Proposed regulations on deferred compensation released
TAX ALERT |
The IRS released proposed regulations under sections 409A and 457 that would apply to deferred compensation plans. While section 457 only applies to governmental and tax-exempt entities (other than churches and certain church-controlled entities), section 409A applies to all employers. For governmental and tax-exempt employers, the proposed guidance makes it clear that section 409A applies in addition to section 457. If plans are designed or operated in violation of the rules, the taxation of deferred amounts may be accelerated, and additional taxes, interest and penalties may apply. Therefore, all sponsors of and participants in nonqualified deferred compensation plans will need to carefully consider the proposed rules in order to anticipate potential future changes to affected plans should the rules be made final.
Additional regulatory guidance was needed under section 457 to incorporate certain statutory changes and required amendments to existing regulations. Accordingly, the proposed regulations incorporate changes with respect to designated Roth contributions, certain public safety officers and qualified military service.
The more significant provisions of the section 457 proposed regulations relate to what would not be subject to the rules of section 457. Section 457 generally discerns between eligible plans, which require income to be reported when paid, and ineligible plans, which require income to be reported when vested. However, certain plans are not subject to section 457, and other plans, while technically subject to the section 457 rules, may be treated as not providing a deferral of income, which means the provisions of section 457 do not apply.
Section 457 currently states that bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, death benefit plans, length of service awards to certain bona fide volunteers and voluntary early retirement incentive plans are not considered to provide a deferral of compensation. The proposed regulations include further detail on most of these categories to assist in the determination of whether a plan would meet one of the exceptions provided. While employers should carefully consider all types of plans to which the rules may apply, severance and vacation pay plans tend to be the plans that can lead to the most uncertainty. In order to not be considered deferred compensation, severance pay would have to be paid in the manner provided for in the proposed regulations and would be subject to a limitation on the amount. The treatment of vacation pay would continue to be based entirely on a facts and circumstances determination, but the regulations do include some factors for consideration, such as whether the amount can realistically be expected to be used and the terms related to the payment of cash for the vacation time. The regulations also acknowledge that additional guidance in this area may be necessary.
In addition, the section 457 proposed regulations include rules and examples for calculating the present value of payments and detail with respect to the deferral of compensation, including a general definition and exceptions for short-term deferrals and recurring part-year compensation. Another important aspect of the proposed guidance relates to the treatment of noncompete clauses or agreements, which generally will be treated as meeting the substantial risk of forfeiture threshold if certain conditions in the proposed guidance are met. Because noncompetes are generally not treated as a substantial risk of forfeiture under section 409A, regardless of the specific circumstances, this is an area where caution will be necessary if the section 457 proposed regulations are not significantly changed before becoming final.
Section 409A already has final regulations, and the majority of the proposed regulations issued under this section are described as clarifications. However, certain provisions are taxpayer-favorable modifications proposed in response to comments received by the IRS with respect to the final regulations. The items to be very cautious of in these proposed regulations are the clarifications the IRS views as the proper interpretation of the previously issued final regulations. Specifically, the IRS lists four positions in the proposed regulations that it states cannot be taken under current guidance. The positions that taxpayers cannot take are (1) the transfer of unvested restricted stock with no section 83(b) election or stock options without a readily ascertainable fair market value results in payment under the plan, (2) a contribution to a section 402(b) trust to fund an obligation is not payment under a plan, (3) a stock sale subject to a section 338 election to deem it an asset sale is a separation from service, and (4) certain accelerated payment provisions for terminated plans only apply to plans in the same category in which the service provider participates.
Also of note in the section 409A proposed regulations is an anti-abuse provision related to determining the amount that must be included in income when a violation occurs. Generally, the full vested amount less any amounts already included in income would be included in taxable income upon the violation. In certain instances in which the facts and circumstances indicate that changes may have been made to abuse the application of the reference to vested amounts, certain unvested amounts would be treated as vested.
Overall, the deferred compensation rules can provide traps for the unwary as they are extremely complicated. The rules have to be expansive because, not only is it a broad category in which the rules have to apply to a large number of different types of plans, but management has great potential to abuse the tax-deferral opportunity and to benefit at the expense of other stakeholders by changing payment timing on their own lucrative contracts. However, nonqualified deferred compensation plans also serve valuable purposes for companies, and employers with such plans or considering such plans need to make sure they comply with such rules. While this new guidance is in the form of proposed regulations, the preambles to the sections 409A and 457(f) regulations provide that taxpayers may rely on content of the proposed regulations prior to the regulations becoming final. Accordingly, we plan on issuing a more comprehensive analysis of the regulations in the near future.