Many tax-exempt and governmental health care organizations use Code Section 457 deferred compensation plans as part of the financial package to attract and retain executives. Internal Revenue Service Notice 2007-62 announces the IRS’s intention to issue guidance that will require sponsors of 457 plans to evaluate and make changes to these plans. In general, the IRS guidance will apply the principles developed in the Code Section 409A regulations to similar provisions under Code Section 457.

The Notice indicates the upcoming guidance will focus on two areas that are central to the design of many health care organizations’ 457 plans: (1) the exemption from Code Section 457(f) for bona fide severance pay plans provided under Code Section 457(e)(11), and (2) the definition of “substantial risk of forfeiture” under Code Section 457(f)(3)(B). In fact, the Notice gives a preview of the new rules, which provides sponsors an opportunity to begin reviewing their plans and developing compliance strategies.

The IRS anticipates the new rules will provide that an arrangement will be an exempt bona fide severance pay plan only if all the following requirements are satisfied.

1. The benefit is payable only upon involuntary severance from employment.
2. The amount payable does not exceed two times the employee’s annual rate of pay, up to compensation limit under Code Section 401(a)(17) (the 2008 cap is $230,000, so $460,000 is the maximum).
3. The arrangement provides payments must be completed by the end of the employee’s second tax year following the year in which the employee separates from service.

The guidance likely will include exceptions from the requirement that benefits be paid only upon involuntary severance from employment for window programs, collectively bargained separation pay plans, and certain reimbursement or in-kind benefit arrangements, similar to the exceptions provided under the Code Section 409A regulations.

The IRS further anticipates the new rules will provide that a number of popular features included in many 457(f) plans will no longer be considered as subjecting the benefits to a substantial risk of forfeiture. These features include:

1. Covenants not to compete,
2. Rolling vesting provisions by which the employer and employee mutually agree to delay the vesting date by written election of the employee one year or more before vesting otherwise would occur, and
3. Employee deferral programs that defer receipt of salary on a tax-deferred and forfeitable basis.

These features are viewed by the IRS as contrary to the principles under the Code Section 409A regulations that compensation is subject to a substantial risk of forfeiture only if the entitlement to the amount is conditioned on the performance of future services or the occurrence of a condition that is related to the purpose of the compensation and the possibility of forfeiture is substantial. The IRS does not view merely refraining from the performance of services, the addition of a risk of forfeiture after the right to compensation arises, or the extension of a period during which compensation is subject to a risk of forfeiture as a valid or substantial risk of forfeiture.

These new rules are expected to apply on a prospective basis. Until further guidance is issued, taxpayers may rely on the definition of a bona fide severance pay plan and the rules regarding a substantial risk of forfeiture described in the Notice. Furthermore, the Notice provides that no inference should be made from the anticipated guidance described in the Notice on these matters regarding the current compliance status of plans under Code Section 457.