Impact of New IRS Rules on Severance Arrangements and Other Deferred Compensation Margo Hasselman Greenough Jani K. Rachelson Tolsun Waddle with contributions from Richard Harmon
Qualified vs Nonqualified Plans Deferral of otherwise taxable compensation Qualified plans subject to Internal Revenue Code/ERISA rules Nonqualified plans not subject to IRC/ERISA rules Both types of plans avoid constructive receipt of income
NQDC Plans in General Normally benefit select group of management or highly compensated employees Some exceptions exist to permit collectively bargained plans and bona fide severance plans NQDC plans must meet requirements of 409A or 457, or of both
Code 409A Long standing requirements All NQDC plans must comply Certain events trigger payment Prohibition on acceleration of distributions Deferral election timing Short-term deferral rule
Code 409A Proposed regulations: new requirements Expanded short-term deferral rule Stock rights Clarity regarding separation pay plans Reimbursement of employment-related legal fees Recurring part-year compensation Status changes: independent contractor vs employee
Code 457(f) Long standing requirements Only governmental or tax-exempt employers may sponsor Lapse of substantial risk of forfeiture (SRF) triggers taxation Must continue providing substantial services in order to have substantial risk of forfeiture Vesting dates or events generally can t be changed (except in case of death or disability) Compliance with 457(f) is in addition to 409A Generally, no elective deferrals Benefits taxable and reported upon vesting
Code 457(f) Proposed regulations Permit employee elective deferrals Covenants not to compete can create substantial risk of forfeiture Involuntary (or voluntary if for good reason) terminations can accelerate vesting Rolling risk of forfeiture is permissible provided certain conditions are met Benefits still taxable and reportable upon vesting, but query whether elective deferrals will be reportable on Form W-2
457(f) Plan Case Study Exempt organization provides all employees with DB plan using the formula years of service x average salary x 1.8% New CEO employment agreement provides: Employee will be compensated for any difference in the current [DB Plan] benefit level of 1.8 and a 2.0 benefit level, such difference to be calculated and paid to the Employee on or about his normal retirement date. How to avoid current taxation based on that provision? To implement that change, entity would adopt a 457(f)-compliant plan Amounts payable under plan would vest at NRD of age 62 Benefits taxable in a lump sum upon lapse of substantial risk of forfeiture at NRD Plan could provide either specific dollar amounts payable (or a formula-based calculation) as of a specified date If participant separates from service prior to that date, no benefit payable Caveats Vesting date cannot be actual date of retirement Vesting date may be delayed provided certain restrictions are met 409A issues
Union/Benefit Plan Severance Provisions for Officials and Employees
Union By-Law Providing Severance Each elected official of the Union who shall have served as a full-time employee for a minimum of five (5) years shall be entitled to severance pay upon the honorable termination of full-time employment as such official, amounting to ten percent (10%) of the official s salary for each year of service as a full-time official, with a maximum credit of fifteen (15) years. 10
Union By-Law Providing Severance Pay The total amount of severance pay hereunder may be paid to eligible former officials in four (4) consecutive annual installments, without interest, commencing upon the termination of services. In the event of death of an eligible official, the severance pay hereunder shall be paid to his/her estate. 11
By-Law Text 457(f) Application - This severance policy establishes an account plan. Each elected official of the local who shall have served as a full-time employee for a minimum of five (5) years, shall be entitled to severance pay upon the honorable termination of full-time employment as such official, amounting to ten percent (10%) of the official s salary for each year of service as a fulltime official, with a maximum credit of fifteen (15) years. The requirement to complete five years of full-time employment is a substantial risk of forfeiture ( SROF ). Once the official completes 5 years, however, and becomes vested in the benefit, there is no SROF. The official is taxed on the value of the account as of the vesting date. For each subsequent year s accrual, through the 15 th year, the official has additional 457(f) taxable income in the amount of that year s credit of 10% of salary, because each additional credit is not subject to a SROF. 12
By-Law Text 409A Application The severance pay provided under the By-law is not subject to 409A. Each elected official of the local who shall have served as a full-time employee for a minimum of five (5) years, shall be entitled to severance pay upon the honorable termination of full-time employment as such official, amounting to ten percent (10%) of the official s salary for each year of service as a fulltime official, with a maximum credit of fifteen (15) years. Until the official vests, the severance is not subject to 409A, because he does not have a legal right to any payment. Once the benefit vests and is taxed under 457(f), the account balance is not considered deferred compensation for purposes of 409A. IRS Notice 2007-62, Part V. As long as no interest is credited to the official s account, the severance pay is completely exempt from 409A. If the benefit credited interest on the account balance in subsequent years, the interest portion, not taxable under 457(f) would be subject to 409A. 13
