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After a decade in the making, the Internal Revenue Service just recently published proposed regulations that apply to deferred compensation. While they may be revised before finalization, employers can rely on the proposed regulations now (and take comfort that the final regulations will likely track the proposed regulations closely).
While many legal principles apply, the tax code primarily controls nonqualified deferred compensation paid by credit unions. Specifically, Code Section 457(f) governs the tax consequences of deferred compensation paid by tax-exempt employers, including credit unions. Although the label sounds deceptively simple, “deferred compensation” is extremely expansive, covering any right to payment that could be made in a future year. This could apply to employment agreements, severance agreements, deferred compensation plans, fringe benefits, retention or incentive bonus plans, or any other arrangement that could result in an employee receiving a right to compensation that may be paid in a later year.
For tax-exempt employers like credit unions, deferred compensation is taxable to the employee as soon as the right to the compensation is vested, even if paid later. If not structured carefully, Section 457(f) could easily create a mismatch between taxation to the employee and receipt of deferred compensation. The existing rules were often unclear and failed to address many common scenarios, creating uncertainty over the correct tax treatment of various types of deferred compensation plans. The proposed regulations largely resolve those uncertainties and replace them with clear boundaries, in most cases loosening the existing rules by providing more flexible timing rules that soften the tax consequences.
The proposed regulations update many aspects of the prior 457(f) rules. They both modernize the existing rules and bring them more into line with Section 409A, which governs deferred compensation more broadly (although it’s important to note that some differences still remain).
Some of the most useful new features include the following:
- Vesting. Under Section 457(f), once an employee’s right to payment vests, it is taxed, regardless of whether the employee actually receives any money. The proposed regulations expand this concept so an employee’s right to payment can remain unvested for as long as the employee is required to continue working or until the employee (or employer) meets a business-related condition causing the payment to vest.
- Noncompetition Covenants. The proposed regulations also allow post-termination non-competes to delay vesting. To use a non-compete to successfully delay vesting under Section 457(f), there must be an enforceable written agreement based on legitimate business interests that the employer makes reasonable efforts to enforce. A non-compete coupled with annual payments lets employees receive compensation over several years following their separation without being taxed on all those amounts in the year of separation.
- Rolling Risk of Forfeiture. The proposed regulations also provide rules explicitly permitting voluntary salary deferrals and “re-deferrals” whereby an employee can extend the original vesting term without adverse tax consequences. Voluntary salary deferrals and “re-deferrals” must materially increase the amount the employee ultimately will receive and must comply with specific timing limitations. These new rules will allow executives to defer their own pay. They also ease the path for executives and credit unions to extend the vesting period (and therefore taxation) if an executive wants to continue working past his or her anticipated retirement.
- Severance Pay Exemption. Under the proposed regulations, a plan will be exempt from Section 457(f) as a “severance pay plan” if the payments are made only upon the employee’s involuntary termination of employment (or resignation for certain “good reasons”), they do not exceed twice the employee’s annualized compensation, and are paid by the end of the second year following the year of termination. Using this exemption allows the taxation of severance pay to be spread over several years, e.g., monthly severance payments for 24 months, without creating taxation of all severance payments in the year of termination.
- Short-Term Deferral Exemption. As anticipated, the proposed 457(f) regulations add a “short-term deferral” exemption. A plan is exempt from Section 457(f) altogether if the employee is paid by March 15 of the year after the employee becomes vested in the payment. This too allows payments to be taxed in the year they are received, instead of the year they become vested.
Clearly, credit unions must take into account many complex sets of overlapping rules when dealing with any agreement that could create deferred compensation. Because this article can only scratch the surface of the relevant issues, credit unions, their boards, and their executives are encouraged to seek competent counsel when designing and drafting these arrangements.
Robert Q. Johnson is an Associate in the ESOPs & Employee Benefits practice group at Kaufman & Canoles. He helps employers navigate the entire spectrum of employee benefits and executive compensation fields. Johnson works alongside private, governmental and tax-exempt employers and plan sponsors to create and maintain qualified retirements plans, nonqualified deferred compensation plans, and health and welfare plans. He also provides broad compensation counseling and plan drafting for companies needing to attract and retain key employees and executives. Rob can be reached at 757.873.6318 or rqjohnson@kaufcan.com.
The Kaufman & Canoles Credit Union Team serves as general counsel to credit unions, large and small, regularly advising clients on consumer compliance issues, NCUA requirements, and the rules governing credit union service organizations. For more information about our team visit www.kaufcan.com.
