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New 457A Tax Rules Overview - Nonqualified Deferred Compensation Plans

Jeffrey R. Capwell, Robert Gordon Chambers, Steven D. Kittrell and G. William Tysse-McGuireWoods LLP


Introduction

SECTION 457A GENERAL RULE

Section 457A generally provides that any compensation deferred by a service provider (such as an employee) under a nonqualified deferred compensation plan that is sponsored by a "nonqualified entity" (see below) is includible in the service provider's gross income when there is no substantial risk of forfeiture associated with the service provider's right to receive such compensation. In other words, the deferred compensation is taxable as soon as it vests. This is in contrast with Section 409A, which generally allows taxation of compensation to be deferred until the compensation is actually paid, regardless of when it vests.


Nonqualified Deferred Compensation Plan

A "nonqualified deferred compensation plan" for purposes of Section 457A is generally defined the same as under Section 409A (i.e., any arrangement that provides an employee or other service provider a legally binding right to receive compensation in a future year). For example, an arrangement between a partnership and an employee of the partnership in which the employee earns an amount based on the performance of the partnership, the payment of which is deferred until investors in the partnership receive a certain return, would be a "nonqualified deferred compensation plan" and therefore subject to the new rules.

Notably, stock appreciation rights (SARs) that may be settled in cash are also automatically covered by Section 457A, even though such rights may be exempt from the requirements of Section 409A. Transfers of restricted property (including profits interests in a partnership) that are taxable under Section 83 of the Internal Revenue Code are generally excluded from Section 457A, similar to the way in which they are currently exempt from Section 409A (pending future guidance to the contrary).

Covered Service Providers

The types of service providers potentially subject to Section 457A are generally the same as the service providers potentially subject to Section 409A. These include employees, directors and certain types of independent contractors of the "covered entity" (as discussed below). As with Section 409A, independent contractors with relationships with multiple, unrelated customers or clients generally are not covered service providers for purposes of Section 457A. However, unlike Section 409A, Section 457A does not automatically exclude accrual-basis service providers.

Substantial Risk of Forfeiture

A service provider's right to receive deferred compensation is considered subject to a substantial risk of forfeiture for purposes of Section 457A only if and to the extent the right is conditioned on the performance of substantial future services by the service provider. For example, an employee's right to receive deferred compensation generally is not considered subject to a substantial risk of forfeiture unless the employee was required to remain continuously employed from the date the right was acquired through the taxable year in which the amount was vested.

Practice Note: Performance Vesting

Unlike Section 409A, Section 457A does not allow conditions relating to the purpose of the compensation (such as performance conditions) to constitute a substantial risk of forfeiture. Therefore, deferred compensation arrangements that an employer has already determined to be exempt as a "short-term deferral" arrangement under Section 409A on the basis of a performance-based vesting condition may need to be reexamined to see whether they present issues under Section 457A. However, other limitations under the Section 409A substantial risk of forfeiture definition - such as the inability of a restrictive covenant to constitute a substantial risk of forfeiture (i.e., a non-compete requirement) and the loss of substantial risk of forfeiture status if a vesting period is or may be extended - also apply under Section 457A.

"NONQUALIFIED" ENTITIES

The new rules apply to nonqualified deferred compensation plans sponsored by the following types of entities:

  • Any foreign corporation unless substantially all of its income is either:
    • Effectively connected with a U.S. trade or business; or
    • Subject to a comprehensive foreign income tax.
  • Any partnership (including any limited liability company that has elected to be taxed as a partnership) unless substantially all of its income is allocated to persons other than:
    • Foreign persons with respect to whom such income is not subject to either U.S. or a comprehensive foreign income tax; or
    • Organizations that are exempt from tax under the Internal Revenue Code, such as a tax-exempt hospital or pension plan.