By-Law Text 409A Application The total amount of severance pay hereunder may be paid to eligible former officials in four (4) consecutive annual installments, without interest, commencing upon the termination of his/her services. In the event of death of an eligible official, the severance pay hereunder shall be paid to his/her estate. 409A(a)(4) requires the written plan to specify the amount of the deferred compensation and the mode of payment of the deferred compensation, commencing upon termination of services or death. The by-law specifies a single mode of payment, i.e., four annual installments following one of the two payment events. The by-law does not condition payment on the official s signing a release. The by-law does not provide any exceptions to the payment events. The by-law satisfies all the requirements of 409A. 14
CBA Severance Pay Provision 1 In the event of layoff or discharge (except for just cause) all employees shall receive severance pay in the amount of one (1) week for every six (6) months of service, with a cap of fifty-two (52) weeks, upon execution of a separation and release agreement acceptable to the Employer. 15
CBA Severance Text In the event of layoff or discharge (except for just cause) all employees shall receive severance pay in the amount of one (1) week for every six (6) months of service, with a cap of fiftytwo (52) weeks, upon execution of a separation and release agreement acceptable to the Employer. Application of 409A and 457(f) Severance is not subject to 409A because it is not deferred compensation, since it is (i) payable only on involuntary termination, and (ii) set forth in a CBA. (Non-bargained severance pay is also exempt if it meets certain conditions.) Severance is subject to 457(f), and fully taxable to employee only if and when involuntarily terminated. Not exempt from 457(f) because (A) unlike the 409A Regulations, there is no exemption from 457(f) for bargained benefits, and (B) this CBA provision does not state that severance must be paid by the end of the 2 nd calendar year following termination. Proposed Regulation 1.457-11(d). 16
Bona Fide Severance Pay Plan A bona fide severance pay plan is exempt from 457(f) when: Severance is paid only upon an involuntary termination; The severance pay does not exceed twice the employee s annualized compensation; and CBA must state that all severance will be paid by no later than the end of the second calendar year following the year of involuntary termination. Proposed Rule 1.457-11(d)(1)(iii). 17
457(f) Taxation Involuntarily terminated employee in December 2016 is taxed in 2016 on the entire 52 weeks (assuming the maximum), including withholdings for employment taxes for OASDI (if applicable) and Medicare, even if the severance benefit is payable in 2017. 18
CBA Severance Provision 2 Employees who retire or resign after twenty (20) years of employment shall receive ten (10) weeks of severance pay. 19
CBA Text Employees who retire or resign after twenty (20) years of employment shall receive ten (10) weeks of severance pay Application of 409A 409A applies, although provision is included in a CBA, because benefit is payable on a voluntary retirement after 20 years of employment. This severance pay plan violates 409A because it fails to describe how the benefit will be paid, e.g., lump sum, periodic installments, or a combination of both, as required under 409A(a)(2)(A)(iv). The employee will be taxed on the 10- week benefit following her 20th year, plus an additional 20% excise tax. (If the benefit is not taxed in the employee s 20th year, the employee will have to pay interest on the unpaid tax liability at the underpayment rate, plus 1%.) 20
CBA Language Employees who retire or resign after twenty (20) years of employment shall receive ten (10) weeks of severance pay Application of 457(f) 457(f) applies following the employee s twentieth year of employment with the Union, when substantial risk of forfeiture lapses, and benefit vests. She will have to pay federal income taxes for the year of vesting, but not employment taxes. Employment tax withholdings are deferred because (i) this a non-account plan, and (ii) as of the vesting date: (A) the amount of payment is unknown (salary may increase), and (B) the employee s retirement date is unknown. 21
457(f) Taxation The employee s 457(f) income is the present value of the 10-week benefit, as of the vesting date, in accordance with the Proposed Regulation: Actuarial assumptions, including interest rate, used to determine the taxable present value must be reasonable, based on all the facts and circumstances. Proposed Regulation permits amount of deferred compensation payment to be multiplied by the probability that a condition on which the payment is contingent will be satisfied, but not by the probability that the payment will not be made due to the employer s insolvency, unwillingness to pay, or the like. 22
