The Treasury Department and the Internal Revenue Service recently issued comprehensive proposed regulations governing nonqualified plans subject to tax under Internal Revenue Code § 457. Code § 457 prescribes the tax rules that apply to “eligible” and “ineligible” nonqualified deferred compensation plans. Code § 457(b) defines the requirements to be an “eligible” nonqualified plan; a deferred compensation plan that does not satisfy the requirements of Code § 457(b) is an “ineligible” plan under Code § 457(f). Eligible and ineligible plans may be maintained only by state or local governments or organizations exempt from tax under Code § 501(c). The proposed regulations make the following changes:
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Eligible plans (Code § 457(b))
The proposed regulations would amend the final regulations issued in 2003 to reflect subsequent statutory changes made to Code § 457.
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Ineligible plans(Code § 457(f))
The proposed regulations make good on the Service’s promise, made in Notice 2007-62, to issue “guidance regarding a substantial risk of forfeiture for purposes of § 457(f)(3)(B) under rules similar to those set forth under § 1.409A-1(d).” This promise prompted much concern amount ineligible plan sponsors and their advisors. Notice 2007-62 was aimed squarely at the interaction between Code § 457(f) and the then recently issued final regulations under Code § 409A. It was clear to many that the latter would have some consequences for the former. To what extent would Code § 409A force unwelcome changes to the rules governing ineligible plans of deferred compensation? When maintained by private sector tax-exempt entities, these plans are restricted to covering only senior management (or, in the parlance of ERISA, the “top-hat group”), which in many institutions, meant the chief executive officer. In particular, sponsors and their advisors worried about three, broad issues:
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Will the narrower definition of ‘substantial risk of forfeiture” set forth in Code § 409A be applied to arrangements governed by Code § 457(f)?
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Will elective deferrals continue to be allowed?
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Will a non-compete agreement continue to operate to defer vesting (and hence the imposition of tax)?
Though not addressed in Notice 2007-62, sponsors of ineligible plans had the following additional worries relating to the interaction between Code § 457 and Code § 409A:
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Code § 457 includes a carve-out for bona fide severance plans; Code § 409A similarly includes a carve-out for severance plans, but only for terminations based on an involuntary termination. It was only a matter of time they surmised, before the regulators intervened to “harmonize” the two provisions of the Code.
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The final Code § 409A regulations contained detailed rules governing what constitutes an “involuntary termination of employment.” Whether a termination of employment is also (critically) important for purposes of Code §457, since only an involuntary termination can defer vesting. Will the same definition apply in each case?
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How “constructive termination” actions (often referenced as “good reason” provisions) would operate as a basis for vesting of benefits for ineligible plans?
In this post, we examine the impact of the proposed regulations on ineligible plans under Code § 457(f) with a particular emphasis on the issues raised above. As a result—or at least it so appears—of comments received in response to Notice 2007-62, the worst fears of sponsors and advisors alike have not materialized. Once these rules are made final, however, there will be a “new” far more constrained “normal.” These regulations will introduce a new level of rigor into the design, maintenance and operation of ineligible deferred compensation plans.
Background
A “plan” for purposes of Code § 457 includes “any plan, agreement, method, program, or other arrangement, including an individual employment agreement, of an eligible employer under which the payment of compensation is deferred. There are, however, certain plans that are not subject to Code § 457. These include bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, and death benefit plans, plans paying solely length of service awards to bona fide volunteers (or their beneficiaries), and bona fide severance pay plans. While these exceptions apply to eligible and ineligible plans alike, the exception for bona fide severance pay plans is of particular interest to sponsors of ineligible plans…