Chapter VI. Specialized Types of Retirement Income Plans Midwinter Report

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1 Chapter VI Specialized Types of Retirement Income Plans 2017 Midwinter Report American Bar Association Section of Labor and Employment Law Employee Benefits Committee February 8-11, 2017 Austin, Texas Daniel N. Janich Holifield Janich Rachal & Associates PLLC Management Chair Ginger B. LaChapelle Blitman & King LLP Union Chair Tolsun N. Waddle National Rural Electric Cooperative Association Contributor

2 I. Employee Stock Ownership Plans Revenue Ruling provides that effective January 1, 2017, a determination letter will only be issued for a new ESOP, upon termination of the ESOP or in other unspecified circumstances. 1 Revenue Procedure provides that the IRS will begin accepting applications from plan document providers for preapproved ESOP documents beginning February 1, Employers will have the option of adopting a preapproved ESOP as soon as the document provider receives IRS approval on their pre-approved plan document. A. Statutory Requirements 4. Special ESOP Distribution Requirements The IRS announced cost-of-living adjustments affecting dollar limitations for pension plans and other retirement-related items for tax year The dollar amount under Code Section 409(o)(1)(C)(ii) for determining the maximum account balance in an employee stock ownership plan subject to a 5-year distribution period is increased from $1,070,000 to $1,080,000, while the dollar amount used to determine the lengthening of the 5-year distribution period is increased from $210,000 to $215,000. II. Section 401(k) Plans B. Special Rules Applicable to 401(k) Plans 2. Contributions a. Elective Deferral Contributions ii. Limitations 1 Rev. Rul also provides that expiration dates on determination letters issued prior to January 4, 2016 are no longer operative and determination letters issued after January 4, 2016 will no longer contain expiration dates. Additional guidance is also provided under Rev. Rul with regard to plan amendments 2 IR (October 27, 2016). Off cycle filings were also discontinued effective July 21, In Rev. Rul the IRS provided further guidance on the elimination of the determination letter program for individually designed retirement plans effective January 1,

3 The elective deferral limit under Section 402(g)(1) for employees who participate in 401(k) plans remains unchanged at $18,000 for The catch-up contribution limit for employees aged 50 or over who participate in 401(k) plans pursuant to Section 414(v)(2)(B)(i) remains unchanged at $6,000 for The limitation for defined contribution plans under Section 415(c)(1)(A) is increased from $53,000 to $54,000. iii. Automatic Contribution Arrangements IRS Notice issued on January 29, 2016, provides guidance on midyear changes 3 to safe harbor plans under Section 401(k). A mid-year change either to a safe harbor plan or to a plan s safe harbor notice does not violate the safe harbor rules solely because it is a mid-year change, provided that: (i) applicable notice and election opportunity conditions as outlined in the Notice are satisfied and (ii) the mid-year change is not a prohibited mid-year change under the Notice. IRS Notice is effective for mid-year changes to safe harbor plans made on or after January 29, Under Notice , permitted mid-year changes may require an updated safe harbor notice describing the mid-year change and its effective date be distributed to employees within a reasonable period (30 to 90 days) before the effective date of the change and employees are given a reasonable opportunity before the effective date of the change to change their deferral elections. Where circumstances dictate that prior notice is not practicable, the notice and election change must then be provided as soon as practicable, but not later than 30 days after the change is adopted. The Notice also details which mid-year changes remain prohibited and which ones are not subject to the notice requirement. The Notice does not specifically address mid-year changes relating to plan sponsors involved in 3 For purposes of the Notice, a mid-year change is any change that is first effective during a plan year but not effective as of the beginning of the plan year, or any change that is effective as of the beginning g of the plan year but adopted after the beginning of the plan year. 3

4 mergers and acquisitions or to plans that include an eligible automatic contribution arrangement, which may be the subject of further guidance. C. SIMPLE 401(k) Plans 2. Contribution Requirements The limitation on the exclusion for elective deferrals to SIMPLE retirement accounts pursuant to Code Section 408(p)(2)(E) remains unchanged at $12,500 for The maximum amount of catch-up contributions that individuals aged 50 or over may make to SIMPLE 401(k) plans pursuant to Section 414(v)(2)(B)(iii) remains unchanged at $3,000 for III. NONDISCRIMINATION TESTS A. General In Notice , the IRS provided guidance on mid-year changes to a safe harbor plan under Code 401(k) and 401(m). The Notice provides that a mid-year change either to a safe harbor plan or to a plan s safe harbor notice does not violate the safe harbor rules merely because it is a mid-year change, provided that applicable notice and election opportunity conditions are satisfied, and the change is not otherwise prohibited, as described in the Notice. For purposes of the Notice, a mid-year change is (i) a change that is first effective during a plan year, but not effective as of the beginning of the plan year, or (ii) a change that is effective as of the beginning of the plan year, but adopted after the beginning of the plan year. If a permitted change to a safe-harbor plan involves an item that is required to be included in the plan s annual safe harbor notice, an updated safe harbor notice describing the change must be provided to plan participants, either (i) within a reasonable period of time prior to the effective date of the change (at least 30 days, 4

