Game Changer: New Rules on Deferred Compensation for Tax-Exempt Employers and Governments

The whole point of deferred compensation plans is to let independent contractors and employees put off receiving wages they’re earning now – so they can (hopefully) be taxed at a lower rate down the road AND save their earnings for years when they otherwise wouldn’t be earning as much (like at the end of a contract or after retirement, for example). Save money and pay less in taxes. What’s not to love?

As an employer, offering deferred compensation plans can make a big difference in your ability to attract and retain employees and independent contractors. But the rules governing deferred compensation can put a damper on those plans and drastically affect your employees’ tax bills IF the rules aren’t followed.

These new proposed regulations issued under IRC §457 are intended specifically for tax-exempt employers and governments. Within these regulations are requirements that must be met to prevent employees’ vested deferred compensation from being taxed now (instead of at that time down the road when it becomes payable) and rules regarding how to determine the amount that’s taxable.

But it’s not all bad news. One of the bright spots is that the regulations allow for the deferral period to be extended as long as certain conditions related to timing are met and the payment is increased by 25% or more. They also state that certain short-term deferrals are not treated as deferred compensation.

The new proposed regulations do a lot to define “substantial risk of forfeiture”. They also define what qualifies as severance pay and bona fide sick or vacation leave plans, which don’t count as deferred compensation and are not subject to these rules. Bona fide disability, severance, and sick and vacation leave plans are generally only taxable when amounts are received by the employees. For other plans, deferral of income is only allowed if the deferral is part of an eligible plan that meets specific requirements or if it’s subject to a substantial risk of forfeiture. By this new standard, there’s a substantial risk of forfeiture if the compensation is only payable when a service condition is satisfied, such as working for a certain length of time, or a performance-based condition is met, such as completing certain achievements or hitting specific standards.

Bona Fide Severance Pay Plans

The statute and prior regulations have never defined bona fide severance pay plans before now. These plans aren’t considered deferred compensation and aren’t subject to the deferred compensation rules. Now is a great time for organizations that maintain severance arrangements for executives to review those arrangements to be sure that the provisions conform to the new definition.

First, payments can only be made in one of these three situations:

  • Involuntary separation from service (including certain voluntary terminations for good reason, such as previously identified, unilateral actions by the employer that cause a material adverse change to the working relationship);
  • Participation in a window program (e.g. offering employees incentives to retire during a limited period of time); or
  • Certain incentives for voluntary early retirement maintained by educational entities in coordination with a defined benefit plan.

Second, the total amount paid cannot exceed two times the individual’s annual compensation. This amount is based on the employee’s annual rate of pay for the calendar year immediately preceding the calendar year in which severance occurs. (In other words, if someone is let go in 2017, compensation for 2016 will determine the rate for severance pay.) If compensation was increased during the year that’s being used to establish the rate of severance pay, the rate should be adjusted, if that newly increased rate was expected to continue indefinitely if the participant had not severed employment.

Third, per written plan terms, the amounts must be paid by the end of the calendar year following the termination.

Bona Fide Sick or Vacation Leave Plans

A bona fide sick or vacation leave plan is a plan with a clear primary purpose of providing employees with paid time off from work because of sickness, vacation, or other personal reasons. How can you tell if your sick or vacation leave plan qualifies? Determining factors include:

  • Whether the amount of leave is expected to be used during employment and before cessation of services;
  • Limits, if any, on the ability to exchange unused accumulated leave;
  • The amount and frequency of any in-service distributions in exchange for unused accumulated sick leave;
  • Whether the payment is made promptly after severance or paid over a period of time after severance; and
  • Whether the sick leave, vacation leave, or combined sick and vacation leave is offered to a broad group of employees or available only to certain employees.

Substantial Risk of Forfeiture

With some exceptions, deferred compensation plans are taxed when amounts are payable and not subject to a substantial risk of forfeiture. In other words, an amount is taxable when the employee or independent contractor has an unconditional right to it, whether or not it’s payable.

