On June 21, 2016, concurrent with its issuance of proposed regulations under Code section 409A, the IRS also issued proposed regulations under Code section 457, which address deferred compensation arrangements covering employees of tax-exempt and governmental employers. The proposed regulations contain amendments to the final 2003 regulations to reflect subsequently-passed legislation; describe the types of plans that are not subject to the 457 rules; and provide rules for determining when deferred amounts under 457(f) plans are includible in income.

In general, the proposed regulations will become effective for compensation deferred under a plan for calendar years beginning after the date the regulations are finalized, but taxpayers may rely on the proposed regulations until that time. The effective date will be delayed for plans maintained pursuant to collective bargaining agreements and governmental plans where legislation is required to amend the plan.

Amendments to 2003 Final Regulations Reflecting Subsequent Legislation

These new proposed regulations make changes to the 2003 final regulations to reflect statutory changes to Code section 457 since the publication of those regulations, to provide guidance on certain issues that are not addressed in the 2003 final regulations, and to provide additional guidance under section 457(f). Specifically, the 2003 final regulations under Code section 457 are amended to provide that:

• Eligible governmental 457(b) plans may include a qualified Roth contribution program.
• With respect to certain amounts distributed to an eligible public safety officer, distributions from an eligible governmental 457(b) plan meeting the requirements of Code section 402(l) (pertaining to distributions for health and long-term care insurance) are excluded from gross income.
• For a participant who dies while performing qualified military service, the survivors of the participant generally are entitled to any additional benefits that would been provided under the 457(b) plan had the participant resumed and then terminated employment on account of death.
• Leave for certain military service is treated as a severance from employment for purposes of the plan distribution restrictions that apply to eligible 457(b) plans.

Clarification on Plans Not Subject to Code Section 457.

Bona fide severance pay plans, bona fide death benefit plans, bona fide disability pay plans, and bona fide sick leave and vacation leave plans will not be subject to the restrictions in Code section 457 provided the requirements applicable to each type of plan are met, as described below.

Bona fide severance pay plans.

Bona fide severance pay plans will not be subject to Code section 457 provided that the following requirements are met:

• The benefits provided under the plan are payable only upon a participant’s involuntary severance from employment or pursuant to a window program or voluntary early retirement incentive plan.
• The amount payable under the plan to a participant does not exceed two times the participant’s annualized compensation based upon the annual rate of pay for services provided to the employer for the calendar year before the year in which the participant has a severance from employment (or, for a participant who had no compensation from the employer in the preceding calendar year, the current calendar year), adjusted for certain increases in compensation during the year.
• Under the terms of the plan, the severance benefits are required to be paid no later than the last day of the second calendar year following the calendar year in which the severance from employment occurs.

An involuntary termination of employment means a termination due to the employer’s independent exercise of its authority, and not resulting from an implicit or explicit request by the participant. The requirement that severance from employment be involuntary does not apply to window programs or to voluntary early retirement incentive programs of limited duration. Whether a termination is involuntary is a facts and circumstances determination.

Severance from employment for good reason may be treated as an involuntary termination, provided that it occurs under bona fide conditions that are specified in advance in writing. In addition, it must be a unilateral action by the employer that results in a material reduction in the employee’s duties, working conditions, or pay that results in the good reason termination. The proposed regulations include a safe harbor “good reason” provision, which includes severance of employment within a period that does not exceed two years following a material change to the participant’s geographic work location, or a material diminution of the participant’s base compensation; his or her authority, duties, or responsibilities; the authority, duties, or responsibilities of his or her manager or a change in the person to whom the participant is reporting; the budget over which the participant has authority; or any other action or inaction that constitutes a material breach by the employer of the agreement under which the participant is providing services.

A window program is defined under the regulations as providing separation pay in connection with a pending severance from employment, with or without the imposition of specified circumstances. The employer must make the program available to employees who have a severance during the window period, which typically cannot exceed 12 months, and (if applicable) meet the specified circumstances. A program will not be considered to be offered for a limited period of time if there is a pattern of repeatedly providing similar programs.

A voluntary early retirement incentive program is defined as providing early retirement benefits, retirement-type subsidies, or early retirement benefits greater than normal retirement benefits, paid in coordination with a defined benefit plan sponsored by a governmental entity or a tax-exempt education association, but only to the extent that they otherwise could have been provided under the defined benefit plan with which the voluntary early retirement incentive program is coordinated.

Bona fide death benefit plans and bona fide disability pay plans.

Bona fide death benefit plans and bona fide disability pay plans will not be subject to the restrictions under Code section 457. Under a bona fide death benefit plan, benefits may be provided through insurance, and any lifetime benefits under the plan that may be includible in income will not include the value of any term life insurance coverage that the plan provides.

Under a bona fide disability pay plan, a participant will be considered disabled if, by reason of physical or mental impairment that can be expected to result in death or last for at least 12 months, he or she is unable to engage in substantial gainful activity and is receiving income replacement benefits for at least three months under an accident or health plan. In addition, a participant will be considered disabled if he or she is determined to be totally disabled by the Social Security Administration or the Railroad Retirement Board.