5 but not more than 90 days, prior to the effective date of the change); or, if advance notice is not practicable, (ii) no later than 30 days after the effective date of the change. Each employee required to be provided an updated safe harbor notice must also be given at least 30 days to make changes to their deferral elections. The following mid-year changes are not permitted, unless the applicable regulatory conditions corresponding to each specified change are satisfied: (i) adoption of a short plan year, or any change to the plan year (permitted only as described in Treas. Reg (k)-3(e)(2), (3), and (4) and 1.401(m)-3(f)(2), (3), and (4); (ii) adoption of a safe harbor plan status on or after the beginning of the plan year (permitted only as described in Treas. Reg (k)-3(f) and 1.401(m)- 3(g)); and (iii) reduction or suspension of safe harbor contributions or changes from safe harbor plan status to non-safe harbor plan status (permitted only as described in Treas. Reg (k)-3(g) and 1.401(m)-3(h)). Other applicable laws may also affect he permissibility of mid-year changes, including, for example, the anti-cutback restrictions of Code 411(d)(6), the nondiscrimination restrictions of Code 401(a)(4), and the anti-abuse provisions of Treas. Reg (k)-1(b)(3). Unless required by applicable law, the following mid-year changes are prohibited: (i) a mid-year change to increase the number of completed years of service required for an employee to have a nonforfeitable right to the employee s account balance attributable to safe harbor contributions under a QACA pursuant to the safe harbor rules under Treas. Reg (k)-3(k)(3) or 1.401(m)-3(a)(2); (ii) a mid-year change to reduce, or otherwise narrow, the group of employees eligible 5

6 to receive safe harbor contributions; (iii) a mid-year change to the type of safe harbor plan, for example, a change from a traditional 401(k) safe harbor plan to a QACA 401(k); and (iv) a mid-year change to modify (or add) a formula used to determine matching contributions (or the definition of compensation used to determine matching contributions) if the change increases the amount of matching contributions, or to permit discretionary matching contributions. B. Actual Deferral Percentage Test On January 8, 2016, the IRS Office of Chief Counsel issued a memorandum providing examples of acceptable interpretations of who may be considered excludable employees for purpose of coverage testing under Code 410(b)(4)(B) and performing the ADP test under Code Section 401(k)(3). The memorandum, which cannot be used or cited as precedent, concludes that an excludable employee may include an employee (i) until the date on which he or she attains age 21 and completes one year of service, (ii) through the earlier of the date six months after he or she attains age 21 and completes one year of service or the first day of the first plan year after he or she attains age 21 and completes one year of service, or (iii) through the date on which he or she attains age 21 and completes one year of service and any additional waiting period stating in the plan. 4 IV. INDIVIDUAL RETIREMENT ARRANGEMENTS A. Section 403(b) Plans 2. Contributions The annual elective deferral limit under a 403(b) plan remains unchanged at $18,000 for The limit on additional catch-up contributions for employees 4 C.C.M (Jan. 8, 2016). 5 IRS Information Release (Oct. 27, 2016). 6

7 age 50 or older remains unchanged at $6,000 for The annual additions limit is increased to $54,000 for B. Individual Retirement Arrangements, Simplified Employee Pension Plans, SIMPLE IRA Plans, and Deemed IRAs 1. IRA Structures, Eligibility, and Participation b. Employer-Established IRAs: SEPs, SIMPLE IRA Plans, and Deemed IRAs i. SEPs An employer maintaining a SEP must make contributions on behalf of each employee who is at least 21, performed services for the employer during at least three of the preceding five years, and, for 2017, earns at least $600 in compensation from the employer during the plan year Contributions to IRAs The limits on deductible IRA contributions for 2017 remain at $5,500 for individuals under the age of 50, and $6,500 for individuals age 50 or older. 9 a. Deductible Contributions to Traditional IRAs If a taxpayer is an active participant in an employer-sponsored retirement plan, the deductible amount of the taxpayer s traditional IRA contribution for the taxable year is phased out between certain modified adjusted gross income ( MAGI ) levels. The income phase-out range for 2017 for single taxpayers is between $62,000 and $72, The income phase-out range for married taxpayer 6 Id. 7 Id. 8 Id. 9 Id. 10 Id. 7

