IRS Issues Final Regulations on Exempt Organization Deferred Compensation
By Harry J. Friedman, Greenberg
Traurig, Phoenix Office
View or download the PDF version of this Alert
The IRS has recently issued Final Regulations under Section 457 of the
Code. The Regulations address issues in connection with non-qualified deferred
compensation plans of state and local governmental entities and tax-exempt
entities. These Regulations became effective on July 11, 2003. The Final
Regulations were issued following a public hearing held by the IRS on August
|"The Final Regulations retained
the interpretation of the coordination of Section 457(f) and Section
83 that effectively preclude discounted mutual fund options."
Section 457(b) of the Internal Revenue Code of 1986, as amended, (the
“Code”) provides rules for the treatment of “non-qualified deferred compensation
plans” for employees of governmental entities and tax-exempt entities. Generally,
in the case of for-profit employers, an employee is not subject to tax on
any amount of deferred compensation promised to the employee to be paid
in the future but not set aside for the employee in a manner that would
free the amounts from the claims of the employer’s creditors. The typical
nonqualified deferred compensation plan of a for-profit employer is treated
as simply a promise to pay compensation in the future. The compensation
becomes subject to taxation when the employee actually receives the payment
or the amount is set aside in a fund free from the creditors of the employer.
(Different rules apply to amounts set aside in a qualified plan subject
to Section 401, et seq. of the Code.) Treasury Regulations promulgated
under Section 83 of the Code, which deals with the transfer of property
to an employee as compensation, provide that a mere promise to pay compensation
in the future does not constitute a transfer of property to an employee
that would result in the recognition of current income.
The absence of taxation to the employee is symmetrical with the employer’s
deduction for the compensation. An employer is not entitled to a deduction
for non-qualified deferred compensation until the payment is made to the
employee or is otherwise required to be included in the income of the employee.
Even on accrual basis, the employer is required to defer the deduction.
The nonqualified compensation is beneficial to the employee in that the
taxation of the income is deferred, but adverse to the employer who must
defer the tax deduction for the compensation.
In the case of a governmental entity or a tax-exempt entity, the symmetry
of the for-profit employer/employee situation breaks down. The governmental
or tax-exempt entity, as a non-taxpayer, is not concerned with the deductibility
of compensation, unless it is related to unrelated trade or business income.
As a result, absent Section 457, a tax-exempt employer would not be adverse
to an employee deferring income in order to defer the resulting tax liability
even if the cash is effectively removed from access by the employee (although
still subject to the employer’s creditors).
Section 457(f) of the Code addresses this policy problem. It provides
that in the case of an employee of a governmental entity or tax-exempt entity,
in contrast to the employee of a for-profit employer, compensation must
be included in income by the employee in the first year in which there is
no substantial risk of forfeiture with respect to the compensation. The
fact that the employee may not receive the payment because the cash is subject
to the creditors of the employer is not sufficient to preclude taxation
in the year the compensation is earned. Exceptions from this required inclusion
are provided for “eligible deferred compensation plan” defined in Section
457(b) and for various types of qualified pension plans. In addition, transfers
of property described in Section 83 are excluded from this rule.
Section 457(b) describes permissible non-qualified deferred compensation
plans for employees of governmental entities or tax-exempt entities (other
than churches). Generally, Section 457(b) permits an employee of a governmental
entity or a tax-exempt entity to defer, in 2003, $12,000 of income that
is part of an “eligible plan.” The amount that may be deferred in an eligible
plan will increase by $1,000 each year through 2006. In order for the deferred
compensation plan to constitute an eligible plan under Section 457(b), the
plan must provide that all amounts of compensation that are deferred remain
subject to the claims of the employer’s general creditors; this requirement
is similar to the rules that are applicable to non-qualified deferred compensations
of for-profit entities.
The Regulations provide substantial detail on the requirements to comply
with Section 457(b). Under the Regulations, the amounts deferred under an
eligible plan of a tax-exempt organization are includable by the employee
for the taxable year in which the amount is paid or made available to him.
Amounts deferred under the plan are not considered made available to employees
solely because he is permitted to choose among various investments under
the plan. Amounts are deemed available on the earliest date after severance
or termination of employment on which the plan allows distribution to begin.
