IRS Proposes New Tax Status Regulations on Non-qualified Deferred Compensation Plans

Recently, the IRS proposed new tax status regulations related to the Section 457(f) non-qualified deferred compensation plans offered by tax exempt employers.

Proposed regulations

The goal of the proposal was to clearly define which deferred and actual amounts the IRS will tax as income following the lapse of the risk of forfeiture. A Spencer Fane LLP report found a portion of the proposed rules are similar to the existing language under 409A, but some differences between the overlap of Sections 457(f) and 409A will be explained. Most notably, the substantial risk of forfeiture terms, which are different in 457(f) and 409A, are unified in the new rules.

Since the IRS’ public hearing on the proposal is scheduled for Oct. 18, the expectation is that the regulations will not be finalized until sometime in 2017, which would most likely mean the implementation date will be 2018.

Substantial risk of forfeiture language has changed

While deferrals of compensation remain the same in the proposal, the language under the substantial risk of forfeiture is changed. Specifically, Spencer Fane LLP research found a 457(f) non-qualified deferred compensation plan participant will need to be aware that his entitlement to the deferred amount is contingent on three new options.

The first of these newly defined amounts are contingent on substantial future service performances. Another option participants have is if the possibility of forfeiting the plan is a substantial hit, they will be allowed to keep the compensation in the plan. A final alternative is participants can reach an agreement to not compete with their employers, which enables participants to maintain the tax advantages of the deferred amounts.

On one hand, this noncompete clause is an agreement between the employer and the plan participant for the employee not to join a competing organization. But the employee can also reach a noncompete agreement with an employer if he has bona fide interest in keeping the tax-advantaged status of his plan while engaging in activities with a competitor.

Overall, the clarification in this language was designed to outline the types of elective deferrals that may be treated as substantial risk of forfeiture. Specifically, the definition of a substantial risk of forfeiture is any amount that exceeds 25 percent more than the amount the employee would lose if he had not elected to defer.

Other notable changes

Among the major changes is that short-term deferrals and bona fide severance pay plans will now be tax exempt. This is significant because while the language is similar for the two terms between 457(f) and 409A, they are not identical.

Deferred amounts will also keep their tax exempt statuses for involuntary employment termination. Previously, there were slight differences in the language between the two tax codes for voluntary and involuntary terminations.

The regulations will need more clarification

The IRS intended for the proposal to clarify the terms of incentive compensation plans, employment agreements and bonus arrangements that employers reach with employees. As compensation deferrals for tax purposes is such an important issue, clearer definitions of activities that could potentially risk forfeiture are needed. This is particularly true for language differences that still exist between 457(f) and 409A. Until the proposal is finalized, though, employers and employees have the ability to begin to adjust to the new regulations.

In the meantime, employers will have the ability to submit comments and questions to the IRS on the new proposal until Sept. 20.