8 filing jointly is between $99,000 and $119, For a taxpayer who is not covered by an employer-sponsored retirement plan, but whose spouse is covered by an employer-sponsored retirement plan, the income phase-out range is between $186,000 and $196, b. Nondeductible Contributions to Traditional and Roth IRAs Nondeductible contributions generally may be made to a Roth IRA subject to annual maximum and phase-out rules based on the taxpayer s MAGI, similar to the rules that apply to traditional IRAs. The income phase-out range for contributions to a Roth IRA for 2017 is between $118,000 and $133,000 for individual filers and between $186,000 and $196,000 for married taxpayers filing jointly. 13 V. Deferred Compensation Plans That Are Not Qualified Under Code Section 401 A. Section 409A 1. In General On June 22, 2016, the IRS proposed new regulations 14 under Code Section 409A (the Proposed Regulations ). These Proposed Regulations clarify and modify both the final regulations under Code Section 409A from and the proposed regulations from (collectively, the Existing Regulations ). The Proposed Regulations address several different concepts under 409A, each discussed separately below. Deferral of Compensation Coordination with Section 457A 11 IRS Information Release (Oct. 27, 2016). 12 Id. 13 Id Fed. Reg , I.R.B. 15 (July 11, 2016) Fed. Reg Fed. Reg

9 Under the Existing Regulations, the rules under Section 409A apply to nonqualified deferred compensation plans ( NQDC plans ) separately and in addition to the rules under Section 457(f). 17 The Proposed Regulations clarify that the same is true for NQDC plans that are established under Section 457A (relating to NQDC plans sponsored by tax indifferent parties, such as foreign corporations). 18 Short-Term Deferral The Existing Regulations provide that an amount is not considered deferred compensation (and thus not subject to Section 409A) if that amount is required to be paid and is actually or constructively paid on or before the 15th day of the third month following the end of the employee s or the employer s tax year (whichever is later) in which the employee s right to the payment is no longer subject to a substantial risk of forfeiture. 19 Under the Proposed Regulations, a employer may delay the payment beyond that date to avoid a reasonably anticipated violation of federal securities law or other applicable law provided that the payment is made as soon as reasonably practicable following the first date on which the employer anticipates or reasonably should anticipate that making the payment would not cause such violation. 20 The Proposed Regulations clarify when each of the following situations do not provide for a deferral of compensation as defined under Section 409A. If there is no deferral of compensation under Section 409A, the described arrangement is not subject to the 409A rules. Stock Rights The Existing Regulations provide that nonstatutory stock options and stock appreciation rights (collectively, stock rights ) do not provide for a deferral of 17 Treas. Reg A-1(a)(4). 18 Prop. Treas. Reg A-1(a)(4), 81 Fed. Reg , Treas. Reg A-1(b)(4). 20 Prop. Treas. Reg A-1(b)(4)(ii)), 81 Fed. Reg ,

10 compensation under Section 409A if certain rights are met. 21 Recognizing that employers may wish to reduce the amount payable under a stock right if the employee engages in behavior harmful to the employer, the Proposed Regulations provide that a stock right that does not otherwise provide for a deferral of compensation will not be treated as providing for a deferral of compensation solely because the amount payable under the stock right upon an involuntary separation from service for cause, or the occurrence of a condition within the employee's control, is based on a measure that is less than fair market value. 22 Additionally, the Proposed Regulations modify the definition of eligible issuer of employer stock to include pre-employment grants of stock rights, provided the employee is reasonably expect to begin (and actually begins) providing services within 12 months after the grant date of the stock right. 23 Separation Pay Plans Under the Existing Regulations, separation pay plans do not provide for the deferral of compensation to the extent certain requirements are met. One requirement is that the separation generally cannot exceed two times the lesser of (i) the employee s annualized compensation based on the employee s annual rate of pay for the calendar year preceding the calendar year in which the separation from service occurs, or (ii) the compensation limit under Code Section 401(a)(17) for the year in which the separation occurs. 24 The Proposed Regulations clarify that the separation pay plan exception is for employees whose employment begins and ends in the same tax year. In those circumstances, the employee s annualized compensation for the taxable year in which separation occurs may be used for purposes of the separation pay plan exception provided the employee had no 21 Treas. Reg A-1(b)(5). 22 Prop. Treas. Reg A-1(b)(5)(iii)(A), 81 Fed. Reg , Prop. Treas. Reg A-1(b)(5)(iii)(E), 81 Fed. Reg , Treas. Reg A-1(b)(9)(iii)(A)(2). 10

