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IRS Issues Long-Awaited Rules on Deferred Compensation

July 11, 2016

A decade-long IRS regulatory project has produced a notice of proposed rulemaking (NPRM) prescribing rules for section 457(f) deferred compensation plans maintained by exempt organizations and state and local governments. 

Nonqualified deferred compensation plans make a portion of an employee's current compensation payable in a later taxable year. The determination of whether compensation is deemed part of a section 457(f) deferred compensation plan and the timing of vesting is important for income tax purposes. Compensation in a 457(f) plan is subject to income tax when it vests. 

The proposed regulations:

  • Broadly define deferred compensation for purposes of section 457(f) as when an employee has a legally binding right to compensation during a taxable year that is or may be payable in a later taxable year (qualified retirement plans and section 457(b) plans are excluded, among others).
  • Specify that short-term deferrals will not be considered inside a 457(f) plan. Short-term deferrals are when a payment is made by the 15th day of the third month following the calendar year in which the payment vests (e.g., a bonus for 2016 that vests on December 31, 2016 and is paid by March 15). The bonus will be subject to tax in 2017 when it is paid, rather than in 2016 when it vests.  If there is any arrangement whereby payment can be delayed beyond the required timeframe, the payment will not be considered a short-term deferral.
  • Explain other exceptions to the 457(f) rules, including bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, and death benefit plans, with a focus on spelling rules for what constitutes a bona fide severance pay plan. The rules also make it clear that legal settlements are not covered by 457(f).
  • Clarify that the use of an agreement not to compete constitutes a valid substantial risk of forfeiture, a component required by the rules, as long as the non-compete agreement meets certain requirements. This is helpful to colleges and universities because such agreements are frequently used in contracts of senior administration and athletic directors as a post-termination substantial risk of forfeiture to which deferred compensation is linked. The IRS had previously not permitted non-competes to be recognized as such.
  • Provide parameters for calculating present value. When compensation becomes subject to tax, under section 457(f) the amount included in income is the present value of the compensation as of the vesting date. The proposed rules address how to determine that amount.

The rules will go into effect for calendar years beginning after the date the final regulations are published. They will apply to amounts deferred after that date and amounts deferred prior to that date that have not yet vested. There are special rules postponing the effective date for collectively bargained plans and for government plans for which legislative changes are required to amend the plans. The proposed rules may be relied upon before publication of final regulations.

Contact

Mary Bachinger
Director, Tax Policy
202.861.2581
E-mail