Internal Revenue Service – US Department of the Treasury
Kirk D. Sherman
James S. Patterson
Sherman & Patterson, Ltd.
November 9, 2016
Supplemental Comments on Proposed 457(f) Regulations
In this memo, we provide supplemental comments on a few aspects of the proposed 457(f) regulations. We have tried not to repeat comments we previously submitted in writing or made at the hearing on the regulations, but rather build upon those comments.
We address the following points:
Treatment of amounts deferred prior to the effective date of the new regulations.
Effective date considerations.
Loan regime split dollar exemption.
Two-year minimum deferral for non-elective supplemental employer deferrals.
Time for evaluating noncompete restrictions.
Treatment of amounts deferred prior to the effective date of the new regulations
Notice 2007-62 created an expectation that deferrals that occurred before the new rules were issued would not be subject to the new rules, but rather would be taxed under the rules that were in effect at the time of the deferral. For example, in Part IV of the Notice, after describing the 409A rule that elective deferrals must meet the materially-greater standard to be deemed subject to a 409A substantial risk of forfeiture, the Notice states:
The Service and Treasury anticipate that upcoming guidance under §457(f) will generally adopt the rules relating to substantial risk of forfeiture that are contained in § 1.409A-1(d). (Emphasis added.)
Then, Part V of the Notice states:
If the standard for a substantial risk of forfeiture for purposes of § 409A described in Part IV of this notice is adopted… (Emphasis added.)
Finally, the Notice in Part VI states:
The Treasury and the Service anticipate that the guidance described in this notice would be prospective. With respect to periods before such guidance is issued, no inference should be made from the anticipated guidance described in this notice regarding either the definition of a bona [fide] severance pay plan for purposes of § 457(e)(11)(A)(i) or the determination of substantial risk of forfeiture for purposes of § 457(f). (Emphasis added.)
We interpret these passages as the IRS saying:
We aren’t sure what the new rules for 457(f) will be, but we like the general approach of 409A and anticipate that is where they will end up.
Irrespective of the final content of the regulations, they will only apply to amounts deferred after the final rules become effective, which makes sense because we haven’t told you what the rules will be, only what we think they might be.
Even though we have told you what the new rules might be, do not infer from the description what we think the rules are currently.
If now the IRS were to change its approach and test deferrals made before the final regulations become effective, significant disruptions to reasonable benefit plans would ensue. For example, employers have regularly allowed participants to elect vesting dates for annual employer credits, subject to a two-year minimum. One of the key purposes of this type of arrangement is to accumulate significant deferrals subject to cliff vesting. This provides a strong retention incentive as executives gain experience and become more marketable. The larger the pot subject to forfeiture, the less likely the executive is to leave. If the IRS were now to tax those arrangements because the materially greater standard was not met when the participant elected the vesting date, the employer’s investment in the retention strategy would be impaired. If the benefits are taxed early, the employer would be under pressure to distribute tax dollars at a minimum, and potentially the entire account (“I have been taxed on the dollars, so pay them to me to eliminate the creditor risk.”). Those early distributions would significantly impede the retention strategy.
Other previously-allowed plans that would now become taxable would include elective deferral plans and plans with noncompete restrictions that do not meet the higher bar.
We have heard the IRS respond to this concern with, “But we told you all along that these deferrals don’t work.” However, we have trouble finding a single official IRS statement saying voluntary deferrals or elective vesting dates don’t work to defer taxes without a matching contribution. IRS comments about noncompete restrictions have similarly confirmed that the facts and circumstances test applied. Of course, there are comments made at luncheons and CLEs, but those entire discussions have been under the disclaimer, “These represent my personal views and not those of the IRS.”
What we have instead are private letter rulings allowing elective deferrals under Section 457(f) (see, e.g., PLR 9030025) and decades of audit experience where no IRS auditor has said anything to our clients about elective deferrals or vesting dates being a problem. (The auditors expressed concerns about noncompete restrictions and choice among benefits, but in only four of those 30+ audits did the IRS require plan modifications. And in the four, the concern was not the elective vesting dates or elective deferrals, but whether the noncompete restrictions passed the facts and circumstances test, which the proposed regulations say work if the arrangement meets the higher standard.)
Finally, the CPE texts addressing substantial risks of forfeiture for 457(f) purposes have not said that elective deferrals, elective vesting dates, and noncompete restrictions do not work. Rather, they describe that they should be subjected to closer scrutiny to make sure the dollars are at risk of forfeiture.
Given this history generally, and specifically the Notice 2007-62 statement that the IRS anticipated applying the regulations prospectively, we believe the only equitable way for the IRS to proceed would be to apply the new rules only to amounts actually deferred after the effective date of the final regulations. (Dollars deferred prior to the final effective date would remain subject to IRS challenge based on the pre-regulation law.) Moreover, that approach would preserve the general understanding of the word “prospective” (i.e., that it applies to future deferrals, not that it taxes prior deferrals now rather than requiring participants to file amended returns for open years). If the IRS is concerned about employers “stuffing” deferrals into pre-regulation plans, the IRS could also specify that this treatment only applies to deferrals arrangements that were writing when the proposed regulations were issued and that were not materially modified after that date.
If the IRS decides to tax pre-regulation deferrals when the final regulations become effective, we recommend an express exemption from the 409A anti-acceleration rule so that employers have the flexibility to distribute the full benefits if they so choose (rather than just distributing the taxes, which would already be exempt from 409A penalties).