11 compensation from the employer in the tax year prior to the year in which the separation occurs. 25 Employment-Related Expense Reimbursements Under the Existing Regulations, an arrangement does not provide for the deferral of compensation if it provides for amounts to be paid as settlements or awards resolving bona fide legal claims, such as wrongful termination or employment discrimination, or for reimbursements or payments of reasonable attorneys fees or other reasonable expenses incurred by the employee related to such bona fide legal claims. 26 Recognizing that employment agreements may provide for the reimbursement of attorneys fees in connection with employmentrelated disputes, the Proposed Regulations provide that a plan does not provide for the deferral of compensation under Section 409A if it provides for the payment or reimbursement of reasonable attorneys fees and other expenses incurred by a employee to pursue a bona fide legal claim against the employer with respect to the service relationship. 27 Recurring Part-Year Compensation Recognizing that educational institutions structure their pay plans to provide even cash flow for employees who work for less than 12 months in a year, the proposed regulations simply current guidance regarding part-year compensation. Recurring part-year compensation earned over a period of service does not provide for the deferral of compensation if (1) payment of the recurring part-year compensation is not deferred beyond the last day of the 13th month following the first day of service period, and (2) the recurring party-year compensation does not exceed the Code Section 401(a)(17) limit applicable to qualified plans for the calendar year in which the service period begins 28 (which is $270,000 for 2017) Prop. Treas. Reg A-1(b)(9)(III)(A), 81 Fed. Reg , Treas. Reg A-1(b)(11). 27 Prop. Treas. Reg A-1(b)(11), 81 Fed. Reg , Prop. Treas. Reg A-1(b)(13), 81 Fed. Reg ,

12 For example, a teacher providing services during a school year beginning in August 1, 2017, and ending in June 1, 2018, and receiving a salary of $265,000 for that period could receive the compensation for that school year between August 1, 2017, and September 30, Separations from Service Deemed Asset Sales The Existing Regulations permit a buyer and seller in an asset sale to specify whether the seller s employee is treated as separating from service with the seller where the employee is hired by the buyer after and as a result of the sale. 30 The Proposed Regulations clarify that this rule does not apply to stock sales, which are treated as deemed asset sales under Code Section 338, because under Section 338, the seller s employees do not experience a termination from employment with the seller. 31 Change in Status from Employee to Independent Contractor (or Vice Versa) The Existing Regulations provide that a separation from service occurs if the facts and circumstances indicate that the employer and employee reasonably anticipate that no further services are to be performed after a certain date, or that the level of services to be performed (whether as an employee or an independent contractor) would permanently decrease to no more than 20 percent of the average level of services performed (whether as an employee or an independent contractor) over the preceding 36-month period. 32 The Proposed Regulations clarify the application of this rule to an individual whose status changes from being an employee to being an independent contractor, or vice versa, by deleting language in the Existing Regulations that could have been interpreted otherwise. In other words, 29 IRS Notice Treas. Reg A-1(h)(4). 31 Prop. Treas. Reg A-1(h)(4), 81 Fed. Reg , 40580; see also 26 U.S.C Treas. Reg A-1(h)(5). 12

13 an individual must separate from service both as an employee and as an independent contractor to be treated as having separated from service. 33 References to Payment Being Made New General Rule The Existing Regulations provide guidance for when a payment is made for certain purposes (such as the short-term deferral rule discussed above), but do not include a rule that generally applies for all purposes to determine when a payment is made for Section 409A purposes. The Proposed Regulations add such a rule. Under the Proposed Regulations, a payment is made, or the payment of an amount occurs, when any taxable benefit is actually or constructively received. Furthermore, payment does not occur upon (1) the grant of an option that does not have a readily ascertainable fair market value; (2) a transfer of property that is substantially nonvested for which the employee did not make a valid election under Section 83(b); or (3) a contribution a taxable trust described in Section 402(b) or a transfer or creation of a beneficial interest in a Section 402(b) trust unless the amount is includible in income under Section 402(b). 34 Additionally, payment occurs for all purposes under Section 409A upon income inclusion under Section 457(f)(1)(A). 35 Note, though, that an amount includible in income under Section 457(f) may not be a short-term deferral under Section 409A. For example, under the Section 457(f) proposed regulations, benefits may be conditioned on compliance with a covenant not to compete, but the benefits would not be subject to a substantial risk of forfeiture under Section 409A. Assuming compliance with the covenant not to compete (discussed below), amounts payable at the end of the non-compete period are include in income under Section 457(f), but are considered deferred compensation (and not short-term deferrals) under Section 409A. 33 Prop. Treas. Reg A-1(h)(5), 81 Fed. Reg , Prop. Treas. Reg A-1(q), 81 Fed. Reg , Id. 13