457(f) Taxation If the IRS determines actuarial assumptions used are not reasonable, it will re-calculate present value using applicable federal rate ( AFR ) and the applicable mortality table used under Code section 417(e)(3)(B) for lump sum distributions. The assumption for the payment commencement date can be any date that is not beyond 5 years from the vesting date, unless it would be unreasonable not to assume an earlier date. 23
CBA Provision For Severance Upon Merger Section 1 Should any employee be laid off or terminated as a direct result of the Employer's merger with another labor organization, the affected employee shall receive a severance payment in the amount of three (3) weeks for every year of employment. Section 2 Should any employee elect to resign his or her position in any new merged union within one (1) year of the merger (defined as the time when the governing bodies of the two (2) unions have voted in favor completing a merger), such employee shall give the Employer not less than sixty (60) days notice of his or her intentions and such employee shall receive a severance payment in the amount of three (3) weeks salary for every year of service. Section 3 Any severance payable under this Article is conditioned upon the employee s execution of a separation and release agreement acceptable to Employer. 24
MERGER Section 1 Should any employee be laid off or terminated as a direct result of the Employer's merger with another labor organization, the affected employee shall receive a severance payment in the amount of three (3) weeks for every year of employment. Section 2 Should any employee elect to resign his or her position in any new merged union within one (1) year of the merger (defined as the time when the governing bodies of the two (2) unions have voted in favor completing a merger), such employee shall give the Employer not less than sixty (60) days notice of his or her intentions and such employee shall receive a severance payment in the amount of three (3) weeks salary for every year of service. Section 3 Any severance payable under this Article is conditioned upon the employee s execution of a separation and release agreement acceptable to Employer. Application of 409A Section 1 is exempt from Code 409A because it is payable only upon an involuntary termination and pursuant to a CBA. It is not exempt from Code 457(f) because the requirement that the severance payment be paid out within two calendar years following the year of involuntary termination is not stated in the agreement. If and when there is a merger, and employees are involuntarily terminated, 457(f) is triggered. (But the employee also receives the payment.) 25
MERGER Section 1 Should any employee be laid off or terminated as a direct result of the Employer's merger with another labor organization, the affected employee shall receive a severance payment in the amount of three (3) weeks for every year of employment. Section 2 Should any employee elect to resign his or her position in any new merged union within one (1) year of the merger (defined as the time when the governing bodies of the two (2) unions have voted in favor completing a merger), such employee shall give the Employer not less than sixty (60) days notice of his or her intentions and such employee shall receive a severance payment in the amount of three (3) weeks salary for every year of service. Section 3 Any severance payable under this Article is conditioned upon the employee s execution of a separation and release agreement acceptable to Employer. Application of 409A Section 2, a limited one-year voluntary walkaway severance benefit following a merger, is not exempt from 409A because it is payable on a voluntary termination of employment. Section 2 violates 409A because (A) the mode of payment is not specified, and (B), because of the required release in Section 3, which renders the payment date unspecified. 26
MERGER Section 1 Should any employee be laid off or terminated as a direct result of the Employer's merger with another labor organization, the affected employee shall receive a severance payment in the amount of three (3) weeks for every year of employment. Section 2 Should any employee elect to resign his or her position in any new merged union within one (1) year of the merger (defined as the time when the governing bodies of the two (2) unions have voted in favor completing a merger), such employee shall give the Employer not less than sixty (60) days notice of his or her intentions and such employee shall receive a severance payment in the amount of three (3) weeks salary for every year of service. Section 3 Any severance payable under this Article is conditioned upon the employee s execution of a separation and release agreement acceptable to Employer. Application of 457(f) The walk-away severance benefit will also be taxable under 457(f), because the substantial risk of forfeiture lapses upon the approval of merger by the governing bodies of the two unions. At that point, all employees subject to the collective bargaining agreement are entitled to the severance benefit All covered employees will have taxable income equal to the present value of the severance benefit, whether they actually elect it or not. The same present value amount (3 weeks of pay for every year of employment) will be subject to employment tax withholdings. If the employee decides not to resign, then in the year that the election expires, he or she can deduct the previously taxed 457(f) income as an itemized miscellaneous deduction on his/her Form 1040 Schedule A. 27
