued as temporary regulations, the effective date rules are of special interest. The regulations provide the following general effective date rules:
Generally, these regulations are proposed to apply to compensation deferred under a plan for calendar years beginning after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register, 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 these proposed regulations become applicable. Taxpayers may rely on these proposed regulations until the applicability date.
From a practical standpoint the last sentence is the key one, although since this deals with employee benefit plans there is a risk that a taxpayer implementing a plan using these rules may find a need to revise the plan once final regulations are issued, to the extent that the rules differ from those in the proposed regulations.
The regulations also provide for special rules for the effective date related to collective bargaining agreements, changes to part-year compensation rules and provisions that would require legislative changes for a government agency to adopt.