“Anticipated” Section 457(f) Regulations

Section 457 of the tax code governs the taxation of nonqualified deferred compensation plans sponsored by tax-exempt employers. It divides plans into two categories:

  • “Eligible deferred compensation plans” that limit annual deferrals (no more than $18,000 in 2015) and that meet a variety of limitations similar to qualified plans are subject to 457(b); and
  • All other plans. These other plans are governed by section 457(f). Common names for these plans are SERPs, Capital Accumulation Accounts, and Retention Payment Plans.

NAFCU Services | Compensation and Severance Plan Rule Changes May Impact Your Credit Union

Upcoming IRS regulations may require changes to your nonqualified deferral plans and severance plans. Kirk and Jim explain more on the NAFCU Services blog.

Expected impact of 457(f) regulations on credit union plans

After years of waiting, we are hearing rumblings that the proposed 457(f) regulations should be issued in 2012, perhaps during the first part of the year. The IRS “anticipates” changing the current 457(f) rules to recognize only cliff vesting and disallow elective deferrals. Plans using noncompete restrictions as the sole risks of forfeiture will no longer defer taxes. Fortunately, 457(b) plans would not be affected. As nonqualified deferral plans for credit unions normally use cliff vesting to qualify for tax deferral under 457(f), and supplemental employer contributions rather than elective deferrals, the new rules should require few if any changes to credit union plans.

The guidance is also expected to address what qualifies as a bona fide severance benefit for purposes of 457(f). Compensation paid under a bona fide severance plan will be taxed as received. Compensation in excess of the bona fide severance limits will be taxed in a lump sum at termination. We expect the bona fide  plan limit to be two times the lesser of (i) the executive’s annual compensation, or (ii) the qualified plan compensation limit ($250,000 in 2012).

As with deferred compensation, we expect that few changes will be required to comply with the new rules, and certainly there is no expectation that severance will actually have to be limited to the two-times limit.

As we wait for the proposed 457(f) regulations to be issued, credit union boards and management should consider:

  1. Does the credit union have any nonqualified deferral plans that use noncompetes or elective deferrals?
  2. Has the credit union established severance arrangements (contained in employment agreements or in separate arrangements) that exceed the expected bona fide limits?

If so, you should be prepared to update your plans when the new rules come out. If not, it will still be important to verify that no other changes to your plans are required.

The Future of Noncompetes

Thousands of nonqualified deferred compensation plans use noncompete restrictions as substantial risks of forfeiture (SRFs) to defer taxes under 457(f). If the yet-to-be published 457(f) guidance does as expected and "disallows" noncompetes, the restrictions will still have a role to play in deferred compensation planning:

1. Continued Employer Protection.

It may surprise some, but boards really do value noncompete restrictions. In a nonqualified plan, they protect against unfair competition much more effectively than injunctive noncompetes in employment agreements. Enforcing the noncompete in a deferral plan involves doing nothing—not writing the check. Enforcing injunctive noncompetes often involves lawyers, Latin words and long-lasting litigation. We expect many employers to continue to include noncompete restrictions in their plans, just not rely on them to defer taxes.

Example:  The Deferral Plan provides an annual employer contribution of $10,000. Each year's contribution vests three years after it is made. Upon vesting, the contribution is taxable and the employer distributes enough to pay the taxes due, but retains the balance. It distributes the balance two years after the executive terminates employment, provided the executive does not compete with the employer during the two-year period.

2. Section 83.

So far, the IRS comments about the anticipated guidance indicate it will apply only to 457(f) plans, and not to Section 83 plans. Section 83 governs the taxation of property that is transferred to an employee. Like 457(f), Section 83 recognizes bona fide noncompete restrictions as SRFs that defer taxes. Therefore, it appears that noncompete restrictions will continue to defer taxation under Section 83 arrangements even after the IRS publishes the 457(f) guidance.

Example:  The employer transfers ownership of a life insurance policy to a key physician. The physician must return the policy to the employer if the physician terminates employment prior to age 62 and competes with the employer. The life insurance is property, so its transfer is governed by Section 83. Therefore, assuming the anticipated guidance is limited to 457(f), the physician will not be taxed on the value of the policy until remaining employed to age 62 or satisfying the noncompete restrictions.

If the anticipated guidance concludes noncompete restrictions are not SRFs, we fully expect that well-intentioned advisers will use phrases such as "Noncompete restrictions in deferral plans are illegal."  They will not be illegal. They could not be used to defer taxation in 457(f) arrangements, but they can be used to protect against unfair competition. Depending on the scope of the guidance, they may also continue to defer taxation under Section 83 arrangements, and possibly under some 457(f) arrangements if the IRS decides to grandfather any prior plans.

Repeat Lesson from Great-grandfathered 457(f) Plans

Individuals who participated in a tax-exempt organization's nonqualified deferred compensation plan on August 16, 1986, are not subject to 457(f). Rather, they are taxed on basic constructive receipt principles, the same as participants in plans sponsored by taxable employers. That "great-grandfathered" status remains so long as the plan's "fixed formula" is not changed. Consistent with prior practice, the IRS just published another private letter ruling concluding that a reduction in the benefit formula is not a change in the formula that forfeits great-grandfathering.

Given the limited (and dwindling) number of great-grandfathered plans, the more important impact of the ruling is its confirmation that reducing benefits is generally not treated as a change in benefits. This is important for law and regulatory changes that, like the Tax Reform Act of 1986, are not express about the issue. For example, the 2003 split dollar regulations give nearly no guidance on what constitutes a "material modification" that forfeits grandfathering. This new private ruling gives additional analogous support for reducing split dollar benefits without forfeiting grandfathering and subjecting the plan to the new regulations. (Compare 409A, which specifically states that a reduction in benefits is not a material modification that forfeits grandfathering.)

§ 457(f) regs to "clean-up" § 409A

A key IRS attorney said last week that the § 457(f) regulations will be used as a vehicle to do some § 409A "clean-up." He also referred to the initial guidance being proposed rules. These comments seem to indicate that the regulations are moving forward, are broader than originally thought, and have a better chance of receiving earlier rather than later attention. The indication that they will come out in proposed form is positive news as it will not only give a chance for comment, but a longer period for easing into the new rules. From: bna.com