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The tax code provides two general tax regimes for the taxation of deferred compensation. The regime that applies depends on the tax status of the employer. If tax-exempt, Section 457(f) applies. If taxable, Section 451 applies. 2
Today s presentation applies only to tax-exempt employers. Credit Unions are tax-exempt, but some subsidiaries and affiliates are taxable. Taxable subsidiaries and affiliates (e.g., some CUSOs) are not subject to Section 457(f). 3
1986 Congress extends 457(f) to tax-exempt employers. Deferred compensation taxable when substantial risks of forfeiture (SRF) lapse. 2001 Enron debacle 2005 Congress reaction 409A, which imposes rules about time and form of payment and stiff participant penalties on participants for rule violations. Many employers attempt to qualify for exemptions from 409A under the separation pay plan exemption or the shortterm deferral exemption. The short-term deferral exemption applies if the plan is nonelective and subject to cliff vesting, and if the benefit is paid in a short-term after the benefit vests. 4
2007 IRS Notice 2007-62 IRS anticipates issuing new 457(f) rules (no noncompetes, no voluntary deferrals, severance definition) 2016 IRS issues proposed 457(f) regulations 5
Public comment period closes September 20, 2016. Hearing to be held October 18, 2016. New rules will be effective January 1 of year after year in which the final regulations are issued. 6
New rules apply to all deferrals that occur on or after the effective date, whether under an old plan or a new plan. Final regulations are expected to clarify that pre-effective date deferrals are taxed under the pre-effective date rules (which are not black and white). This offers a type of grandfathering, but not a no challenge protection. 7
457(b) plans and loan-regime split dollar arrangements are not impacted by the proposed rules. 8
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Old Rules: Facts and circumstances test, such as age, training, health, and competitive market; forfeiture likely to be enforced if participant competes; 2-year minimum. New Rules: Higher hurdle. Employer must have a substantial and bona fide interest in preventing competition; key factors are showing significant adverse economic consequences, and reasonable ongoing efforts to verify compliance with all noncompete agreements. Employee must have a bona fide interest in competing and ability to compete ; key factors are employee s reputation, specialized skills, and financial need. New rules are similar to Section 83 analysis must show competition is likely absent the 457(f) plan. 10
To defer taxes, consulting requirements must last for a minimum of two years, and the consulting hours must be substantial in relation to the amount of deferred compensation. Therefore, for larger benefits, post-term consulting may not be workable. 11
For voluntary deferrals to be deemed subject to an SRF, the present value of the deferred dollars must be more than 125% of the present value of the non-deferred dollars (e.g., matching contributions or other supplemental employer credit to get to >125%). It is not clear how the present value is calculated in cases of early termination. Each dollar deferred must be deferred a minimum of 2 years from its regular payment date. For example, a voluntary deferral plan has benefits vesting at age 65. Therefore, any deferrals after age 63 would fail the 2-year minimum test and would not be tax-deferred. Initial deferral of 2 years is okay, but re-deferrals need to be 5 years under the 409A redeferral rule, and subject to the >25% match. 12
The proposed regulations provide that if a deferred compensation benefit is exchanged for a non-deferred compensation benefit (e.g., retiree medical coverage), then the new benefit is also treated as deferred compensation. This provision would be effective for exchanges occurring after the regulations become final. How this would apply to loan regime split dollar is unclear since all amounts received under loan regime split dollar must be repaid (to the carrier and to the employer). Given the repayment obligation, there appears to be no payment or benefit received to which taxation could apply. 13
Severance pay that qualifies as bona fide severance pay is taxable as received instead of as it vests. Old 457(f) definition of bona fide severance pay was loose; generally at up to 2X total compensation, and benefits payable only following an involuntary termination without cause. 409A tightened the rules. Benefits could also be paid following a good reason termination, but the exemption is limited to the lesser of 2X total compensation or 2X the qualified plan compensation limit (which is $265,000 in 2016 for a total maximum exemption of $530,000). Anything over the 2X limit is subject to the deferred compensation rules. New 457(f) rules removed the qualified plan limiter. Anything over 2x comp is taxable in a lump sum at the beginning of the severance period. 14
The IRS created the short-term deferral exemption under 409A. A plan with the exemption is not subject to 409A s penalties. The exemption only applies to non-elective deferred compensation subject to cliff vesting, with benefits paid within a short-term after vesting. The IRS extended the concept to Section 457(f), with the difference that elective deferrals meeting the >125% standard and noncompetes that meet the high bar can also qualify for the exemption. 15
The 457(f) short-term deferral exemption removes the plan from 457(f) s tax on vesting rule and instead taxes the benefit on receipt. For example, under current rules, if a participant vests on 12/31/2016, the participant is taxed in 2016 even if the benefit is not paid until 2017. Under the new 457(f) short-term deferral exemption, where the benefit is payable within 2-1/2 months after the end of the year in which vesting occurred, the benefit is taxed in the year received, which could be either 2016 or 2017. (The employee cannot be allowed to choose the year of taxation.) 16
CAUTION: The 457(f) short-term deferral exemption does not exempt the plan from complying with 409A, which has its own more restrictive definition. Example A deferred compensation plan uses a 3-year noncompete as the SRF. At the end of the 3-year period, the employer will pay the benefit to the terminated participant. During the 3-year period, the dollars are not deferred compensation for purposes of 457(f), but they are deferred compensation for purposes of 409A, as the noncompete is not a 409A SRF. Therefore, if the employer and executive were to make a change, such as reducing the 3-year noncompete to 2 years, that would violate 409A as an impermissible acceleration. 17
The new rules add/clarify: Definitions for bona fide vacation leave, sick leave, severance pay, disability pay and death benefit plans that are exempt from 457(f). Income is taxable on a present value basis when it vests. The regulations give some guidance on how to calculate present value, providing safe harbor interest rates and mortality tables. If an individual is taxed under section 457(f) on the present value of a benefit that is later forfeited, the participant gets a miscellaneous tax deduction for the excess amount taken into income. The new regulations incorporate several changes that Congress has made to 457(b) plans sponsored by governmental entities (e.g., Roth contributions). These do not apply to 457(b) plans of tax-exempt employers. 18
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