Bona fide sick leave and vacation leave plans.

A sick or vacation leave plan will generally be treated a bona fide plan if, based on the facts and circumstances, it can be demonstrated that the primary purpose of the plan is to provide employees with paid time off from work due to sickness, vacation, or other personal reasons. The proposed regulations provide a number of factors to be included in the determination as to whether a sick or vacation leave plan is bona fide. In recognition of the wide variety of the sick and vacation leave plans, additional rules in this regard may be forthcoming from the IRS in the form of revenue rulings, notices, or other guidance.

Treatment of Amounts Includible in Income under Ineligible 457(f) Plans.

Under the proposed regulations, compensation deferred under an ineligible 457(f) plan will be includible in a participant’s gross income as of the date that he or she obtains a legally binding right to the compensation or, if later, the date that any substantial risk of forfeiture applicable to the compensation lapses (the “applicable date”). A substantial risk of forfeiture exists when entitlement to deferred amounts is conditioned upon the future performance of substantial services, or upon the occurrence of a condition that is related to a purpose of the compensation (i.e., to the employee’s performance of services for the employer or to the employer’s tax-exempt or governmental activities or organizational goals) if the possibility of forfeiture is substantial. As always, whether a substantial risk of forfeiture exists is a facts and circumstances determination.

As good news for sponsors, the regulations as drafted continue to allow compensation to be considered subject to a substantial risk of forfeiture if future receipt of the compensation is conditioned on compliance with a noncompetition covenant, provided that the noncompetition covenant meets the requirements specified in the regulations. Specifically, the noncompetition covenant must be provided for in an enforceable written document; the employer must make reasonable efforts on a consistent basis to verify compliance with the noncompetition agreement; and, at the point in time when the noncompetition covenant becomes binding, the employer must have a substantial and bona fide interest in preventing the employee from engaging in the prohibited services, and the employee must have a bona fide interest in engaging in those services. This last prong is a facts and circumstances determination, with the proposed regulations identifying several relevant factors.

The amount includible in income on the applicable date is equal to the present value, as of that date, of the amount of compensation deferred, including earnings on the amounts deferred under the plan. Earning on such compensation after the applicable date will be taxable under IRC section 72 when either paid or made available to the participant. The proposed regulations prescribe rules for determining the present value of deferred compensation, which are similar to the rules under the proposed 409A regulations (except that the present value calculation is determined on the date that there ceases to be substantial risk of forfeiture under the proposed 457 regulations, versus as of the end of the employee’s taxable year, as provided under 409A), and which the IRS intends to coordinate with the proposed 409A regulations when they are finalized for ease of administration.

For the purpose of determining whether section 457(f) applies, a plan will be considered to provide for “deferral of compensation” if a participant has a legally binding right during a taxable year to compensation that, under the terms of the plan, is or may be payable in a later year. A participant does not have a legally binding right to the compensation if it may be unilaterally reduced or eliminated by the employer after the services resulting in that compensation have been performed. Whether a plan provides for deferral of compensation is a facts and circumstances determination based on the provisions of the plan at the time the legally binding right arises.

Amounts that satisfy the short-term deferral requirements under Code section 409A also will not be considered a deferral of compensation under Code section 457(f). For this purpose, the applicable measuring period ends on of 15th day of the third month following the end of the first calendar year (or, if later, the employer’s taxable year) in which the amounts are no longer subject to a substantial risk of forfeiture.

Interaction of Code Section 457 with Code Section 409A.

The proposed regulations provide that the rules under Code section 457(f) apply to plans separately and in addition to the requirements under Code section 409A. Thus, a deferred compensation plan of an eligible tax-exempt or governmental employer that is subject to Code section 457(f) may also be considered nonqualified deferred compensation subject to Code section 409A. For example, in the context of amounts conditioned on noncompetition covenants, this may present the issue of an amount being subject to a substantial risk of forfeiture under Code section 457(f) and not under Code section 409A. Close attention should be paid to determine whether the requirements of Code sections 457 and 409A overlap for any particular deferred compensation arrangement.

What Does This Mean to You?

Sponsors of 457 plans should consider what changes, if any, they either may want or will need to make pending finalization of the proposed regulations, such as adding a Roth feature or revising the qualified military service provisions. Tax-exempt and governmental employers who sponsor severance pay plans, death benefit plans, disability pay plans, and sick leave and vacation leave plans are encouraged to review those plans’ provisions in advance of the issuance of final regulations, to assess whether they would continue to be exempt from Code section 457 if the proposed regulations are finalized as currently drafted. And, sponsors of 457(f) plans may wish to review the conditions of forfeiture under those plans to likewise determine whether those conditions would be consistent with the final regulations, assuming the proposed regulations are finalized without change, as well as whether there is any overlap with the proposed 409A regulations.