Practice Note: Determining the Type of Entity

Whether an entity is a corporation or partnership is determined under U.S. tax law, not foreign law. This may lead to a situation in which a foreign "hybrid" entity (i.e., an entity that is classified as a partnership or other pass-through entity under foreign law but as a corporation under U.S. tax law) that has any income that is not effectively connected with a U.S. trade or business is subject to the new rules, even though the entities' owners are subject to U.S. or a comprehensive foreign income tax on income from the entity. This might occur because a foreign corporation that has any income that is not effectively connected with a U.S. trade or business is only exempt from the new rules to the extent the corporation itself (as opposed to its owners) is subject to a comprehensive foreign income tax. In this case, the hybrid entity itself would not subject to such a tax. The IRS and Treasury Department officials have indicated that this was the intended result.

Nonqualified Entities - Foreign Corporations

A foreign corporation is generally treated as subject to a "comprehensive foreign income tax" if

  • It is eligible for the benefits of a comprehensive foreign income tax treaty between its country of residence and the U.S.; or
  • It can demonstrate to the satisfaction of the Treasury Department that it is resident in a foreign country that has a comprehensive income tax.

Practice Note: List of Countries

Treasury Department officials have stated that there are currently no plans to publish a list of foreign countries that would be treated as meeting the "comprehensive foreign income tax" exclusion under Section 457A. In the absence of such guidance, affected corporations will need to make a reasonable, good-faith determination of whether their country of residence qualifies.

There are two caveats for foreign corporations which think they might qualify for the "comprehensive foreign income tax" exclusion. First, the corporation must not be taxed under a foreign tax regime that is materially more favorable than the general corporate income tax regime of the country of residence. For example, some foreign corporations may be eligible to be taxed under an "investment company" tax regime of their country of residence rather than the country's general corporate income tax regime. If the alternative tax regime is materially more favorable to the corporation than the general income tax regime, then the corporation is not eligible for the "comprehensive foreign income tax" exclusion.

Second, no more than 20% of the corporation's income may be income from "excluded sources." Excluded source income includes any nonresidence income that is not included in the corporation's taxable income or that is subject to a rate of tax that is less than 50% of the corporation's general income tax rate. For example, dividends received by a foreign corporation from a nonresident subsidiary may be taxed in the corporation's country of residence at a rate that is less than 50% of the corporation's general income tax rate. If more than 20% of the corporation's income came from such dividends (or other excluded sources), then the corporation would not be eligible for the "comprehensive foreign income tax" exclusion.

Practice Note: Carve-Out For Effectively-Connected Income, etc.

Importantly, excluded source income does NOT include income that is effectively connected to a U.S. trade or business or dividends of either a U.S. corporation or other corporation substantially all of the income of which is subject to a comprehensive foreign income tax. Because the latter part of this carve-out only covers dividends, foreign corporations that receive income from unincorporated branches or other business units ("branch income") cannot use the carve out, even if the income is subject to U.S. or a comprehensive foreign income tax.

Nonqualified Entities - Partnerships

Although only foreign corporations may be subject to the new rules, domestic as well as foreign partnerships (including any limited liability company that has elected to be taxed as a partnership) can be covered. The key for determining whether a partnership is a "nonqualified entity" is to know how and to whom the partnership's income is ultimately allocated. This requires both an understanding of the partnership agreement as well as knowledge of the partnership's owners at all levels of ownership. Because of the complexity of some partnership structures, determining the ultimate allocation of the partnership's income can be a difficult task. Unfortunately, the new rules require this task to be performed annually, further complicating compliance.

A partnership is a "nonqualified entity" if less than 80% of its gross income is allocated to "eligible persons." Income is generally treated as allocated to an "eligible person" for this purpose if it is (i) effectively connected with a U.S. trade or business, (ii) unrelated business taxable income, (iii) allocated to a U.S. taxable person (with some limited exceptions), or (iv) allocated to a foreign taxable person that is subject to a comprehensive foreign income tax. For tiered partnership or other pass-through structures, the allocation is traced and examined at the level where the income ultimately stops getting passed through.