14 Permissible Payments The Existing Regulations provide that compensation subject to Section 409A may only be paid at a specified time or upon an event set forth in the Existing Regulations. The Proposed Regulations modify the rules applicable to payments upon death and payments of transaction-based compensation. 36 Payments Following Death The Proposed Regulations expand the rule applicable to payments made on account of an employee s death to apply to payments made on account of his or her beneficiary s death. That is, a payment made on account of the death of the employee s beneficiary is made timely if it occurs at any time between the date of death and December 31 of the calendar year after the year of beneficiary s death. 37 Transaction-Based Compensation The Proposed Regulations clarify that the special payment rules applicable to transaction-based compensation also apply to stock options and stock appreciation rights. 38 Prohibition on Acceleration of Payments A plan subject to Section 409A generally cannot permit acceleration of the time or schedule of any payment. The Proposed Regulations modify some of the permitted exceptions to the general rule. 39 Payments to a Beneficiary Under the Existing Regulations, the addition, deletion, or substitution of a permissible payment event generally results in an impermissible acceleration of 36 Treas. Reg A-3(a). 37 Prop. Treas. Reg A-3(b), 81 Fed. Reg , 40581; Prop. Treas. Reg A-3(d)(2), 81 Fed. Reg , Prop. Treas. Reg A-3(d)(5)(iii), 81 Fed. Reg , Treas. Reg A-3(j). 14

15 payments under Section 409A if the addition, deletion, or substitution could result in the payment being made at an earlier date. 40 A plan subject to Section 409A may, however, allow for distributions due to the employee s death, disability, or unforeseeable emergency. 41 The Proposed Regulations provide that this exception also applies to the payment of deferred amounts upon the death, disability, or unforeseeable emergency of a beneficiary who has become entitled to payment due to an employee's death. The Proposed Regulations also clarify that a schedule of payments (including payments treated as a single payment) that has already commenced prior to an employee's or a beneficiary's death, disability, or unforeseeable emergency may be accelerated upon the death, disability, or unforeseeable emergency. 42 Compliance with Bona Fide Foreign Ethics Laws or Conflicts of Interest Laws Under the Existing Regulations, a plan may provide for acceleration of the time or schedule of a payment to the extent reasonably necessary to avoid the violation of a federal, state, local, or foreign ethics or conflicts of interest law. With respect those foreign laws, though, the Existing Regulation only applies the exception to foreign earned income from sources within the foreign country that promulgated the law. 43 The Proposed Regulations expand the scope of this provision to permit the acceleration of any nonqualified deferred compensation if the acceleration is reasonably necessary to comply with a bona fide foreign ethics or conflicts of interest law. 44 Plan Terminations and Liquidations 40 Treas. Reg A-3(j). 41 Treas. Reg A-3(j). 42 Prop. Treas. Reg A-3(j)(1), 81 Fed. Reg , Treas. Reg A-3(j). 44 Prop. Treas. Reg A-3(j)(4)(iii)(B), 81 Fed. Reg ,

16 The Existing Regulations provide that a plan may be terminated and liquidated, and compensation deferred under the plan distributed, if (1) the employer terminates and liquidates all plans sponsored by the employer that would be aggregated with the terminated plan under the Section 409A plan aggregation rules if the same employee had deferrals of compensation under all such plans; and (2) for a three-year period, the employer does not adopt a new plan that would be aggregated with the terminated and liquidated plan if the same employee participated in both plans. 45 The Existing Regulations identify nine types of NQDC plans under the plan aggregation rules, including but not limited to account balance plans providing for elective deferrals, account balance plans that do not provide for elective deferrals, non-account balance plans, and stock right plans. 46 To address the questions raised by commenters, the Proposed Regulations clarify that the acceleration of a payment pursuant to the plan termination rule rule is permitted only if the employer terminates and liquidates all plans of the same category that the employer sponsors, and not merely all plans of the same category in which a particular employee actually participates. The Proposed Regulations also clarify that under this rule, for a period of three years following the termination and liquidation of a plan, the employer cannot adopt a new plan of the same category as the terminated and liquidated plan, regardless of which employees participate in the plan. 47 Amounts Includible In Income Under the Existing Regulations, the IRS issued proposed income inclusion rules. Generally, under those rules, when a plan that is subject to Section 409A fails to comply with Section 409A, all amounts deferred under the plan as of the end of the tax year of the failure (plus any payments under the plan made during the year), less the portion of the amount deferred under the plan that is subject to a 45 Treas. Reg A-3(j)(4)(ix). 46 Treas. Reg A-1(c). 47 Prop. Treas. Reg A-3(j)(4)(ix)(A), 81 Fed. Reg ,

