IRS has issued proposed regulations prescribing rules under section 457 of the Internal Revenue Code for the taxation of compensation deferred under plans established and maintained by State or local governments or other tax exempt organizations.
The proposed regulations include rules for determining when amounts deferred under these plans are includible in income, the amounts that are includible in income, and the types of plans that are not subject to these rules. Significant provisions in the proposed regulations include:
- Guidance on what constitutes a bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, and death benefit plan, which are treated as not providing for a deferral of compensation for purposes of section 457
- Guidance regarding plans paying solely length of service awards to bona fide volunteers (or their beneficiaries) that also are treated as not providing for a deferral of compensation for purposes of section 457.
- Amendments to existing regulations to reflect statutory changes that allow an eligible governmental plan to include a qualified Roth contribution program, and requiring eligible governmental plans to include provisions that where a participant dies while performing qualified military service, the survivors of the participant generally are entitled to any additional benefits that would have been provided under the plan if the participant had resumed and then terminated employment on account of death
Bona Fide Severance Pay Plans
The rules for a bonafide severance pay plan are very similar to the rules for separation pay plans in the final section 409A regulations.
- First, the benefits provided under the plan must be payable only upon a participant’s involuntary severance from employment or pursuant to a window program or voluntary early retirement incentive plan.
- Second, the amount payable under the plan with respect to a participant must not exceed two times the participant’s annualized compensation based upon the annual rate of pay for services provided to the eligible employer for the calendar year preceding the calendar year in which the participant has a severance from employment (unlike the 409A regulations, there is no cap on how high this amount can go).
- Third, pursuant to the written terms of the plan, the severance benefits must be paid no later than the last day of the second calendar year following the calendar year in which the severance from employment occurs.
Bona Fide Disability Pay Plan
The proposed regulations provide that a bona fide disability pay plan must meet three conditions, which mirror the 409A definition of Disability):
- The participant is unable to engage in substantial gainful activity by reason of a medically determinable physical or mental impairment that can be expected to result in death or last for a continuous period of not less than 12 months
- The participant is, by reason of any medically determinable physical or mental impairment that can be expected to result in death or last for a continuous period of not less than 12 months, receiving income replacement benefits for a continuous period of not less than three months under an accident or health plan covering employees of the eligible employer; or
- The participant is determined to be totally disabled by the Social Security Administration or the Railroad Retirement Board.Short Term DeferralsThe proposed regulations provide that a deferral of compensation does not occur with respect to any amount that would be a short-term deferral under the 409A regulations, substituting the definition of a substantial risk of forfeiture provided under the 457 proposed regulations for the definition under § 1.409A-1(d). There is considerable overlap between the definition of substantial risk of forfeiture for purposes of section 457(f) and the definition of substantial risk of forfeiture for purposes of section 409A.
As with the 409A regulations, under the proposed 457 regulations, if a plan provides that entitlement to an amount is conditioned on an involuntary severance from employment without cause, the right is subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial.
Income Inclusion Under 457(f)
The proposed regulations provide that if a 457 plan of an eligible employer provides for a deferral of compensation for the benefit of a participant or beneficiary and the plan is not an eligible plan (i.e. is is an ineligible plan subject to Code Section 457(f)), the compensation deferred under the plan is includible in gross income as of the later of
- the date the participant or beneficiary obtains a legally binding right to the compensation or,
- if the compensation is subject to a substantial risk of forfeiture, the date the substantial risk of forfeiture lapses.
The proposed regulations also provide general rules for determining the present value of compensation deferred under an ineligible plan. These rules are similar to the rules for determining present value in the proposed section 409A regulations. One difference is that income inclusion under the proposed 457 regulations is determined as of the date the substantial risk of forfeiture lapses, whereas income inclusion under section 409A is determined as of the end of the service provider’s taxable year.