Sections 409A and 457(f): The Proposed Rules Are Here, What’s Next?


The waiting game is finally over for the Treasury Department and Internal Revenue Service’s much-anticipated proposed regulations regarding tax code sections 409A and 457(f) issued June 21.  Both sets of proposed regulations did not contain major surprises for practitioners.

The proposed regulations affect nearly all companies who defer to a later year some executive pay.  These nonqualified deferred compensation plans differ from qualified deferred compensation plans, like 401(k) plans.

Section 409A applies to NQDC plans, generally, and section 457(f) applies to deferred compensation plans of tax-exempt entities.  The proposed regulations provide additional guidance to help navigate practitioners and plan sponsors through the complex requirements of 409A and 457(f) plans.

NQDC Plans

Section 409A regulates the taxation of NQDC plans and provides strict requirements for these plans (e.g., timing of elections and distributions).  Failure to comply with 409A will require the taxpayer to include the deferred amount in gross income, to the extent the amount is not subject to substantial risk of forfeiture, and pay an additional tax of 20 percent and premium interest. 

The proposed regulations offer a laundry list of long-awaited clarifications and technical corrections to the existing final regulations issued nearly nine years ago in 2007, and proposed regulations regarding income inclusion issued in 2008. The new regulations are generally consistent with current practices by practitioners and previously issued informal guidance. 

One of the most significant changes to the existing regulations concern the partial withdrawal of income inclusion rules, which was replaced with an amended version that limits the ability to make changes to an unvested benefit without incurring a penalty.  Andrew Oringer of Dechert LLP in New York told Bloomberg BNA June 30, “There was already some reticence about using the proposed inclusion regulations as a way of making substantive changes to a plan where benefits happened not to have vested yet. There's still some relief here, and there's certainly some more flexibility as compared with the state of play before the inclusion regulations were proposed. I don't think the new changes on this front will generally be seen as unfair.” 

Regina Olshan of Skadden Arps Slate Meagher & Flom LLP in New York told Bloomberg BNA July 1, “If a taxpayer desires to correct a possible 409A violation by changing time and form of payment of an amount which is unvested as of applicable year end, it will need to have a reasonable, good faith basis to conclude that an actual 409A violation was present. It will also need to consider whether and how similar 409A failures were dealt with in the past, and be careful about repeating the same failures in new plans or deferred amounts. Finally, in many instances, the way in which such failure needs to be corrected will be dictated by the current IRS correction programs. For example, if a plan with unvested deferred amounts as of year end contains an impermissible payment event toggle, the way in which the plan must be corrected is dictated by the procedure set for correcting such a documentary error in Notice 2010-6.”

While most practitioners are pleased with the new regulations, they also quickly noted additional 409A issues that could use further guidance.  Daniel Hogans of Groom Law Group Chartered, in Washington, D.C. told Bloomberg BNA June 30, “One issue I think practitioners were hoping for guidance on, that was not addressed, involves replacing unvested but in-the-money stock options or SARs with restricted stock units (RSUs) that vest on the same schedule.” 

“Certain aspects of the treatment of options being cashed out for future payment is still arguably unclear,” Oringer said. 

Comments on the proposed regulations regarding 409A are due by Sept. 20. Taxpayers, however, can rely on the proposed rules immediately—the final regulations are not expected to differ significantly from the proposed regulations. 

Deferred Compensation Plans of Tax-Exempt Entities

Section 457(f) regulates the taxation of deferred compensation plans of state and local governments or other tax-exempt entities under § 501(c) of the tax code.  The deferred amount is includible in gross income in the later year that the taxpayer obtains a legally binding right to compensation or when the amount is no longer subject to a substantial risk of forfeiture. 

The proposed regulations provide new rules for determining when deferred amounts are includible in gross income, calculation of includible income and identifies the types of plans that are not subject to 457(f).  Significantly, the new regulations differentiates the definition of substantial risk of forfeiture as used in 457(f) from 409A despite attempts to harmonize both regulations.  The new regulations also conform the existing final regulations issued in 2003 to a number of statutory changes to 457. 

While practitioners acknowledge that the proposed regulation clarified ambiguities in the 2003 final regulations, they also noted additional 457(f) issues that could use further guidance.  Daniel Morgan of Blank Rome LLP in DC told Bloomberg BNA June 30, “The amount of severance pay cannot exceed two times the employee’s ‘annual rate of pay’ to avoid tax treatment as deferred compensation.  One matter not addressed by the proposed regulations is the meaning of annual rate of pay leaving open the question of whether annual bonus payments are to be taken into account in making the calculation.” 

Morgan also said, “Tax-exempt employers should review their existing employment contracts, deferred compensation agreements, and incentive compensation plans to identify potentially problematic areas.  This review might also include an evaluation of whether any leave arrangements are likely to run afoul of the standards in the proposed regulations.” 

Morgan further said, “Employers, if they choose, may rely on the proposed regulation now” noting that the final regulations are not expected to differ significantly from the proposed regulations. 

Comments on the proposed regulations regarding 457(f) are due by Sept. 20.  A hearing is scheduled at the IRS headquarter Oct. 18.  Specifically, the Treasury and IRS requests feedback on whether: 

  • transition rules are needed for 457(f) plans established before the applicability dates of the 457(f) proposed regulations;
  • additional exceptions are appropriate to apply the 409A proposed regulations to determine the amounts includible in income under 457(f); and
  • provisions for newly eligible employees are needed in the context of 457(f) plans. 

Stay tuned for more posts on 409A, 457(f) and other Executive & Director Compensation matters. 

See related story, Deferred Compensation Proposed Rules Offer Clarity

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