Tax-exempt and governmental employers do not pay Federal income tax and therefore, unlike for-profit entities, are not affected by the timing of tax deductions relating to the payment of compensation. Tax authorities are suspicious of deferred compensation arrangements entered into by these employers with their employees, as they could defer the taxation of compensation for extended periods of time without any negative impact on the employers. As a result, a special set of rules applies to deferred compensation arrangements under Section 457 of the Internal Revenue Code.

In general, unless Code Section 457 provides otherwise and applicable requirements are met, benefits accrued under deferred compensation arrangements entered into by tax-exempt or governmental employers are taxable to their employees as soon as they are no longer subject to a substantial risk of forfeiture. In this context, deferred compensation is to be understood broadly and includes not only retirement-type benefits, but also incentive pay and severance pay. Covered arrangements do not have to be plans covering groups of employees, but may take the form of individual agreements, such employment agreements or termination agreements.

After almost ten years of waiting, the IRS finally issued new guidance in the form of proposed regulations that can be relied on by taxpayers until the effective date of the final regulations. Among other things, the guidance clarifies (1) what constitutes deferred compensation for purposes of Code Section 457, (2) what will be treated as a substantial risk of forfeiture that will effectively delay taxation, and (3) what arrangements may benefit from exemptions if certain requirements are met, such as severance pay or short-term deferrals.

It is not clear whether the IRS will grant any transition relief for existing deferred compensation arrangements. Now is probably a good time to review these arrangements and determine whether certain design changes are needed to comply with the new guidance.