GT Alert

IRS Issues Final Regulations on Exempt Organization Deferred Compensation

April 2004
By Harry J. Friedman, Greenberg Traurig, Phoenix Office

  View or download the PDF version of this Alert here.

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 28, 2002.

Section 457

"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.

Stock Options

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.

© 2004 Greenberg Traurig

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