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The Proposed 457 Regulations: Bona Fide Severance Pay Plan and Substantial Risk of Forfeiture

July 11, 2016

Last month, the IRS issued comprehensive proposed regulations which mark the first official guidance since IRS Notice 2007-62 on the application of Code section 457 to certain deferred compensation plans of state and local governments and tax-exempt entities (the “Proposed Regulations”).  This client alert is an update to our February 2009 client alert “Bona Fide Severance Plan and Substantial Risk of Forfeiture under Section 457”, including action items for employers.

I. Bona Fide Severance Pay Plan

A bona fide severance pay plan is treated as not providing for the deferral of compensation and thus not subject to Code section 457.[1] The Proposed Regulations outline three criteria that a plan must meet in order to be a bona fide severance pay plan for purposes of the exclusion provided by Code section 457(e):

  • The benefits provided under the plan must be payable only upon a participant's involuntary severance from employment or pursuant to a window program or voluntary early retirement incentive plan.

  • The amount payable to a participant must not exceed two times the participant’s annualized compensation based upon the annual rate of pay for the calendar year preceding the calendar year in which the participant has a severance from employment, subject to certain adjustments.

  • Pursuant to the written terms of the plan, the severance benefits must be paid no later than the last day of the second calendar year following the calendar year in which the severance from employment occurs.

As anticipated by IRS Notice 2007-62, these criteria are analogous to those for separation pay plans under Code section 409A which may also apply to certain plans separately and in addition to any applicable requirements under Code section 457.  However, the criteria are not identical.  The Proposed Regulations do not limit annualized compensation to the amount that may be taken into account under Code section 401(a)(17).  Also, the Proposed Regulations do not include exceptions for collectively bargained separation pay plans, foreign separation pay plans, and reimbursements and certain other separation payments. 

II. Substantial Risk of Forfeiture

Deferred compensation subject to Code section 457 is generally includible in gross income under Code section 457(f) on the later of the date the employee obtains the legally binding right to the compensation or, if the compensation is subject to a substantial risk of forfeiture, the date the substantial risk of forfeiture lapses.

The Proposed Regulations generally provide that a substantial risk of forfeiture exists only if entitlement to the deferred compensation is conditioned on the future performance of substantial services, or upon the occurrence of a condition that is related to a purpose of the compensation if the possibility of forfeiture is substantial.  However, subject to specific criteria, the Proposed Regulations describe the following arrangements which may also provide for a substantial risk of forfeiture:

  • A noncompetition requirement.

  • An initial deferral of current compensation.

  • An extension of an existing substantial risk of forfeiture.

IRS Notice 2007-62 originally anticipated that some of these scenarios would not constitute a substantial risk of forfeiture.  In allowing for them, the Proposed Regulations may also differ from the rules under Code section 409A which provide, inter alia, that an amount is not subject to a substantial risk of forfeiture merely because it is conditioned upon refraining from the performance of services and that an extension of a period during which compensation is subject to a substantial risk of forfeiture is disregarded when determining whether deferred compensation is subject to a substantial risk of forfeiture.

III. What Can Employers Do Now?

In general, the Proposed Regulations apply to compensation deferred under a plan for calendar years beginning after the date they are published in final form in the Federal Register.  Taxpayers may rely on the Proposed Regulations until the applicability date, although no implication is made regarding application of the law prior to the applicability date.  In the meantime, state and local governments and tax-exempt entities that sponsor deferred compensation plans subject to Code section 457 may wish to:

  • Review existing plans in light of the Proposed Regulations, and consider whether current or prospective revisions are appropriate.

  • Draft new plans in compliance with the Proposed Regulations, including provisions for the flexibility to amend when final regulations are issued.

  • Determine whether a plan is also subject to Code section 409A and, if so, how to ensure documentary and operational compliance with both regimes.

This client alert has discussed select aspects of the Proposed Regulations as they concern certain deferred compensation plans of state and local governments and tax-exempt entities.  For more information about the Proposed Regulations in general or other issues concerning your employee benefit plans, please contact Joanne C. Youn at or at 202.862.7855.


[1] Although these criteria are similar to those under long-standing Department of Labor regulations for determining whether a severance pay plan is considered a pension plan, a distinct determination must be made for employers who are otherwise subject to Title I ERISA.


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