Consequences for not complying with 409A An employee is not taxed on deferred compensation until the lapse of the substantial risk of forfeiture. An additional 20% excise tax applies to the now-taxable deferred amount on the lapse of the substantial risk of forfeiture. 28
Consequences for not complying with 409A Un-taxed 457(f) account earnings/interest is 409A deferred compensation. If the deferred compensation is not reported and taxed in the year of the 409A violation, interest is added to the tax liability on the deferred compensation at the underpayment rate, plus 1%. 29
Consequences for not complying with 409A The deferred compensation under an account plan is also subject to employment tax withholdings for OASDI (if applicable) and Medicare in the same year as includible in income. If not an account plan, employment tax withholdings apply when the (i) amount of the deferred compensation, (ii) the payment commencement date, and (iii) the mode of payment are all known. 30
Taxation Under 457(f) The employee is subject to income tax on the deferred compensation when the substantial risk of forfeiture has lapsed (vesting event) and future substantial services are no longer required. The present value of the deferred compensation is reported on the employee s Form W-2 in the year of the vesting event. 31
Taxation Under 457(f) If there is no payment of deferred compensation upon a vesting event, then there cannot be any income tax withholdings for 457(f) income taxes. Treasury Regulation section 31.3401(a)- 1(b) (for FIT withholding wages are limited to compensation that is received by the taxpayer). See TAM 199903032. 32
Taxation Under 457(f) For employment taxes (OASDI and Medicare), 457(f) deferred compensation is subject to the same reporting rules that apply to 409A plans of deferred compensation. If it is an account plan, then employment taxes are assessed on the account balance as of the vesting event. 33
Taxation Under 457(f) If not an account plan, employment taxes are not assessed and withheld until the date that the amount, the commencement date, and the mode of payment are all known. 34
457(f) Loss Deduction If 457(f) deferred compensation is forfeited or lost in a subsequent calendar year, the employee is entitled to an itemized miscellaneous deduction on Form 1040, Schedule A. The amount of the deduction is limited to the amount forfeited/lost, and that was previously taxed in a prior year. 35
457(f) Loss Deduction An employee has no deduction for forfeited/lost 457(f) income if limited to the applicable standardized deduction from AGI. Even if the employee can itemize deductions on Schedule A, only those itemized miscellaneous deductions that exceed 2% of AGI are deductible. 36
Tax-Exempt Employer Reporting 457(f) Income The tax-exempt employer who sponsors a 457(f) ineligible plan of deferred compensation must report on IRS Form 990 any reported 457(f) income for its fiscal year on Form 990, Schedule J, Part II, column B(iii). 37
IRC 409A and 457 Issues for Employee Representatives
Issues for Employee Representatives Pitfalls in negotiating employment agreements IRC 457 regulation updates: Implications for LTD plans Comments by National Employment Lawyers Association on updated IRC 457 regulations
Pitfalls in Negotiating Employment Agreements Some improvements to severance offers can run afoul of 409A or 457 Examples Accelerated vesting NQDC Stock options Be sure to meet requirements of an exemption Plan for possible early taxation where any question
Pitfalls in Negotiating Employment Agreements Examples Negotiating more favorable for cause definition Negotiating broader good reason definition E.g. material diminution in bonus, not just salary Eliminates safe harbor May not violate, but becomes case-by-case
Pitfalls in Negotiating Employment Agreements Examples Thinking you can evade 409A E.g. Subbing new severance for forfeited NQDC The IRS has thought of that!
New 457 regulations: Implications for LTD plans Bona fide disability pay plans exempt from 457(f) New regs set out three alternative conditions for payment to be bona fide Disability finding by SSA or Railroad Retirement Board Payment upon participant meeting disability definition requiring condition expected to last at least 12 months or result in death Unable to engage in substantial gainful activity Or receiving income replacement per accident or health plan Not clear who is permitted to make determination Plan administrator? Treating physician? Definitions restrictive compared to many private LTD plans
New 457(f) regulations: Comments by NELA Mostly pro Asked for clarifications Contributions and withdrawals from Roth account maintained for the participant Includes Roth IRAs? Or only employer-sponsored plans? Severance agreements Asked for sample language allowing employer to state separation was voluntary, without risking violation of 457(f) Would facilitate resolution of employment disputes Disability pay plans Asked who can make medical determination and still have plan qualify