An important provision is that a plan may provide a distribution in the
event of an unforeseen emergency which is defined as a severe financial
hardship resulting from illness or accident of the employee, his spouse
or dependent, loss of property due to a casualty or other similar extraordinary
and unforeseen circumstances. The Regulations indicate, for example, that
the eminent foreclosure or eviction from the participant’s residence may
constitute an unforeseen emergency.
An additional area addressed in the Regulations is procedures for self-correction
of excess deferrals made in connection with an otherwise eligible plan.
The Regulations permit a plan of a tax-exempt entity to distribute to a
participant any excess deferrals not later than the first April 15 following
the close of the taxable year of the plan. This should permit plans to void
disqualification because of excess deferrals.
The Final Regulations include guidance concerning the impact of ineligible
deferred compensation plans governed by Section 457(f). The Treasury Regulations
provide that the amount included in gross income under Section 457(f) should
be equal to the present value of the compensation deferred on the date that
it is required to be included in the taxable income of the employee. The
Regulations illustrate this concept with the following example: In 2010,
X, a tax-exempt entity, agrees to pay deferred compensation to its employee
in the amount of $100,000. The compensation is to be paid in 10 years. Because
the commitment was not subject to a substantial risk of forfeiture, the
employee is required to include in income the present value of the future
payment, assumed to be $50,000. In 2018, X transfers property to the employee
having a fair market value equal to $70,000. The Regulations provide that
the employee has income of $30,000, the amount transferred in 2018 computed
by subtracting from the $70,000 received the allocable portion of the basis
that resulted from the $50,000 of income in 2010 based on the present value
of the commitment of $80,000. In 2020, the remaining $12,500 is paid and
X has an additional $2,500 of income.
The Regulations addressed the coordination of Section 457(f ) with Section
83. Generally under Section 83, a grant to an employee of an option to acquire
property where the option lacks a readily ascertainable fair market value
is not treated as income to the employee in the year of receipt of the option
even if the option is not subject to a risk of forfeiture. See Treas.
Reg. § 1.83-7. Instead, an employee has income in the year in which the
option is exercised equal to the difference between the fair market value
of the property received and the amount paid by the employee on exercise
of the option. This general rule is the underpinning of typical employee
non-qualified stock option plans used frequently by for-profit employers.
In recent years, a number of tax-exempt organizations have utilized the
same concept to provide employees with an option to purchase property in
the future. Since the employer has no stock that can be acquired by the
employee, typically the option granted to the employee was to purchase shares
in a mutual fund or a basket of public securities. Often the option price
was at a discount to the fair market value of the mutual fund shares or
basket of securities at the time the option is granted. Many commentators
suggested that the same deferral rules that apply to for-profit employees
would be equally applicable to employees of tax-exempt organizations. This
was based on the provision in the Code that excludes from Section 457(f
) that portion of any plan “which consists of a transfer of property described
in Section 83.”
At the time the Proposed Regulations were issued, the Service requested
comments on the coordination of Section 457(f ) and Section 83. Many commentators
objected to the proposed coordination that would not treat options as exempt
from Section 457(f ).
Under the Proposed Regulations, the use of discounted mutual fund options
as a tax component of compensation would not receive favorable treatment.
The Final Regulations retained the interpretation of the coordination
of Section 457(f) and Section 83 that effectively preclude discounted mutual
fund options. An example is contained in the Final Regulation to clarify
the application of this rule. In the example, the tax-exempt entity employee
receives an option that lacks a readily ascertainable fair market value
within the meaning of Section 83 (the usual precondition to deferral of
the value of the option from income, and almost always the case when an
option is issued). The example assumes that the option has a value on the
date of grant equal to $100,000. Eight years later, the employee exercised
the option by paying an exercise price of $75,000 and receives property
that has the fair market value of $300,000. The example indicates that the
employee has income of $100,000 on the grant of the option and an additional
income of $125,000 on the exercise date of the option.
A number of commentators have indicated concern for the ability of tax-exempt
organizations to compete with for-profit organizations for employees as
a result of this effective prohibition from using options. The amount of
compensation that can be deferred with non-qualified deferred compensation
plans governed by Section 457(b) or qualified plans are significantly limited
in comparison to the deferred compensation that can be provided to a for-profit
executive using stock options of the employer. Tax-exempt organizations
will need to consider other types of incentives to recruit executives.
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