Last week Ilya Enkishev, an attorney from the IRS Office of Associate Chief Counsel, said it would be “incredibly optimistic” to think the final 457(f) regulations will be out this year. According to Enkishev, the IRS working group has struggled to reach a consensus on the terms of the safe harbor for bona fide paid leave plans. The IRS is also preparing final 409A regulations that it hopes to publish in tandem with the 457(f) regulations, making publication in 2017 less likely. The final regulations become binding on January 1 of the year following publication. This means that effected organizations may well have at least one more year to prepare before the new rules take effect.
Kirk and Jim submitted the following memo to the IRS supplementing their prior written comments and discussions at the hearing.
Yesterday Kirk Sherman and Jim Patterson presented their comments to an IRS panel on the [proposed regulations] to [26 U.S.C. § 457(f)]. They were the only two scheduled speakers on the [agenda].
PROPOSED 457(f) Regulations: Bona Fide Severance Pay Plan
One of the primary terms that the proposed 457(f) regulations define is “bona fide severance pay plan.” Severance payments do not vest except upon certain types of termination of employment, and so are not deferred compensation for 457(f) purposes. This post summarizes how the proposed regulations define bona fide severance pay plans and what types of severance can give rise to them.
The regulations articulates three requirements that a severance pay plan must meet to be exempt from general deferred compensation treatment:
- The amount of the severance benefit cannot exceed two times the participant’s total annual compensation. Amounts in excess will be taxable in a lump sum at the beginning of the severance period, even if not paid until later.
- The entire severance benefit must be paid by the end of the second calendar year following severance, and a written plan document must specify such.
- The benefits may only be payable upon involuntary severance from employment, or upon voluntary severance from employment for good reason. The 457(f) regulations define these two as follows:
o “Involuntary severance from employment” occurs when the employer independently exercises “unilateral authority to terminate the participant’s services, other than due to the participant’s implicit or explicit request, if the participant was willing and able to continue performing services.” For example, an employer may decline to renew a contract upon its expiration, even though the employee remained willing and able to renew its terms. Whether a termination was involuntary is determined based on the facts and circumstances, regardless of how the employer or participant characterizes it.
o “Severance from employment for good reason” occurs if the participant voluntarily terminates employment because the employer caused a “material negative change” to the participant’s relationship with the employer, to such a degree that it effectively amounts to involuntary termination. Some examples include material reductions in duties or compensation, or relocation or similar negative changes in the working conditions. However, the voluntary severance from employment must happen in accordance with conditions pre-specified in writing, and the primary purpose of the separation must not be to avoid section 457.
Safe Harbor. A voluntary severance is deemed to be for good reason if it meets the following safe harbor conditions:
♣ The severance occurs within two years of the good reason arising, the reason arises without the participant’s assent, and the conditions amounting to good reason are specified in writing at the time the legally binding right to payment arises.
♣ The terms of the severance payment are substantially the same is if the severance had happened involuntarily.
♣ The participant provides notice to the employer of the existence of the applicable condition and provides the employer a period of at least 30 days to remedy it.
With the proposed 457(f) regulations released, we will be posting a series of articles summarizing the key provisions and their import. This post summarizes two key features: when these regulations come into effect, and the regulations’ unexpected treatment of noncompete agreements.
The changes will take effect January 1 of the year following the release of the final regulations. The earliest this could be is January 1, 2017. That said, it will be pushed back to 2018 if the IRS does not issue the final regulations before the end of 2016. The public comment period closes on September 20, with a public hearing on October 18, leaving the IRS two and a half months to consider any issues raised by comments and revise the regulations. If this process takes longer than expected and the final regulations are not released until 2017, the effective date moves back a year.
In the meantime, employers may rely on the proposed regulations while making decisions.
457(f) plans are taxable once the benefit is no longer subject to a substantial risk of forfeiture. Before 2007, benefits contingent on a valid noncompete agreement were not taxable until after the term of the agreement had run. When the IRS announced that it would publish 457(f) regulations, it implied that under the new regulations, a noncompete agreement would no longer constitute a substantial risk of forfeiture. In one of the most unexpected provisions of the new regulations, however, a noncompete agreement will be considered a substantial risk of forfeiture if the following conditions are met:
• The right to payment of the amount is expressly conditioned upon the employee upholding the noncompete agreement
• The employer makes reasonable ongoing efforts to verify compliance with all of its noncompetition agreements (including the noncompetition agreement applicable to the employee).
• The employer must have a “substantial and bona fide interest” in enforcing the agreement.
• The employee must have a “bona fide interest in, and ability to, engage in the prohibited competition.”
These last two factors are subject to a “facts and circumstances” test. Factors taken into account 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.
While making deferred compensation conditional on compliance to a noncompete agreement can still amount to a substantial risk of forfeiture under the proposed regulations, employers must take several steps to certify that an agreement meets the conditions. Specifically, employers must be able to demonstrate that they reasonably monitor employee compliance with the agreement, that the employee has the ability and incentive to violate the agreement, and that the employer has a “substantial and bona fide interest” in its enforcement.
According to Carol Weiser, Treasury deputy benefits tax counsel, the IRS’s guidance on tax-exempt deferred compensation, which has been in the works for 9 years, is “weeks, not months” away.
Stephen Tackney, deputy associate chief counsel, stated, “We’re kind of at the end of the assembly line, [but] they can always be plucked off the assembly line.” According to Tackney, most of the guidance should be taxpayer friendly, although a few issues could generate comments.
Once the guidance is out, there will be a comment period before the regulations are finalized.
Sherman & Patterson will continue to post updates on 457(f) guidance publication here. Once guidance is issued, we will also conduct webinars elaborating on any changes.
The IRS has released its updated qualified plan limits for 2016. Little has changed that would affect a qualified plan this time around. Some of the key limits remain as follows for 2016:
- The compensation limit remains $265,000.
- The deferral limit for 401(k), 457(b), and 403(b) plans remains unchanged, at $18,000.
- Age 50 catch-up remains $6,000.
- The limitation used for defining highly-compensated employees remains $120,000.
Jim co-wrote an article with Chris Burns-Fazzi on Oregon's new board compensation law.
On June 16, Oregon governor Kate Brown signed into law a bill that will permit reasonable compensation for members of state-chartered credit union boards of directors. The new law makes Oregon the 16th state to permit board compensation, and the third to permit the practice in the last three years.