Firm Asks IRS to Clarify Deferred Compensation Regs

The confusion arises in the statement that the new rules:

For example, if an employer promises in 2015 to provide $10,000 a year in deferred compensation for each year the executive remains employed, and then the new rules become effective January 1, 2018, the $10,000 that accrued in 2015, 2016 and 2017 would not be subject to the new rules, but the $10,000 that accrue in 2018 and later would be subject to the new rules. We recommend the IRS provide a clarifying example in the final regulations.

2. General Effective Date. Transitioning from current deferral plan designs to those allowed under the new regulations will require many months' lead time. Plan architects and consultants will need time to understand the new parameters and develop compliant designs. Boards will need time to evaluate plan options and how their strategic objectives will be impacted by moving to the new designs. Once a new design is approved, the employer will need to develop new communication material, and meet with plan participants to explain the modifications. Participants will then need time to evaluate the modifications and the impact on their personal financial goals and strategies.

We believe that an orderly transition would require six to nine months at a minimum. Therefore, we encourage the IRS not to attempt to issue final rules this year and have them take effect January 1, 2017. Rather, a much more orderly approach would be for the IRS to issue the final rules in January or February 2017, with an effective date of January 1, 2018. If publication of the final regulations is delayed beyond March 2017, then ideally the effective date would be deferred to January 1, 2019.

3. Plan Documentation Compliance Date. Transitioning to compliant plans will also require new plan documentation. We recommend allowing at least 12 months after the operational effective date of the final 457(f) regulations before documentation compliance is required. This approach would be consistent with that used by the IRS throughout the 409A regulatory process.

4. "More than 125%" Standard. To facilitate design, communication and administration of elective deferral plans, we recommend changing from the "more than 125% of the present value" standard to "at least 125% of the present value." This change would simplify discussions and avoid unnecessary machinations, such as providing a matching contribution of 25% plus one penny just to meet the more than standard.

5. Bona Fide Severance Plan -- "To the Extent That". As drafted, the bona fide severance plan definition would be met by a plan providing 24 months of compensation, but not a plan providing 25 months of compensation. Given that competitive severance in many instances is greater than 24 months, we recommend adopting the Section 409A separation pay plan exemption approach of "to the extent that." This would mean that the first 24 months of severance would be treated as a bona fide severance plan (assuming the other qualifications are met), and any excess would not.

For example, a plan providing 30 months of compensation as severance payable would be treated as a bona fide severance plan for the first 24 months and a deferred compensation plan for months 25 through 30. The plan would then need to deal with the taxation of months 25 through 30, either paying them in a lump sum at the beginning of the severance period, or distributing enough to pay the taxes on months 25 through 30 at the beginning of the severance.

6. Severance Subject to Offset. Often employers provide a guaranteed period of severance followed by an extended period that will be provided only if the employee has not found other employment. Other designs provide an extended period to begin with, and then provide that the severance benefits will be offset by any earnings from new employment. In these designs, the full extent of the severance benefits is not known at the beginning of the severance period. We recommend the IRS clarify in the regulations that the portion of the severance period that is subject to offset not be taxable unless and until it is actually paid (assuming the bona fide severance plan exemption does not apply). This would be consistent with the taxation of other cliff vested deferred compensation that is not taxable unless and until it is certain to be paid.

Because the participant had no option to receive the dollars in cash, it seems that the participant's election of a vesting date should not count as a voluntary deferral, even if the participant elects something other than the minimum vesting date. We recommend the IRS specify in the regulations that where the participant has no cash option, the ability to elect a vesting date longer than two years is not a voluntary deferral or an addition or extension of a risk of forfeiture.

2. FLEX Plans. FLEX plans provide participants the option to allocate an employer-provided allowance among welfare benefits and deferred compensation. We ask the IRS to clarify whether the ability to allocate the allowance would make the selection of the deferred compensation an elective deferral subject to the more than 125% standard? Also, if paid time off can be traded by a participant to increase the flexible benefit allowance under the plan, would that be treated as an elective deferral subject to the greater than 125% standard?

3. Loan Regime Split Dollar. The IRS specified in IRS Notice 2007-34 that loan regime split dollar, where there is no provision for waiving or forgiving repayment of the loan, is not deferred compensation that would be subject to Section 409A. We request the IRS make the same pronouncement for purposes of the Section 457(f) regulations.

4. Substantial Risk of Forfeiture -- Likelihood of Forfeiture. The proposed regulations state that forfeiture conditions related to a purpose of the compensation will only be a substantial risk of forfeiture if the likelihood of the forfeiture event occurring is substantial. But it is not clear if the likelihood is measured before or after the plan is installed.

For example, assume an employee is a highly-skilled transplant surgeon in a highly-competitive market. The employer is at great risk of losing the surgeon to a competitor, so it installs a deferral plan providing $1,000,000 of deferred compensation if the surgeon remains employed for five years. Given the risk of losing the $1,000,000, the likelihood of the surgeon leaving early and competing is substantially reduced, so that the likelihood of forfeiture is no longer substantial.

If the likelihood of forfeiture is measured before the plan is installed, it is substantial. After the plan is installed, it is not.

To avoid the concern that an effective deferral/retention plan will be self-defeating by making the likelihood of forfeiture insubstantial, we request that the IRS specify that the likelihood of forfeiture is measured absent the deferral plan.

5. Noncompete Restrictions -- Financial Need. The proposed regulations specify that one of the key facts and circumstances in evaluating whether a noncompete is a substantial risk of forfeiture is the employee's financial need to compete. Although the concept seems reasonable (an independently wealthy executive of advanced years should be uninterested in competing), we question the practicality of using such a standard. It raises questions of privacy (who is going to look into the executive's personal finances?) and scale (how does one measure need and by what standard?), and it ignores the very real need many executives have to remain involved and active even though they don't "need" the additional income. We recommend eliminating financial need as a factor in the evaluation.