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Feb 23, 2018

2016 Proposed Section 457(f) Regulations - Planning Opportunities for Non-profit Organizations

Introduction 

In 2007 the IRS has promised future guidance under Section 457(f) for non-profit organizations with respect to compensation planning techniques that were commonly used at that time:

  • Severance pay arrangements
  • Non-compete agreements,
  • Extension of a risk of forfeiture (so-called, "Rolling Risk of Forfeiture") and,

In June 2016 (after only 9 years), the IRS issued Proposed Section 457(f) Regulations that provide helpful guidance, and even some surprisingly good news. The Regulations are effective for years beginning after the publication of the Final Regulations; however, taxpayers can rely on the Proposed Regulations now.

Severance Pay Exemption

The Proposed Regulations provide needed clarification, and indicate that a severance pay arrangement is exempt from Section 457(f) if it meets certain requirements:

  • Separation from service must generally be involuntary
  • However, a voluntary separation from service may qualify for exemption if:
    • For "good reason," as defined in the Regulations 
    • Or during a window period
  • The payments must be made by the end of the second year following termination
  • The amount must not exceed 2 times the annualized rate of pay for the prior year:
    • Note 457(f) / 409A difference: There is no limit under the Proposed Section 457(f) rules with respect to the amount of severance pay that is exempt, whereas the limit under Section 409A is 2 times the compensation limit ($550,000 for 2018).

Non-Competition Agreement as a "Substantial Risk of Forfeiture"

Under the Proposed Section 457(f) Regulations, a non-compete agreement may represent a "substantial risk of forfeiture" and defer the timing of taxation if the agreement is:

  • In writing
  • Enforceable under applicable law 
  • There is a bona fide interest for the participant and the employer to enter into the agreement
  • And there is compliance with on-going requirements for monitoring by the organization and written verification from the participant
This clarification of the rules creates an opportunity to defer the taxation of compensation beyond separation from service, and provides the employer non-compete protection.
  • Note 457(f) / 409A Difference: This is another case of inconsistency with Section 409A, which does not recognize a non-compete agreement as a "substantial risk of forfeiture." Therefore, the deferral of compensation after separation from service under Section 457(f) must be coordinated with the Section 409A distribution rules. 

Voluntary Deferral of Compensation

In 2007, the IRS's position was that it would be irrational for an employee to voluntarily defer compensation that was already earned and vested to a substantive risk of forfeiture and, therefore, it would not recognize elective deferrals.

However, the 2016 Proposed Section 457(f) Regulations provide that the voluntary deferral of compensation will be recognized if the employee has an opportunity to earn a "materially greater" amount of compensation at the end of the vesting / deferral period. More specifically;

  • The deferral election must be made before the beginning of year of service during which the compensation will be earned,
  • The minimum amount of the benefit payable at the end of the vesting / risk of forfeiture period that would meet the "materially greater" test is 125% of the amounts voluntarily deferred, on a present value basis and,
  • The minimum period of extension of the vesting / risk of forfeiture period is 2 years, during which substantive services are provided and/or an enforceable non-compete agreement is in place.

Extension of the Risk of Forfeiture

The vesting / risk of forfeiture period may be extended using the same 125% test. In addition:

  • The agreement to extend the risk of forfeiture period must be made at least 90 days before the original vesting date and,
  • The period of extension must be at least 2 years.
  • Note 457(f) / 409A difference: If the agreement to extend the risk of forfeiture period is based on a non-compete agreement, the arrangement comply with the subsequent election rules under Section 409A (12 months prior election / 5+ year extension). 

In Summary

The 2016 proposed Section 457(f) regulations provide helpful guidance and a number of planning opportunities; subject to strict compliance with the new rules.

Hypothetical Example

The following example illustrates a one possible planning concept under the Proposed Section 457(f) Regulations:

  • Problem / Issues:
    • A non-profit organization would like to encourage the CEO to:
      • Continue working for 2 years past his normal retirement date,
      • And to enter into a consulting / non-compete arrangement for 2 years after the extended retirement date.
    • The CEO needs additional retirement savings.
  • Possible solution:
    • The CEO agrees to voluntarily defer $100,000 of his $300,000 annual salary for each of the two years of extended full-time employment, and 100% of the $150,000 annual consulting fee paid for the 2-year consulting / non-compete period.
    • Amounts deferred are credited to a deferred compensation account in the name of the CEO as is interest at the 10-year Treasury Bond rate.
    • The Organization promises to credit to the CEO's account a retention bonus in the amount of $150,000 at the end of the 2-year consulting / non-compete period.
  • Result: 
    • The CEO would continue to work full-time for two more years and part-time during a 2-year consulting / non-compete period, during which he would provide substantive consulting services and assist with the transition to the new CEO.
    • The CEO will earn an above market rate of return on the compensation voluntarily deferred to compensate for the voluntarily assumed risk of forfeiture, and add significantly to his retirement savings.

Caveat: This example is intended to illustrate a possible planning concept under the Proposed Section 457(f) Regulations. Any such arrangement must also be compliant with Section 409A, and take into consideration the new Section 4960 21% excise tax on excessive compensation - a subject for a later blog.