(c) New Proposed Rules for 457(f) Plans

On June 22, 2016, the IRS released the oft‐rumored, long‐awaited proposed regulations (the “Proposed Regulations”) regarding certain deferred compensation plans, commonly referred to by their Code designation as “457(f) plans” or “ineligible plans,” maintained by state or local governments or tax‐exempt organizations.⁸¹ The Proposed Regulations affect not only deferred compensation plans, but also supplemental executive retirement plans, certain split dollar insurance arrangements, and severance plans. While the Proposed Regulations did not deviate significantly from prior IRS guidance and prognostications as to what they would contain, they do offer greater clarity and certainty for executive compensation planning purposes.

Many charitable healthcare organizations utilize deferred compensation plans as a means of attracting and retaining top executives. The use of a 457(f) arrangement is particularly popular because there is no limit to the amount of deferred compensation that can be provided under the plan (as long as total executive compensation is reasonable). Much of the uncertainty regarding these 457(f) plans has revolved around what constitutes the “substantial risk of forfeiture” of the income that must be built into the deferred compensation arrangement in order for taxation of the income to be deferred. Severance pay and noncompete obligations are also key terms of executive employment arrangements impacted by the proposed rules.

Of greatest interest, these proposed rules address what qualifies as deferred compensation, what constitutes a substantial risk of forfeiture, when deferred compensation amounts must be treated as taxable income, and what plans are not subject to the deferred compensation rule.

With regard to severance pay, the Proposed Regulations are substantially similar to existing regulations for deferred compensation plans, although there are a few noteworthy distinctions.

Involuntary Severance from Employment. A bona fide severance pay plan will not be treated as deferred compensation under a Section 457(f) plan if the severance pay is payable only as a result of an involuntary severance from employment (or pursuant to a window program or an early retirement incentive plan). A voluntary separation from service for “good reason” will be treated as involuntary. Good reason generally must relate to a material reduction in authority, duties, responsibilities, working conditions, or pay or change in geographic location and requires a notice and cure period. The proposed regulations include a “good reason” safe harbor that is substantially similar to the safe harbor under existing law.

One notable difference from existing regulations relating to “good reason” is that once the bona fide conditions for good reason have been established, the elimination or removal of one or more of the good reason conditions from the severance plan or employment agreement may constitute an extension of a substantial risk of forfeiture, resulting in a potential income recognition event. If this provision is not removed from the final regulation, it will effectively prevent tax‐exempt employers from eliminating good‐reason triggers that are no longer in the employer's best interest.

Maximum Amount of Severance Pay. The maximum amount of severance pay under this exemption is twice the employee's annualized compensation. Note that this is a favorable change from existing regulations, which impose a dollar cap on the maximum amount of severance pay that may be exempted under the separation pay exemption at 2 times the annual compensation limit for qualified retirement plans under the Code (the limit is $270,000 in 2017, subject to cost of living adjustments). Thus, while current law provides that the maximum amount of separation pay that may be exempted is $540,000, there is no dollar cap imposed under the new Proposed Regulations.

Duration of Salary Continuation. As under current law, exempt severance pay must be paid no later than the last day of the second calendar year following the year in which the severance from employment occurs.

However, there is one important difference between the Proposed Regulations and the existing deferred compensation rules. Under the current rules, a bona fide covenant not to compete does not constitute a substantial risk of forfeiture. As described next, the Proposed Regulations will allow a bona fide covenant not to compete to constitute a substantial risk of forfeiture. Thus, it is possible to increase the amount and extend the duration of severance pay by conditioning payments on a bona fide covenant not to compete.

Noncompete as a Substantial Risk of Forfeiture. Under the Proposed Regulations, the right to receive the severance pay or other postemployment compensation may be conditioned upon an employee refraining from the future performance of services in violation of an enforceable noncompetition agreement if all of the following conditions are met:

1. The right to the payment must be expressly conditioned upon the employee refraining from the future performance of service pursuant to an enforceable written agreement;
2. The employer must make reasonable ongoing efforts to verify compliance with all noncompetition agreements (including the noncompetition agreement applicable to the employee at issue); and
3. At the time that the enforceable written agreement becomes binding, the facts and circumstances demonstrate that the employer has a substantial and bona fide interest in preventing the employee from performing the prohibited services and that the employee has a bona fide interest in, and ability to, engage in the prohibited competition. Factors taken into account for this purpose include the employer's ability to show significant adverse economic consequences that would likely result from the prohibited services; the marketability of the employee based on specialized skills, reputation, or other factors; and the employee's interest, financial need, and ability to engage in the prohibited services.

This is a substantial liberalization of the rules in effect under current law, which do not allow a noncompete to form the basis for a substantial risk of forfeiture.

Initial Deferral Elections and Rolling Risk of Forfeiture. As expected, the Proposed Regulations generally provide that an employee may not electively subject current compensation to a substantial risk of forfeiture or extend the deferral period by extending the service vesting period for compensation that is subject to a substantial risk of forfeiture, unless each of the following conditions is satisfied:

1. Substantial Increase in Present Value of Amounts “Deferred.” The present value of the amount paid on the lapse of the substantial risk of forfeiture must be materially greater than the amount voluntarily subjected to an initial substantial risk of forfeiture or to an extension of the service period under a prior substantial risk of forfeiture. The Proposed Regulations provide that the present value will not be treated as materially greater unless it is at least 125% of the amount that would have been paid in the absence of the voluntary substantial risk of forfeiture or an extension of the vesting period.
2. Substantial Risk of Forfeiture Must be Based Solely on Performance of Future Services. The amount subjected to a voluntary substantial risk of forfeiture or an extension of the vesting period must be conditioned on the employee's continued employment and cannot be conditioned on the attainment of individual or organizational performance goals.
3. Minimum Period of Future Services. The minimum service period for the voluntary substantial risk of forfeiture or extension of the vesting period is two years, but payment may be accelerated on death, disability, or involuntary severance from employment.
4. Timing of Election or Contractual Agreement. The agreement subjecting the compensation to a substantial risk of forfeiture or extending the vesting period for compensation previously subject to a substantial risk of forfeiture must be made in writing before the beginning of the calendar year in which the services giving rise to the compensation are performed in the case of an initial deferral of current compensation or at least 90 days before the date an existing substantial risk of forfeiture is due to lapse in the absence of an extension. Note that the Proposed Regulations do not provide an exception for new hires or employees who become eligible for such an election or agreement for the first time. The IRS has requested comments on whether such an exception should be added.

The Proposed Regulations are proposed to become effective for calendar years commencing after the regulations are finalized, but may be relied upon in the interim.