Practice Note: Partnership Example

Domestic partnership P has two partners: A (a domestic taxable corporation) and B (a foreign pass-through entity owned in equal parts by a foreign individual and a foreign corporation). The owners of B include income allocated to B from P on a current basis under the laws of their country of residence and are not subject to a comprehensive foreign income tax with respect to such income. If more than 20% of P's gross income is allocated to the owners of B, then P is a "nonqualified entity" for purposes of Section 457A. The same result would apply if P were a domestic tax-exempt organization instead.

EXEMPTIONS FOR CERTAIN "SHORT-TERM DEFERRAL" ARRANGEMENTS

The following two types of short-term deferral arrangements are exempt from Section 457A:

  • Section 409A Short Term Deferrals: An arrangement that provides for a short-term deferral as defined under Section 409A is exempt from Section 457A, but one must apply the more limited Section 457A definition of "substantial risk of forfeiture" for this purpose. Under Section 409A, such short-term deferrals are defined as an arrangement under which the deferred amount must be paid within 2.5 months after the end of the service provider's or service recipient's taxable year (whichever ends later) in which the amount is no longer subject to a substantial risk of forfeiture; and
  • Section 457A Short Term Deferrals: An arrangement under which the deferred amount must be paid within 12 months after the end of the service recipient's taxable year in which the amount is no longer subject to a substantial risk of forfeiture is also exempt from Section 457A (again applying the Section 457A definition of "substantial risk of forfeiture" for this purpose).

Practice Note: Coordination of Short Term Deferral Rules

An arrangement that may be exempt from Section 409A as a short-term deferral may nevertheless be subject to Section 457A, and vice versa. For example, an arrangement under which the payment of the deferred compensation is subject to a substantial risk of forfeiture based on a performance condition may be an exempt short-term deferral for Section 409A purposes, but would likely be subject to Section 457A. Again, arrangements of covered entities that have previously been determined to be exempt short-term deferrals under Section 409A may need to be reexamined to determine whether they present Section 457A issues as well.

CALCULATION OF TAX UNDER SECTION 457A

General Rule

Except when the amount is not "determinable" (see below), the amount of deferred compensation (including earnings on such amount) includible in income under Section 457A is generally determined under the proposed rules for including deferred amounts in income under Section 409A, described in our 12/11/08 WorkCite.

Special Rules For Amounts Not Determinable

A deferred amount to which a service provider is entitled is treated as not "determinable" if the amount is a "formula amount" under the proposed rules for including deferred amounts in income under Section 409A. Generally, this occurs where the amount (as opposed to the timing) of the payment is unknown at the end of the service provider's taxable year because the factors needed to calculate the amount remain variable. Where a deferred amount is not "determinable" by the end of the year in which it vests, it is not included in the service provider's income for Section 457A purposes until the year in which it becomes "determinable." However, it is also subject to an additional penalty and interest tax, similar to the 20% penalty tax and additional interest tax under Section 409A, at that time.

EFFECTIVE DATES AND TRANSITION RULES

General Effective Date and Partial Grandfathering Rule

Section 457A is currently in effect and applies to any amounts deferred that are attributable to services performed after December 31, 2008. There is a partial grandfathering rule for deferred amounts attributable to services performed before January 1, 2009. These amounts must be included in the employee's or other service provider's income no later than the later of: (i) the last taxable year beginning before January 1, 2018, or (ii) the first taxable year in which the amount is no longer subject to a substantial risk of forfeiture.

Special Relief For Amendments Made Before July 1, 2009

For attribution purposes, deferred compensation subject to a vesting schedule is generally spread over the length of the vesting period. Therefore, a deferred amount will generally be subject to Section 457A if the vesting schedule for such amount extends into 2009 or later, even if the right to receive such amount was acquired before 2009. However, employers and other plan sponsors have a limited opportunity to amend plans to take advantage of the partial grandfathering rule with respect to such amounts, provided they take action soon.

A plan may be amended before July 1, 2009 to provide that a substantial risk of forfeiture that would otherwise lapse on or after January 1, 2009 will be treated as having lapsed prior to January 1, 2009 (thereby making the compensation otherwise subject to such risk of forfeiture eligible for the partial grandfathering rule), provided the acceleration of the vesting schedule is applied consistently to other service providers participating in the same or any substantially similar arrangement.