There are two categories of conditions to consider when determining if a substantial risk of forfeiture exists: time-based and performance-based. Whether or not compensation is subject to a substantial risk of forfeiture is a facts-and-circumstances determination that is made by the employer. Employers should consider conditions, such as:

  • How long an employee will need to work for the organization;
  • Whether or not the employee will have personal performance goals to meet;
  • Whether or not organizational goals will need to be met; and
  • At what level the organization will need to engage in certain tax-exempt or governmental activities.

The first item in this list is a time-based condition, but the last three are all performance-based conditions. While the organizational goals aren’t completely within the individual’s control in the same way personal performance goals would be, the prevailing logic is that the employee is still responsible for contributing to the organization’s performance and helping it to achieve its objectives.

Once risk of forfeiture has been established, the next step is to determine whether or not the risk is substantial. In other words, how likely is it that these conditions will be enforced? Past practices of the employer, the level of control or influence of the employee (both within the organization as a whole and over the individual responsible for enforcing the forfeiture), and local law are all factors to consider in determining how likely a forfeiture provision is to be enforced. If the forfeiture provision is likely to be enforced, then the risk of forfeiture is considered to be substantial.

In a non-compete situation, compensation isn’t necessarily subject to a substantial risk of forfeiture simply because it’s forfeited if the employee accepts employment with a competing employer. Certain conditions have to be met.

First, the payment must be contingent upon the employee not engaging in certain prohibited services (i.e., not working for a competitor). This condition must be part of a written agreement that is enforceable under local law. Second, the employer must consistently make reasonable efforts to verify compliance with all the non-compete agreements to which it is a party. Finally, when the non-compete agreement becomes binding, the facts and circumstances must show that the employer had a bona fide and substantial interest in preventing the employee from performing the prohibited services and that the employee had a bona fide interest in engaging, and the ability to engage, in the prohibited services.

Some employers use what is known as a “rolling risk of forfeiture” to further delay the moment when an employee’s deferred compensation is actually recognized as income. They do this by adding a new risk of forfeiture just before the initial service requirement is satisfied. The IRS had signaled its concern with these arrangements and has now issued proposed rules regulating them. The proposed regulations allow an employee to continue to defer the taxation of income as long as there are continued service or non-competition requirements and the amount to be paid is increased to reflect that further service.

In general, rolling risks of forfeiture need to meet three requirements in order to be effective in deferring income tax. First, the present value of the benefits that will be paid must be at least 125% of what the employee otherwise would have been paid. Second, at least two years of substantial future services must be required of the employee. Third, the agreement must be entered into at least 90 days before the existing substantial risk of forfeiture would have lapsed. Using rolling risk of forfeiture will be useful when employers want to reward an employee for continued service and the employee is willing to defer additional compensation.

Effective Date

The proposed regulations will apply to all compensation that is deferred in years that begin after the regulations are finalized. What may not be as obvious is that they will also apply to amounts deferred in earlier years that have not yet been included as income. Taxpayers can choose to rely on these regulations while waiting for the IRS to finalize them. That’s why now is a good time to review deferred compensation plans to determine if any changes  should be made to maintain desired income deferrals.

Other Issues

Deferred compensation for employees of tax-exempt organizations and governments is subject not only to these rules but also to the general deferred compensation rules of Section 409A. Both sets of rules need to be considered when looking at what your options are for designing compensation plans that can help you to attract and retain the kind of employees you want.

What to Do Now

When preparing for the adoption of these regulations, employers will want to make sure that the plans they’re using or considering take into account rules that apply specifically to tax-exempt and governmental employers, as well as general rules that apply to all employers. A good starting point is to conduct a review of existing plans to determine whether or not revisions are in order. Employers may also want to draft new plans to take advantage of some of the new rules (e.g., those allowing for certain extensions to the time of income inclusion).

Still have questions or aren’t sure how your plan stacks up against these new rules? Reach out to your Cherry Bekaert professional. You can also contact Deb Walker, National Leader of Compensation and Benefits at Cherry Bekaert.