Rules/Regs | Published in October 2016

New Take on ‘Top Hat’ Taxation

IRS regulations will impact taxation of benefits under 457(f) arrangements

By John Manganaro | October 2016
Art by Gracey Zhang
In June, the Internal Revenue Service (IRS) proposed long-awaited regulations expected to influence the reporting and taxation of benefits paid under 457 plans—i.e., deferred-compensation retirement plans for governmental and other tax-exempt employers.
In summary, the IRS says, the proposed regulations will make necessary updates to a previous round of changes, made in 2003, to Sections 457(a), 457(b) and 457(g) of the U.S. Code, to reflect statutory changes to Section 457 since the publication of those regulations. In addition, the proposed regulations provide guidance on certain issues under Sections 457(e)(11) and 457(e)(12) that are not addressed in the 2003 final regulations and provide additional guidance under Section 457(f).
According to Kevin Selzer, a Denver-based associate at Holland & Hart LLP, it is the 457(f) changes that will likely have the biggest impact for retirement plan sponsors. To set the stage for understanding this new IRS proposal, he says, it should be clarified that it is mainly expected to affect “top hat” plans, which allow highly compensated employees to defer amounts beyond the 457(b) limitations.
“In other words, the bulk of the practical impact is on the 457(f) top-hat arrangement, although the proposed regulations touch on a lot besides 457(f) plan taxation, as well,” he says.
By way of background, Selzer observes, the current 457(b) deferral limits have been viewed as restrictive because the limit is composed of both employee and employer contributions. “So you end up with this pretty small limit in the 457(b) context,” Selzer says, “especially if the employer wants to provide any sort of a generous match. It gets really restrictive on how much you can defer.” Once a participant exceeds this amount, he tracks into the 457(f) space, Selzer says.
The proposed regulation will affect the taxation of benefits paid under such 457(f) arrangements, mainly by making updates to the definition of the term “substantial risk of forfeiture.” The term may sound esoteric, but it is critically important in the context of knowing when and how to tax 457(f) payments.
This is because 457(f) plan dollars are taxable not when paid by the employer but when the substantial risk of forfeiture lapses, Selzer explains. “Before this proposed regulation, people really thought there were only two other areas in the code where the substantial risk of forfeiture concept exists. One involves transfers of property in exchange for services, under Section 83. The other is under Section 409(a).”
Put simply, the conflict was that those two definitions were somewhat different, and it caused confusion in terms of knowing what amounts to tax, and when to tax, under 457(f) arrangements. Both definitions of the “lapse of substantial risk of forfeiture” were conditioned on the performance of essential services, but, for instance, one difference was that updates previously made via 409(a) said a non-compete agreement signed by an executive would no longer be considered a substantial risk of forfeiture, and thus it would not protect the employee from facing a tax burden related to 457(f) assets.
“Under Section 83 rules, it also says that generally a non-compete would not prevent a lapse in the substantial risk of forfeiture, but under certain specific circumstances Section 83 says a non-compete potentially could serve the purpose,” Selzer says. “This seemingly slight disagreement has caused significant confusion for plan sponsors over the years, and so this new regulation has been anticipated by many.”
In the lead up to the new regulations, many in the industry actually anticipated the 409(a) standard to be put front and center, meaning a non-compete would no longer work as maintaining the substantial risk of forfeiture, Selzer says. Now the IRS has come out with another update, and in fact the opposite happened—non-competes can, in fact, work to maintain the substantial risk of forfeiture, so long as some fairly restrictive prerequisites are met.
In a Client Alert publication from Groom Law Group, Chartered, in Washington, D.C., Christine Kong, Lori Shannon, Robert Jensen and Erik Vogt write that, under current law, benefits subject to Section 457(f) are taxable “when they are no longer subject to a substantial risk of forfeiture.”
“Section 457(f) provides that benefits conditioned upon ‘the future performance of substantial services’ are subject to a substantial risk of forfeiture, but the regulations did not provide additional guidance regarding the meaning of substantial risk of forfeiture,” the Groom experts observe. “IRS rulings have provided some insight, resulting in the common use of certain features, including covenants not to compete; rolling risk of forfeiture provisions by which the employer and employee mutually agree to delay the vesting date; and use of an employee deferral election to defer the receipt of compensation on a tax-deferred and forfeitable basis subject to a substantial risk of forfeiture.”
Offering their own take on the history of the new regulation, the Groom experts observe that, in 2007, the IRS issued Notice 2007-62, announcing its intent to issue guidance that would apply the Section 409(a) definition of substantial risk of forfeiture to Section 457(f) benefits. “This would result in the features described above no longer creating a substantial risk of forfeiture for Section 457(f) purposes,” the attorneys explain. “Many plan sponsors and practitioners have resisted eliminating these features in hopes that the guidance ultimately issued will allow more flexibility than suggested in Notice 2007-62 … As many had hoped, the proposed regulations do not adopt the same definition of substantial risk of forfeiture that applies under Section 409(a).”
While the definition in the proposed regulations is similar, it differs in several respects, the experts write. “Under the proposed regulations, an amount is generally subject to a substantial risk of forfeiture only if entitlement to that amount is conditioned on the future performance of substantial services (e.g., the hours required to be performed are substantial in relation to the amount of compensation), or on the occurrence of a condition that is related to a purpose of the compensation (i.e., one that relates to the employee’s performance of services or to the employer’s tax-exempt/governmental activities or organizational goals) if the possibility of forfeiture is substantial.”
Under the new paradigm, according to the Groom experts, an amount is not subject to a substantial risk of forfeiture if the facts and circumstances “indicate that the forfeiture condition is unlikely to be enforced, based on, among other things, the past practices of the employer, the level of control or influence of the employee and the enforceability of the provisions under applicable law.”
Practical Takeaways
Plan sponsors will have to review whatever benefits they have, carefully, to ensure they are taxing all benefits correctly and complying with all parts of the rule. Some plans are exempted outright, potentially easing that task. For instance, severance pay or sick or vacation pay is explicitly carved out from the 457(f) changes.
“The severance item is probably another important aspect of the new rulemaking for plan sponsors; before, there was a vague rule that said certain severance plans could be exempt from 457(f), but it was not clear exactly what you had to do to meet that exception,” Selzer says. “Now we have more guidance—generally speaking, these parameters are that you’re limited in the amount of compensation you can pay under severance to two times your annual compensation, similar to the exemption under 409(a).”