Other Transition Relief and Coordination With Section 409A

Income inclusion events under Section 457A are treated as "payments" for Section 409A purposes. Pending future guidance, the income inclusion of earnings on amounts subject to Section 457A is generally treated as a payment in accordance with a fixed schedule for purposes of Section 409A, as long as the earnings are credited at least annually and certain other conditions are met.

Relief from the Section 409A anti-acceleration rules is provided for plans that are not initially subject to Section 457A, but become subject to Section 457A in a future year. Relief is also provided from the Section 409A anti-acceleration and material modification rules to allow plans that provide for Section 457A-grandfathered amounts to be amended on or before December 31, 2011 to permit payment of such amounts by the end of the later of: (i) the last taxable year beginning before January 1, 2018, or (ii) the year in which the amount ceases to be subject to a substantial risk of forfeiture, as described above.

Practice Note: Overlapping Regulatory Schemes Present Traps for the Unwary

Because of Section 457A's stricter definition of "substantial risk of forfeiture," nonqualified deferred compensation plans that are initially subject to and which continuously remain subject to Section 457A will generally always qualify for the short-term deferral exception under Section 409A. However, in some cases an arrangement may be or become subject to both Section 457A and Section 409A (for example an arrangement not initially subject to Section 457A which becomes subject to Section 457A in a future year, or vice versa). In addition, because of the more expansive Section 457A short-term deferral rules, an arrangement may be subject to Section 409A but not subject to Section 457A. Careful attention to plan drafting must be paid to address each of these potential scenarios.

ACTION ITEMS

  • Determine whether you are a "nonqualified entity." This analysis may be complicated, particularly with respect to partnerships, and therefore should be implemented as soon as possible.
  • Examine compensation arrangements with employees and other service providers to determine if any of them are deferred compensation arrangements. This should generally be similar to the process that employers undertook to comply with Section 409A. Unfortunately, employers do not have the same amount of lead-in time before the transition rules expire.
  • Consider what actions may be necessary to bring covered arrangements into compliance with Section 457A and adopt appropriate amendments.

Jeffrey R. Capwell, Partner, jcapwell@mcguirewoods.com

Mr. Capwell practices in all aspects of executive compensation and employee benefits. In the area of executive compensation, he helps companies structure and administer stock-based compensation plans, performance bonus and incentive programs, nonqualified deferred compensation plans and director compensation programs. He represents management and boards of directors in negotiating and drafting employment, severance and change of control agreements.

Robert Gordon Chambers, Partner, rchambers@mcguirewoods.com

Mr. Chambers counsels employers and executives in connection with tax-qualified retirement plans, including 401(k) plans, cash balance/pension equity plans, and ESOPs; executive and incentive compensation programs; employee benefit programs for universities, churches, hospitals, and other tax-exempt organizations; international benefit issues; compensation and employee benefit ramifications of corporate transactions; group insurance and other welfare benefit plans, including COBRA and HIPAA issues; early retirement programs and other group severance arrangements; employment and termination of executives; and ERISA-based litigation.

Steven D. Kittrell, Partner, skittrell@mcguirewoods.com

Mr. Kittrell represents a variety of clients on benefit matters including executive compensation, qualified retirement plans, and incentive compensation plans. He deals with the Treasury Department, national office of the IRS, Department of Labor, and Securities and Exchange Commission on benefits issues. He is a member of the National Association of Stock Plan Professionals, the ESOP Association, and the American Bar Association Section of Taxation.

G.William Tysse, Associate, gtysse@mcguirewoods.com

Mr. Tysse practices within the firm's Taxation and Employee Benefits Department, focusing on employee benefits and executive compensation. He has extensive experience advising public, private and nonprofit clients on all aspects of non-qualified deferred compensation arrangements, including excess and supplemental retirement plans, cash and equity incentive plans, and employment and severance agreements.

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