17 substantial risk of forfeiture or has previously been included in income, are immediately included in income and subject to a 20 percent penalty tax. Because nonvested amounts (i.e., those subject to a substantial risk of forfeiture) are not included in income upon a Section 409A failure, certain Section 409A failures may be corrected without penalty while amounts are not vested. 48 The Existing Regulations also included an anti-abuse rule to deter abuse in allowing the correction of failure of nonvested deferred compensation (such as impermissible changes in the time and form of payment of nonvested amounts). Under that anti-abuse rule, if the facts and circumstances indicate a pattern or practice of permitting impermissible changes to the time and form of payment of nonvested amounts, such amounts may be treated as vested (possibly resulting in immediate income inclusion). 49 The Proposed Regulations attempt to strengthen the anti-abuse rule by making several changes. First, the Proposed Regulations clarify that a nonvested deferred amount will be treated as vested for an employee s tax year during which there is an impermissible change in a plan provision that affects the time or form of payment of the amount, unless the employer has made a reasonable, good faith determination that the original provision failed to meet the requirements of Section 409A, and that the change is necessary to bring the plan into compliance Section 409A. 50 Second, the Proposed Regulations provide the following examples of the types of facts and circumstances that indicate whether an employer has a pattern or practice of permitting impermissible changes in the time or form of payment of nonvested deferred amounts: 48 Prop. Treas. Reg A-4(a)(1)(ii)(B), 73 Fed. Reg Id. 50 Prop. Treas. Reg A-4(b), 81 Fed. Reg ,

18 1) Whether commercially reasonable measures have been taken to identify and correct substantially similar failures promptly upon discovery; 2) Whether substantially similar failures have occurred more frequently with respect to nonvested deferred amounts than with respect to vested deferred amounts; 3) Whether substantially similar failures occur more frequently with respect to newly adopted plans; and 4) Whether substantially similar failures appear intentional, are numerous, or repeat common past failures that have since been corrected. 51 Third, the Proposed Regulations provide that, to the extent generally applicable guidance regarding the correction of section 409A failures prescribes a particular correction method (or methods) for a type of plan failure, that correction method (or one of the permissible correction methods) must be used if a service recipient chooses to correct that type of a failure with respect to a nonvested deferred amount. In addition, these proposed regulations provide that substantially similar failures affecting nonvested deferred amounts must be corrected in substantially the same manner. 52 Individual and Entity Service Providers The Proposed Regulations clarify the Existing Regulations 53 to reflect that a service provider can be an entity as well as an individual. 54 The Proposed 51 Id. 52 Id. 53 Treas. Reg A-1(b)(5)(vi)(A), 1.409A-1(b)(5)(vi)(E), 1.409A-1(b)(5)(vi)(F), and 1.409A-3(i)(5)(iii) 54 Prop. Treas. Reg A-1(b)(5)(vi)(A), 81 Fed. Reg , 40580; Prop. Treas. Reg A- 1(b)(5)(vi)(E), 81 Fed. Reg , 40580; Prop. Treas. Reg A-1(b)(5)(vi)(F), 81 Fed. Reg , 4080; and Prop. Treas. Reg A-3(i)(5)(iii), 81 Fed. Reg ,

19 Regulations also correct an erroneous reference to service provider that should be service recipient. 55 B. Section 457 Plans for State and Local Governments and Tax- Exempt Employers 1. Overview On June 22, 2016, the IRS proposed new regulations 56 under Code Section 457(f) (the 457 Regulations ). As discussed below, the 457 Regulations address several key concepts applicable to ineligible Section 457(f) plans. The 457 Regulations also update existing regulations to reflect statutory changes in Section 457. Qualified Roth Contributions Under the 457 Regulations, eligible governmental plans (as defined in Code Section 457(b)) may include a qualified Roth contribution program under which designated Roth contributions are included in income in the year of deferral. The 457 Regulations provide that contributions and withdrawals of a participant's designated Roth contributions must be credited and debited to a designated Roth account maintained for the participant, and that the plan must maintain a record of each participant's investment in the contract with respect to the account. In addition, the 457 Regulations provide that no forfeitures may be allocated to a designated Roth account and that no contributions other than designated Roth contributions and rollover contributions described in section 402A(c)(3)(A) may be made to the account. 57 Distributions for Qualified Accident and Health insurance Premiums 55 Prop. Treas. Reg A-1(b)(3), 81 Fed. Reg , Fed. Reg , I.R.B. 32 (July 11, 2016). 57 Prop. Treas. Reg , 81 Fed. Reg , ; Prop. Treas. Reg (b)(1), 81 Fed. Reg ,

