457 Exemptions

My last column (“Deferred Gratification,” PLANADVISER, Summer 2007) addressed some of the rules under Section 409A of the Internal Revenue Code (the rules governing deferred compensation) and, more specifically, the relationship between Section 409A and severance pay plans. Since that column was published, the IRS has issued Notice 2007-62 (the “Notice”).  

In that Notice, the IRS announced that it intends to issue guidance regarding certain rules associated with “bona fide” severance plans in the context of Section 457(f) plans.  

By way of background, Section 457 of the Internal Revenue Code governs, with limited exception, all deferred compensation arrangements maintained by tax-exempt entities or state or local governments. Under Section 457, the arrangements must meet either Section 457(b) or Section 457(f). (Certain arrangements are excluded from the limitations under Section 457: any bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, or death benefit plans. Although “bona fide” severance plans are exempt from Section 457, they remain subject to Section 409A.) 

Section 457(b) plans allow tax-deferred contributions. The employer/employee aggregate contribution limit is equal to an annual dollar cap (the lesser of (i) $15,500 in 2007 or (ii) 100% of the participant’s includible compensation, exclusive of any applicable catch-up contributions). These types of plans are popular because the annual dollar cap is not aggregated with amounts contributed as elective deferrals to Section 401(k) or 403(b) plans. Generally, the benefits must be made available no earlier than the calendar year in which the participant attains age 70 세, incurs a termination of employment, or suffers an unforeseeable financial hardship. Significantly, Section 457(b) plans are not subject to the Section 409A rules. 

Section 457(f) plans also allow for tax-deferred contributions. However, the contributions under a Section 457(f) plan must be subject to a substantial risk of forfeiture. Once the substantial risk of forfeiture has been removed (e.g., the benefits become vested), the amounts under the Section 457(f) plan will be subject to income tax, whether or not the amounts are distributed. Section 457(f) plans are subject to the Section 409A rules. 

Still To Come 

Among other issues, the Notice provides that the IRS intends to issue guidance on the rules associated with determining when a plan is a bona fide severance plan (and therefore exempt from Section 457). The Notice outlines the current thinking of the IRS on this issue, which goes something like this: A plan would be a bona fide severance plan if (i) the benefit is payable only upon involuntary severance; (ii) the amount of the benefit does not exceed two times the compensation limit under Section 401(a)(17) of the Internal Revenue Code for the year in which the employee separates from service (in 2007, the Section 401(a)(17) limit is $225,000); and (iii) the severance payments must be payable no later than the end of the second taxable year following the year in which the employee separates from service. Certain exceptions will apply, e.g., to window programs and collectively bargained separation pay plans. 

The Notice provides that the final rules regarding bona fide severance plans would be applied prospectively only. However, a taxpayer may choose to rely, at this time, on the proposed definition of bona fide severance plans set forth in the Notice and outlined above. 

So, why is this column addressing this issue now? Because the deadline for documentary compliance with Section 409A is on or before December 31, 2007. If you have clients who sponsor “bona fide severance plans,” such plans should be reviewed for compliance with Section 409A, even if your client believes that its severance plan is properly exempted from Section 457(f). Given the anticipated guidance and the opportunity to apply the rules in the Notice to arrangements at this time, clients may prefer to meet the Section 409A requirements by following the rules in the Notice now rather than amending the severance plan to meet Section 409A and then again after the final regulations are issued.