Whether you are a state or local government, a tax-exempt organization or a for-profit entity, new deferred compensation plan guidance could affect your business. This past summer, the IRS issued proposed regulations under section 457 (governing nonqualified deferred compensation for tax-exempt organizations and governmental subdivisions) as well as section 409A (administrating overall nonqualified deferred compensation plans). The following summarizes these new and updated rules.
Applicable to tax-exempt and governmental entities, section 457 addresses the treatment of nonqualified deferred compensation. Section 457 provides income taxation rules for both “eligible” and “ineligible” deferred compensation — the most prominent being the timing of the year of the inclusion of the deferral in the gross income of the participant or beneficiary. Depending on whether the plan sponsor is a tax-exempt or governmental entity, different rules for eligible deferred compensation plans apply, the key being that an eligible governmental plan (but not an eligible tax-exempt plan) must hold plan assets in a trust apart from its general assets.
The newly released guidance includes provisions:
- Allowing an eligible governmental plan to include a qualified Roth contribution program
- Modifying the rules for the taxation of eligible governmental plan distributions to an “eligible public safety officer”
- Revising the definition of “plan” to provide additional guidance on bona fide vacation leave, sick leave, compensatory time, severance pay (including involuntary severance from employment including severance from employment for good reason, window programs and voluntary early retirement incentive plans), disability pay and death benefits (which are generally treated as not providing for a deferral of compensation) as well as plans paying solely “length-of-service” awards to “bona fide volunteers”
- Clarifying that compensation deferred in an ineligible plan is includible in the gross income of the participant or beneficiary on the date that is the later of: (1) the date the participant or beneficiary obtains a legally binding right to the compensation, or (2) if the compensation is subject to a substantial risk of forfeiture at that time, the date the substantial risk of forfeiture lapses; any earnings credited on that compensation are includible in the gross income of and taxable to the participant or beneficiary when paid or made available to the participant or beneficiary
These proposed regulations were issued for the specific and narrow purpose of clarifying and modifying the section 409A final regulations and certain proposed “income inclusion regulations” and are designed to assist taxpayers in complying with the requirements of section 409A. The main points of these proposed regulations consist of:
- Clarification of deferred compensation plans. These rules can apply to plans separately and in addition to any requirements applicable to similar plans.
- Explanation of qualified payments. A payment that would qualify as a “short-term deferral,” but is made after the two-and-a-half-month period, may still qualify as such if certain federal securities laws or other applicable law would not be violated.
- Definition of stock price. The grant of certain stock rights, stock options and stock appreciation rights do not provide for the deferral of compensation. A stock price will not be treated as based on a measure other than fair market value if the amount payable is based on a measure that is less than fair market value.
- Clarification of reimbursement payments. Reimbursement of attorneys’ fees or other expenses incurred to enforce a claim by the service provider against the service recipient with respect to the service relationship is not a deferral of compensation.
- Discussion of impact of employees who become independent contractors. An employee who becomes an independent contractor for the same entity and whose anticipated level of services upon becoming an independent contractor are 20 percent or less than the average level of services performed in the immediately preceding 36-month period, will incur a separation from service, even though a complete termination of the contractual relationship has not taken place.
- Definition of actual or constructive receipt. Payment is made when any taxable benefit is actually or constructively received and that the inclusion of an amount in income is treated as a payment.
Other issues addressed in these regulations include separation pay plans, recurring part-year compensation language, “separation of service,” payments upon death of beneficiary, payment acceleration as well as a focus on transaction-based compensation. While proposed regulations are not yet law, taxpayers are encouraged to rely on them now.
If you believe these rules may apply to compensation plans within your organization, please reach out to our Baker Tilly employee benefits specialists.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.