20 The 457 Regulations amend the rules for the taxation of certain eligible governmental plan distributions to eligible public safety officers. Specifically, the 457 Regulations provide that such distributions from an eligible governmental plan meeting the requirements of section 402(l) are excluded from gross income and are not subject to the general rule providing that amounts deferred under an eligible governmental plan are includable in the gross income of a participant or beneficiary for the taxable year in which they are paid. 58 Qualified Military Service The 457 Regulations update existing regulations to provide HEART Act protections to eligible governmental plans 59 and to provide that certain military service is treated as a severance from employment for purposes of the plan distribution restrictions applicable to eligible plans Eligible Plans a. Eligibility and Participation The IRS ruled that the employees of a single-member disregarded entity, which was a subsidiary of a tax-exempt entity sponsoring a 457(b) plan, may participant in the parent entity s plan. The IRS reasoned that the employees of the disregarded entity are treated as employees of the tax-exempt entity, which would allow (but not require) those employees to participate in the 457(b) plan. 61 c. Taxation of Distributions and Rollovers i. Distributions for Unforeseen Emergencies The IRS announced that participants in qualified plans as defined in Code Section 457 may receive hardship distributions from those plans if the participant s 58 Prop. Treas. Reg (b)(4), 81 Fed. Reg , Public safety officer is defined at Code Section 402(l)(4)(C). 59 Prop. Treas. Reg (f), 81 Fed. Reg , Prop. Treas. Reg (b)(1), 81 Fed. Reg , Chief Counsel Advice Memoranda , IRS CCA (July 11, 2016). 20

21 principal place of residence was located in a parish in Louisiana that was affected by a series of storms beginning on August 11, Ineligible Section 457 Plans The 457 Regulations also update and expand the guidance relating to ineligible plans under Section 457(f), addressing several key concepts not covered under prior guidance. Compensation Not Subject to Section 457(f) Short-Term Deferrals The 457 Regulations adopt the short-term deferral exception from Code Section 409A (discussed above). Under that exception, a deferral of compensation does not occur (and therefore the compensation is not subject to Code Section 457(f)) if the compensation is required to be paid and is actually or constructively paid on or before the 15th day of the third month following the end of the employee s or the employer s tax year (whichever is later) in which the employee s right to the payment is no longer subject to a substantial risk of forfeiture. 63 Other Exceptions The 457 Regulations further provide that deferrals of compensation do not occur for Section 457(f) purposes where the plan provides for: The payment of expense reimbursements, medical benefits, or in-kind benefits, as described in Treas. Reg. Section 1.409A-1(b)(9)(v)(A), (B), or (C); Certain indemnification rights, liability insurance, or legal settlements, as described in Treas. Reg. Section 1.409A-1(b)(10) or (11); or 62 IRS Announcement , I.R.B. 355 (August 30, 2016). 63 Prop. Treas. Reg (d)(2), 81 Fed. Reg ,

22 Taxable educational benefits for an employee (but not for the employee s spouse, child, or other family members) as described in Code Section 127(c)(1). 64 The 457 Regulations also provide that there is no deferral of compensation with respect to recurring part-year compensation, as discussed above under the Section 409A Proposed Regulations. Substantial Risk of Forfeiture In General Both the 457 Regulations and the Section 409A Proposed Regulations address the concepts of substantial risk of forfeiture. Under the 457 Regulations, an amount generally is subject to a substantial risk of forfeiture only if entitlement to that amount is conditioned on (1) the future performance of substantial services, or (2) the occurrence of a condition that is related to a purpose of the compensation if the possibility of forfeiture is substantial. An amount is not subject to a substantial risk of forfeiture if the facts and circumstances indicate that the forfeiture condition is unlikely to be enforced based on, among other things, the past practices of the employer, the level of control or influence of the employee, and the enforceability of the provisions under applicable law. 65 Involuntary Severance from Employment Under the 457 Regulations, amounts payable upon an involuntary severance from employment without cause or upon a voluntary termination for good reason is subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial. 66 The 457 Regulations define good reason as being due to a unilateral action taken by the employer that causes a material negative change to the relationship 64 Prop. Treas. Reg (d)(4), 81 Fed. Reg , Prop. Treas. Reg (e)(1), 81 Fed. Reg , Prop. Treas. Reg (d)(2), 81 Fed. Reg ,