Effective Date Considerations
As we review our client list and the plans they sponsor, a large majority of them will require evaluation and adjustment. Typical items will be applying the higher bar noncompete standards, eliminating elective vesting dates, and addressing voluntary deferral plans. Many of these arrangements are plans covering a pool of executives, but many others are in individual employment agreements negotiated with the executive’s or physician’s legal counsel. Boards must consider alternative strategies for plans requiring change—Do they offer a matching contribution for elective deferrals? Do they switch to an after-tax approach? How do they structure non-elective cliff vesting dates? Because these design elements fit into executive and physician attraction and retention strategies, these are complicated discussions. Add to that the need to undertake contract renegotiations, and the task becomes very large.
For these reasons, we encourage the IRS to allow at least 9 months between the issuance of the final regulations and the ultimate January 1 effective date for operational and documentation compliance.
Loan Regime Split Dollar Exemption
During Kirk’s statement at the hearing, his original 10 minutes were running out just as he was addressing the request for an express exemption for loan regime split dollar with no provision for forgiving the employer loan. The government panel seemed amenable to that request, but we got sidetracked on whether Kirk would have additional time to speak. We wish only to reiterate the importance of an express exemption, particularly given the 409A exemption. The absence of a 457(f) exemption could lead some to conclude, by negative inference, that loan regime split dollar is subject to 457(f).
Two-year minimum deferral for non-elective supplemental employer dollars
The proposed regulations contain a provision in the section addressing the “addition or extension” of a risk of forfeiture that the service or noncompete period must be at least two years “after the date the employee could have received the compensation in the absence of the additional or extended substantial risk of forfeiture.” (Prop. Reg. § 1-457(f)-12(e)(2)(ii).) The reference to “additional or extended substantial risk of forfeiture” indicates this standard only applies to arrangements where there is some choice or negotiation involved about whether to defer dollars that otherwise would be paid to the participant. However, some discussions indicate an intent to apply this standard to non-elective supplemental employer deferrals that the participant never had the opportunity to receive other than by meeting the employer-imposed service and/or noncompete requirements.
This would be a departure from prior IRS treatment of non-elective supplemental employer deferrals. For example, in PLR 9211037, the IRS considered a non-elective deferral plan in which participants vested in the benefits on the earlier of 55 and 10 years of service or age 65. Citing the 2-year forfeiture period in the Section 83 regulations, the IRS ruled:
A Participant, who has two or more years of service to perform between the time he or she becomes a participant in the plan and his or her interest vests is subject to a substantial risk of forfeiture until [he] or she attains age 65, age 55 and 10 years of qualified service, disability [sic] or dies in the employment of X. Accordingly, under section 457(f) of the Code, no Plan contributions or benefits are taxable to such a Participant until he or she attains age 65, attains age 55 with 10 years of qualified service, becomes disabled, or dies.
This treatment has worked well for years, providing a plan option that is easily communicated to participants and easily administered. Also, note that all the employer deferrals, even those made right before the vesting date, have been subjected to the minimum two years of service requirement. If the participant is at least two years from the vesting date upon entering the plan, every dollar credited to the account during that two-year period can only be earned if the participant renders services for the entire two years. If the participant quits a day before the vesting date, every dollar is forfeited, including the dollars not credited to the account until a day before vesting.
To preserve this generic type of non-elective deferral, we suggest adding a statement in the general substantial risk of forfeiture provision (§ 1.457(f)-12(e)(1)(i)) that service or noncompete requirements on non-elective supplemental employer deferrals also require a minimum 2-years of service or noncompete. However, instead of referring to “two years from the date the compensation could have been received in the absence of the additional or extended substantial risk of forfeiture,” refer to two years from the date the arrangement became legally binding.
We also suggest adding the following example to the regulations to illustrate this treatment:
Facts. On January 1, 2017, the employer agrees with the physician to credit $1,000 of supplemental non-elective dollars monthly to an account for the physician. The employer will pay the account balance to the physician in January 2019 if the physician continues employment through December 31, 2018.
Conclusion. The amounts deferred are subject to a substantial risk of forfeiture because the physician must render 24 months of service (measured from the date the arrangement becomes legally binding) to be entitled to any of the dollars.
Time for evaluating noncompete restrictions
In the DC Area Bar luncheon, comments were made about when noncompetition restrictions are to be evaluated to see if they pass the higher bar. As we recall, the conversation turned to situations where an individual became disabled during the noncompete period, and whether that disability would become the point where the noncompete restrictions failed to be substantial risks of forfeiture and the benefits would be taxed. There seemed to be general interest in taxing the deferrals at that point.
However, the proposed regulations seem to take a different approach to the issue. They provide:
At the time the enforceable written agreement becomes binding, the facts and circumstances demonstrate that the employer has a substantial and bona fide interest… (Emphasis added.)
Evaluating the facts and circumstances seems the natural and easily enforced approach. Any other approach would require constant evaluation of facts and circumstances (not just monitoring to see if the restrictions are being violated). For example, is the participant required to inform the employer of a cancer diagnosis that makes it so the participant has no interest in competing? How far out of town would an individual need to move before the participant would be deemed to have no interest in competing?
A potential middle ground would be to provide that the evaluation occurs at the time of each deferral. For example, an employer promises to credit $100,000 of non-elective supplemental employer deferrals to the CEO’s deferral account each year for 10 years. At the beginning of year 1, because of another competing hospital located in the same area (and other required factors are met), the benefits are subject to a substantial risk of forfeiture. Just before making the $100,000 for year 5, however, the employer acquires the competing hospital so the noncompete ceases to be a substantial risk of forfeiture. With the middle-ground approach, the $400,000 deferred prior to the acquisition would continue to be tax deferred, but any new dollars credited to the plan would be taxable upon contribution.
We recommend this middle ground approach to ease both administration and enforcement.
Thank you for your consideration of these supplemental comments. If you would like to discuss any of them in more detail, please do not hesitate to email or call.