Bona Fide Severance Plan and Substantial Risk of Forfeiture under Section 457

Section 457(f) governs income inclusion of the non-qualified deferred compensation of employees of most tax-exempt employers. Bona fide severance plans are exempted from the often unfavorable rules of Section 457(f). However, the IRS and the Treasury have announced impending guidance under which a plan may not be considered a bona fide severance plan unless it only applies to an involuntary separation from service and limits both the amount and the distribution period of any benefit. Under Section 457(f), deferred compensation is includible in income when it is no longer subject to a "substantial risk of forfeiture." The new guidance would apply a definition of "substantial risk of forfeiture" that would disregard non-compete agreements, so-called "rolling risk" arrangements, and certain salary-deferral elections.

Bona Fide Severance Plan

In a joint notice issued in July 2007, the Treasury and the IRS stated their intention to issue guidance (to be effective prospectively) on the question of what constitutes a "bona fide severance plan" under Section 457. Notice 2007-62, section III. The Treasury and the IRS anticipate that the guidance will provide that, in order to constitute a "bona fide severance pay plan," the benefits payable under the plan will have to satisfy the following criteria:

• • Involuntary separation. The benefit is payable only upon involuntary separation from service (some exceptions apply); 
  
  
  
   
  • Limited amount. The amount does not exceed the lesser of two times the annual compensation of the employee or two times the compensation limit under Section 401(a)(17) in the year of separation; and
     
  • Limited distribution period. The plan must provide that payments are completed by the end of the employee's second taxable year following the year in which the employee has a termination of employment.

Once issued, the guidance will be effective only prospectively (though it will provide a retrospective safe harbor for any taxpayers who comply with Notice 2007-62 until the guidance is issued). However, it is not yet known how the guidance will apply to pre-existing deferred-compensation. Affected employers and their employees should consider conforming any new agreements to the definition of "severance plan" provided under Notice 2007-62.

Substantial Risk of Forfeiture

In the same Notice, the Treasury and the IRS announced their intent to issue guidance that will define substantial risk of forfeiture under Section 457. Notice 2007-62, section IV. The meaning of "substantial risk of forfeiture" has not been authoritatively defined for purposes of Section 457(f). In the past, the IRS has presumed that non-compete agreements do not create a substantial risk of forfeiture and that most re-deferral elections — the so-called "rolling risk of forfeiture" — do not effectively preserve substantial risk of forfeiture. However, the IRS has never stated this position in any generally applicable guidance, and some affected employers continue to rely on non-compete agreements and rolling-risk arrangements to create substantial risk of forfeiture.

The expected guidance would apply the Section 409A definition of "substantial risk of forfeiture," which definitively rejects the substance of most non-compete and rolling-risk arrangements. This definition would also prevent employees from electing to defer compensation that they may otherwise receive currently; salary-deferral elections would be ineffective. There are two very limited exceptions to the presumed disregard of salary-deferral and "rolling risk" arrangements: (1) if the present value of the deferred amount is materially greater than the amount currently available, and (2) if the compensation is transaction-based compensation triggered by a change in ownership of the employer.

As with the guidance defining a bona fide severance plan, the guidance defining substantial risk of forfeiture, once issued, will be effective only prospectively (though it will provide a retrospective safe harbor for any taxpayers who comply with Notice 2007-62 until the guidance is issued). However, it is not obvious how the guidance will apply to pre-existing deferred-compensation. Affected employers and their employees should consider conforming any new agreements to the definition of "substantial risk of forfeiture" provided under Section 409A.