23 between the employee and the employer. The 457 Regulations also establish a safe harbor definition of good reason that deems good reason to exist where one or more of the following conditions arise without the employee s consent: Material reduction in the employee s compensation; Material diminution in the employee s authority, duties, or responsibilities; Material diminution in the authority, duties, or responsibilities of the employee s supervisor; Material diminution in the budget over which the employee has authority; Material change in the geographic location of the employee s work site; or Any material breach of the employee s work agreement. 67 The good reason conditions agreed to by the employee and employer must be pre-established in writing; if they are later changed, there may be a deemed rolling risk of forfeiture. Covenants Not to Compete The 457 Regulations allow the substantial risk of forfeiture to survive after the employee s severance from employment if the employee has entered into a covenant not to compete. The covenant not to compete must meet each of the following requirements: The right to payment is expressly condition upon the employee refraining from performing future competing services pursuant to an enforceable written agreement; 67 Id at

24 The employer consistently makes reasonable ongoing efforts to verify compliance with all of the covenants not to compete to which it is a party; and At the time the agreement is entered into, the facts and circumstances show that the employer has a substantial and bona fide interest in preventing the employee from competing and that the employee has a bona fide interest in competing. 68 Extensions to Substantial Risk of Forfeiture The 457 Regulations permit extensions to the period covered by a substantial risk of forfeiture (i.e., rolling risks of forfeiture) in limited circumstances: The present value of the amount to be paid upon lapse of the substantial risk of forfeiture (as extended) must be materially greater than the amount would be paid absent the substantial risk of forfeiture (and, if applicable, as extended); The initial or extended substantial risk of forfeiture must be based upon the future performance of substantial services or compliance with a covenant not to compete; The period for which substantial future services must be performed must be at least two years (with earlier payments being permissible upon death, disability, or involuntary severance from employment without cause); and The parties must agree in writing to the addition or extension: o For initial deferrals, the agreement must be made in writing before the calendar year in which any services giving rise to the compensation are performed; 68 Prop. Treas. Reg (e)(1)(iv), 81 Fed. Reg ,

25 o For extensions of the risk of forfeiture period, the agreement must be made in writing at least 90 days before the date on which the existing substantial risk of forfeiture would have lapsed; and o For newly hired employees, the agreement must be made in writing within 30 days after hire, but only with respect to amounts attributable to services rendered after the addition or extension is agreed to in writing. 69 In order for the compensation to be materially greater after the extension of the risk of forfeiture period, the present value of the amount subject to the additional or extended substantial risk of forfeiture must be more than 125 percent of the present value of the amount the employee would have received absent the extended period. The 457 Regulations provide that compensation an employee receives for additional services is not taken into account when calculating whether the present value of the additional compensation is materially greater than the current compensation. As an example, if an employee becomes vested in an amount of $100 on December 31, 2017, and the employer extends that vesting date to December 31, 2019, the $100 that would have vested in 2017 must be increased by at least $ VI. MISCELLANEOUS A. Catch-Up Contributions The annual limit on the amount of compensation that may be deferred under 69 Prop. Treas. Reg (3)(2), 81 Fed. Reg , Id. 25

26 401(k), 457(b), and 403(b) plans remained at $18,000 for The annual limit on age-50 catch-up deferrals for 401(k), governmental 457(b), and 403(b) plans remained at $6,000 for B. Tax Credit for Qualified Retirement Savings Contributions The income limits for the credit rate for 2017 are as follows: 73 AGI Joint Filers AGI Head of Households AGI All Other Filers Credit Rate $0-$37,000 $0-$27,750 $0-$18,500 50% $37,001-$40,000 $27,751-$30,000 $18,501-20,000 20% $40,001-$62,000 $30,001-$46,500 $20,001-$31,000 10% Over $62,000 Over $46,500 Over $31,000 0% 71 IRS Notice (Oct. 27, 2016). 72 Id. 73 IRS webpage Retirement Topics Retirement Savings Contributions Credit (Saver's Credit) as updated Oct. 31, 2016, available at: Savings-Contributions-Savers-Credit. 26