Over the past decade, we have seen instances where governmental subdivisions (including independent school districts) have designed "severance pay" programs that have resulted in less than favorable tax treatment to its employees. This tax result is attributable to special rules that apply to nonqualified deferred compensation plans maintained by governmental subdivisions and rural electric cooperatives.
The critical issue here is that when designing any severance pay benefit program for a governmental or rural electric cooperative, extreme care must be given to meet the intended goals of the arrangement while not backing into the less than optimal tax timing rules of section 457(f) or the stringent nonqualified deferred compensation rules of section 409A. Accordingly, employers should make certain that qualified tax professionals are reviewing these arrangements in order to avoid unintended harsh results. This article will briefly summarize these rules, focusing on these types of programs and the interrelationship between Internal Revenue Code sections 457 and 409A.
Section 457 of the Internal Revenue Code was enacted by Congress in 1978 to address the tax consequences of certain unfunded, nonqualified deferred compensation of state and local governments and rural electric cooperatives. In 1986, section 457(f) was added to the Code to address the tax treatment of deferred compensation in plans which did not meet certain requirements of an "eligible deferred compensation plan". The legislative history of the Revenue Act of 1978 indicates that Congress believed that state and local government employees should not be totally prohibited from participation in unfunded deferred compensation plans on an elective, tax-exempt basis. However, imposing limitations on the amount of compensation that could be deferred and allowed to accumulate on a tax-exempt basis also seemed appropriate.
As indicated above, nonqualified deferred compensation plans under section 457 may be either "eligible" or "ineligible". In a deferred compensation plan that meets the requirements to qualify as an "eligible" plan under section 457(b), amounts deferred are not taxed to the plan participants until they are paid or made available (i.e. constructively received) by the participant or beneficiary. These requirements incorporate limitations on the amount of compensation deferred, plan distribution rules closely aligned with those applicable to qualified plans, and "coordination rules" that apply in cases of multiple tax-favored arrangements. Finally, section 457(g), added to the Code in the mid- 1990s, requires that the assets and income of an eligible governmental deferred compensation plan must be held in trust apart from the reach of creditors and for the exclusive benefit of participants and beneficiaries.
If any plan of deferred compensation offered to its employees by a governmental subdivision or rural electric cooperative does not meet the criteria of a section 457(b) eligible deferred compensation plan, the plan becomes subject to the rules of Internal Revenue Code Section 457(f). These "ineligible deferred compensation plans" tax deferrals at the time the deferral is made unless the amounts are subject to a "substantial risk of forfeiture". Where a substantial risk of forfeiture exists, amounts are taxable in the year in which the substantial risk of forfeiture lapses. A substantial risk of forfeiture occurs if a person’s rights to deferred compensation are conditioned on the future performance of substantial services by any individual. Therefore, in some cases, the present value of a section 457(f) plan benefit may become subject to income taxation more than a few years before the benefit is actually scheduled to be paid.
The enactment of section 409A of the Internal Revenue Code has further complicated any tax analysis associated with any distribution of benefits from nonqualified deferred compensation plans maintained by governmental entities and rural electric cooperatives. Since section 409A applies to ineligible section 457(f) plans, such plans will potentially be subject to the requirements of both section 457(f) and section 409A.
Following the enactment of section 409A, the Service issued Notice 2007-62 which addressed the interaction of Internal Revenue Code Section 457 plans and Internal Revenue Code Section 409A and announced the intent to issue future guidance. An interesting aspect to the current interrelationship between section 457 and section 409A involves the applicability to severance pay arrangements. Currently, section 457 does not apply to a severance arrangement that qualifies as a "bona fide severance pay plan". Although there is no statutory definition for "bona fide severance pay" within section 457, the Service has taken a formal position that severance benefits are not excluded from section 457 if they are "payable upon termination for any reason". The Service has also stated, in Notice 2007-62, that it intends to issue guidance in the future that would define the term "bona fide severance pay plan" and that any guidance will be prospective. Included in that Notice is a definition expected to be included in such guidance, providing that an arrangement is a ‘bona fide severance pay plan exempt from the application of Section 457 if:
- The benefit under the plan must be payable only upon involuntary separation from service,
- The benefit may not exceed two times the employee's annual rate of pay (taking into account only pay that does not exceed the maximum amount that may be taken into account under a qualified plan pursuant to the qualified compensation limitation of Section 401(a)(17) for the year in which the employee has a severance from employment (i.e., two times $255,000 or $510,000 in 2013)), and
- The plan must provide that the payments must be completed by the end of the employee's second taxable year following the year in which the employee separates from service.
Meanwhile, section 409A, while not incorporating an exception based on "bona fide severance plans", currently provides instead an exception for "severance pay arrangements". Under section 409A, severance will be excluded from Section 409A if:
- The payment is made only upon an "involuntary termination" (including certain resignations by the participant for "good reason")
- The payments do not exceed two times the lesser of the participant’s annual compensation for the preceding calendar year or the compensation limitation of section 401(a)(17) (2 x $255,000, or $510,000, for 2013), and;
- The payments must be completed by the end of the second calendar year following termination
Obviously, the regulatory definition of the term "severance pay arrangement" and the anticipated definition of "bona fide severance pay plans" are quite similar. However, until the future guidance promised by Notice 2007-62 is issued, severance plans that are intended to meet and are currently being treated as qualifying under the "bona fide severance pay plan" exception of section 457 may still be subject to section 409A if the plan does not meet the definition within the regulations interpreting section 409A for "severance pay arrangements". This would be particularly true if the distribution of severance extends beyond the two year grace period provided by section 409A. And, of course, plans in the future that fail to satisfy both the anticipated definitions of "bona fide severance" under section 457 and "severance pay arrangement" under section 409A could be subject to the application of both sections 409A and 457(f).