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Deferred Compensation Redesign

Most nonprofit hospitals, and many other tax-exempt employers, make tax-favored retirement plans, such as 403(b) plans, generally available to all of their employees. Some nonprofit hospitals, and other tax-exempt employers, also provide non-qualified deferred compensation plans and severance plans to certain senior managers.

However, these non-qualified deferred compensation plans and severance plans may soon be subject to much tougher tax rules. If finalized, the new rules would greatly restrict or eliminate several popular deferred compensation plan and severance plan designs, and force many employers to redesign their plans completely.

A. Substantial Risk of Forfeiture

Section 457(f) of the Internal Revenue Code regulates non-qualified deferred compensation plans of tax-exempt employers. Under that section, participants are subject to income tax when the deferred compensation is no longer subject to a "substantial risk of forfeiture" (that is, when it becomes vested).

This is different than the tax treatment for participants in non-qualified deferred compensation plans sponsored by taxable employers. Those participants are generally not subject to income tax until the deferred compensation is paid.
Section 457(f) provides that a substantial risk of forfeiture (SROF) exists if a participant's rights to the deferred compensation are "conditioned upon the future performance of substantial services." Beyond that definition and a few IRS rulings, there has been little guidance on what constitutes a SROF.

This lack of guidance has resulted in many nonprofit deferred compensation plans being designed somewhat aggressively. These designs include: Non-compete provisions. Many plans provide that deferred compensation is not vested (that is, remains subject to a SROF) until the participant satisfies a non-compete requirement after retirement. Practitioners have been especially comfortable with this approach, if there is a good chance that the participant would accept a job with a competitor, and, therefore, forfeit the benefit.

Rolling risk of forfeiture. Some plans provide that deferred compensation becomes vested (that is, no longer subject to a SROF) after the participant remains employed for a certain additional period of service, but allow the participant to delay the vesting date by making an election at least one year before the original vesting date.

Salary deferrals. Other plans allow participants to make salary deferrals, and provide that the deferrals are not vested (and subject to a SROF) until the participant completes an additional period of service.

B. IRS Announcement

The IRS has neither endorsed nor ruled against any of these SROF designs. However, the enactment of Section 409A of the Internal Revenue Code, effective January 1, 2005, signaled a change in this laissez-faire attitude.

Section 409A established new election and distribution rules for all deferred compensation plans. Among other things, Section 409A required the IRS to define the term "substantial risk of forfeiture" for Section 409A - not Section 457(f) - purposes.

Subsequently, the IRS has established a Section 409A definition of SROF that is narrower than what was understood to be the Section 457(f) definition. At about the same time, the IRS also began questioning deferred compensation plan SROF provisions, like those described above, during IRS audits of tax-exempt employers.

Not surprisingly, the IRS, in Notice 2007-62, announced its intention to apply the more restrictive Section 409A SROF definition for Section 457(f) purposes. If that intention is finalized, it would have the following impact:

Non-compete provisions. A non-compete provision would no longer constitute a SROF - even if the participant would likely take a job with a competitor.

Rolling risks of forfeiture. Extensions of vesting periods would no longer be recognized. Therefore, deferred compensation would always become taxable income at the end of the original vesting period.

Salary deferrals. Pay would not be subject to a SROF after the date the participant could have received it. This means that stand-alone salary deferral plans would no longer work.

Curiously, salary deferrals could still qualify for favorable tax treatment if the amount subject to a SROF is materially greater than the pay the participant could have received.

For example, if a participant defers $10,000 of salary in 2008, but is required to work through the end of 2010 to receive it, the $10,000 would, nonetheless, be taxable income in 2008 because there is no SROF. However, if the employer provided a $5,000 matching contribution in addition to the salary deferral, and both were conditioned on continued service through the end of 2010, then neither would be taxed until 2010. This is because the amount subject to a SROF ($15,000) is materially greater than the pay the participant could have received ($10,000).

C. Bona Fide Severance Plans
A "bona fide" severance plan sponsored by a tax-exempt employer is exempt from Section 457(f). Therefore, an employee's promised benefits under such a plan are not subject to income tax until paid.
As with the definition of "substantial risk of forfeiture," there has been little guidance on what is a "bona fide" severance plan. Again, this has led to aggressively designed plans. These include providing severance for both voluntary and involuntary termination of employment, and providing severance amounts that greatly exceed the participant's final annual pay.

In Notice 2007-62, the IRS has signaled its intention to crack down on these designs as well. If that intention is implemented, a severance plan would be "bona fide" and exempt from Section 457(f) only if it satisfies each of the three following conditions:

1. Benefits are payable only upon involuntary termination from employment. It is likely that the IRS would also allow benefits to be payable upon a "good reason" resignation, as long as the good reason definition meets IRS standards. (A "good reason" resignation is generally one that results from the employer taking actions that cause a "material negative change" in the employment relationship, such as a material cut in pay or reduction of job responsibilities.)

2. The amount payable does not exceed two times the lesser of: (i) the participant's annual rate of pay, or (ii) the limit of annual compensation that may be taken into account in determining benefits under tax-qualified retirement plans ($230,000 in 2008).

3. Payments must be completed by the end of the second calendar year following the year of severance. If each of these conditions are met, severance benefits would not be taxable income until paid. If any of these conditions are not met, severance payments would be taxable income when they are first vested. (that is, when there is no longer a SROF).

For example, a hospital might enter into a severance agreement with its CEO to provide $500,000 in severance, payable in 24 monthly installments upon the CEO's involuntary termination. If the CEO's final annual pay were $180,000, then the plan would satisfy the first and third conditions above, but only $360,000 (2 x $180,000) of the severance would satisfy the second condition. Therefore, $360,000 (24 monthly installments of $15,000) would be exempt from Section 457(f) and would be taxable income when paid. The remaining $140,000 would not be exempt from Section 457(f), and would be taxable income in the year of involuntary termination (when the CEO no longer has a SROF).

D. Next Steps

The guidance in Notice 2007-62 has not been finalized, and final guidance is not expected until early 2008. The IRS has said that the final guidance will only be implemented on a prospective basis after the final guidance is published. Moreover, it is possible that the final guidance will differ from Notice 2007-62.

Even so, it is not too early for tax-exempt sponsors of non-qualified deferred compensation or severance plans to begin considering redesign options.

In that regard, it is important to remember that the new Section 457(f) rules would not make an affected plan design illegal - it would just accelerate taxation to the participant. Therefore, one redesign option would be to retain the existing plan design, have the participant pay income tax when vested, but "gross up" the participant's pay to cover the taxes that would be due. (Of course, this could put the participant in a better position, since the participant would have had to pay the applicable taxes, albeit at a later date, under the old tax rules.)

Finally, any "change" to an existing deferred compensation plan must also comply with Section 409A rules that in the future will make certain changes to deferred compensation and severance plans very difficult to implement. Fortunately, however, a transition rule allows sponsors and participants to make changes to deferred compensation and severance plans through December 31, 2008, without running afoul of Section 409A.


December 21, 2007




Rosen, Barry F.