Legal Alert

IRS Proposes Regulations On Nonqualified Deferred Compensation Plans Of State And Local Governments And Tax-Exempt Organizations

On May 8, 2002, the Internal Revenue Service published in the Federal Register longawaited proposed regulations under section 457 of the Internal Revenue Code (the “Code”) governing nonqualified deferred compensation plans maintained by state and local governmental employers and by tax-exempt organizations. The Service issued final regulations under Code section 457 in 1982. Since then, substantial legislative changes have been made to Code section 457. The new proposed regulations provide guidance concerning these changes, clarify issues arising under the old final regulations, and set forth rules about long-standing issues that had not previously been addressed. The proposed regulations address both “eligible” plans, within the meaning of Code section 457(b), and “ineligible” plans, which are governed by Code section 457(f).

Generally

The proposed regulations address or clarify a number of points, including the following:

•   An eligible plan must be established in writing.
•   The rules governing eligible plans apply to both employee deferrals of compensation and employer nonelective and matching contributions.
•   Accumulated sick pay, accumulated vacation pay and back pay are eligible for deferral, provided that the deferral election with respect to these amounts is made before the first month in which the participant could actually receive these amounts in cash.
•   The proposed regulations slightly relax, from the standpoint of plan administration, the rules governing permissible distributions for unforeseen emergencies.
•   Amounts will not be considered taxable merely because they are disposed of in accordance with a qualified domestic relations order (“QDRO”).
•   Helpful rules are provided to preserve participants’ tax-deferred retirement savings in cases of plan termination or an employer’s conversion to a status that is ineligible to maintain a 457 plan.
•   The Service is in the process of updating guidance on tax reporting on distributions and expanding its retirement plan correction program to eligible plans, and will in the interim accept ad hoc requests for corrections.

Special Rules for Eligible Governmental Plans

The proposed regulations also establish or elaborate significant rules specifically applicable to eligible plans of state and local governments, including the following:

•  The new age-50 catch-up is to be applied to deferrals under an eligible governmental plan in the same manner as it applies to deferrals under a 401(k) plan or 403(b) annuity, as set forth in proposed regulations issued in October 2001 under Code section 414(v).
•   In the three years before the participant’s normal retirement date under the plan, a participant may instead make use of the long-standing section 457(b)(3) catch-up contribution, which is equal to two times the applicable limit for the year reduced by the “underutilized amount” (i.e., the amount the participant was eligible to contribute but did not contribute in previous years (not taking into account any age-50 catch-up contributions made by the participant)). The proposed regulations include complicated rules for computing the underutilized amount for years prior to 2002, when section 457 contribution limits were coordinated with section 401(k) and 403(b) plans. Rules governing the determination of normal retirement age for this purpose are also provided.
•   Excess deferrals (i.e., amounts in excess of the maximum permissible amount for any year) and allocable net income on the excess deferrals may be distributed from an eligible governmental plan and, if these amounts are timely distributed, the plan will continue to be an eligible plan.
•   The proposed regulations authorize plan loans and provides that they will not be taxable to the participant provided (a) the loans complies with the section 72(p) rules for loans from qualified plans (which limit the amount and term of the loan and require at least quarterly, level repayments), (b) the loan bears a reasonable rate of interest and is made on commercially reasonable terms, (c) loans are available to all participants on reasonably equivalent terms, and (d) the arrangement is otherwise a loan rather than a distribution on all the facts and circumstances.
•   Distribution elections that were made before 2002 on a irrevocable basis, to comply with then-applicable law, may be modified.
•   The required distribution and direct rollover rules applicable to section 401(a) plans are generally incorporated by reference. The rules for rollovers and plan-to plan transfers are elaborated, and the detail of those rules will merit attention.
•   The funding rules – that the assets of an eligible governmental plan must be held in a trust, custodial account or insurance contract meeting certain requirements – are discussed. It is unclear whether funding agreements issued by insurance companies are allowed under the proposed regulations. In addition, a space is reserved in the proposed regulations for future guidance concerning the funding of multiple plans under a single funding vehicle.

Special Rules for Eligible Plans of Tax-Exempt Employers

The proposed regulations also address certain requirements applicable only to eligible plans of tax-exempt employers:

•   In distinction from governmental plans, the proposed regulations provide that the plan of a tax-exempt employer generally will cease being an eligible plan if it accepts excess deferrals. Only one exception is provided: if the maximum limits on deferrals are violated by a participant as a result of deferrals during a calendar year under plans of more than one employer, however, neither a governmental plan nor a tax-exempt employer plan will be treated as an ineligible plan, though the excess deferrals will be includible in the gross income of the employee.
•   For plans of tax-exempt employers, under which participants are taxable when amounts are paid or made available, amounts will not be treated as made available merely because (a) a participant can elect to receive, one time during participation in the plan, a distribution of an amount that does not exceed the threshold above which involuntary distributions cannot be made from qualified plans (currently, $5,000), if no annual deferrals were made by or on behalf of the participant during the two-year period preceding the distribution or (b) a participant is allowed, before distributions are to commence, to make an election to defer (but not accelerate) the time at which distributions are to commence or to elect a form of payment.

Arrangements Subject to Code Section 457

The proposed regulations provide only limited guidance on the types of arrangements treated as outside the scope of section 457 and thus not subject to its requirements and limitations.

•   Code section 457 excludes from its purview bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, or death benefit plans. The proposed regulations merely recite that list and do not provide guidance on the difficult issue of what types of arrangements will be considered to qualify for this exclusion. The taxpayer community has long requested guidance on those issues.
•   Similarly, section 457 is inapplicable to “that portion of any plan which consists of a transfer of property described in section 83.” Some tax-exempt employers have provided employees discounted options on securities such as mutual fund shares, on the theory that since the taxation of these options was governed by section 83, these arrangements were not subject to section 457 and employees could be provided deferred compensation in excess of the section 457 limits. Though the proposed regulations and the preamble do not discuss this issue extensively, it appears that the Service is taking the position that these arrangements do not achieve the results desired by employers and employees. Specifically, the proposed regulations provide that “a transfer of property described in section 83” is “a transfer of property to which section 83 applies.” They then provide that exception from taxation under Code section 457(f) for Code section 83 transfers will apply only if the date on which there is “no substantial risk of forfeiture” with respect to the compensation that has been deferred occurs after the date there has been a transfer of property to which Code section 83 applies. The proposed regulations do not explicitly mention options in this context, but the language used and examples illustrating the rules governing the interaction of sections 83 and 457 can be read to suggest that an employee who receives a discounted option is taxable upon receipt of the option (or, if later, when the option vests) on the present value of the option. Whether an employee who receives an undiscounted option recognizes taxable income under Code section 457(f) is unclear, because the proposed regulations do not provide guidance on whether such an arrangement involves the deferral of compensation. That such an implication was intended is also suggested by the special effective date provision that the rules for coordinating Code sections 457 and 83 do not apply to an option without a readily ascertainable fair market value that was granted on or before May 8, 2002 (the date of the publication of the regulations), even though the proposed regulations are generally effective for taxable years beginning after December 31, 2001.

While the proposed regulations are helpful in many respects, we anticipate that clarifications or refinements may be appropriate to consider. If you have questions about the proposed regulations or would like to consider submitting comments to the IRS, we would be pleased to assist.

Sutherland Legal Alerts are intended to provide clients with information on recent legal developments, not to render legal advice.