Proposed Deferred Compensation Plan Rules May Aid Exempt Hospitals

Stay ahead of developments in federal and state health care law, regulation and transactions with timely, expert news and analysis.

By Matthew Loughran

Oct. 26 — Proposed IRS regulations governing deferred executive compensation could provide nonprofit hospitals and their executives with an opportunity to structure their relationships for greater mutual benefit, health-care tax law practitioners told Bloomberg BNA.

The proposed regulations, published in the Federal Register in June, clarify the requirements for establishing a nonqualified deferred executive compensation plan under Section 457(f) of the tax code.

Practitioners said the rules should help nonprofit hospitals in both recruiting and retaining executive talent. They also could present accounting and reporting challenges.

“The regulations actually ended up being significantly more favorable than we as professionals were anticipating seeing originally,” Mary K. Samsa, a executive compensation and tax attorney with McDermott Will & Emery LLP in Chicago told a panel discussion on the proposed regulations.

“We view that there are potentially a lot of opportunities for companies to use if they have 457(f) arrangements in place,” she added.

“We were trying to make it easier, and thus we developed similar but not identical rules to the Section 409A rules,” said Victoria A. Judson, the associate chief counsel of the Tax Exempt and Government Entities division of the Internal Revenue Service said. Judson was referring to the similar final rules governing executive compensation plans offered by for-profit corporations under Section 409A of the tax code.

She said the proposed regulations appeared to have been well received by the tax-exempt entities that they are meant to cover. Judson pointed out that the public hearing on the proposed regulations attracted only a small number of attendees.

Both women spoke at the American Health Lawyers Association’s Tax Issues for Health Care Organizations conference in Arlington, Va. Oct. 20.

Retaining Executive Talent

Under the proposed regulations, an executive can agree to defer a portion of his or her compensation to a later year in return for an agreement to provide two years of substantial services or an agreement not to compete with the nonprofit for two years. Additionally, the proposed regulations require the compensation paid out to equal more than 125 percent of the amount that the executive agreed to defer.

Both of these features make 457(f) plans useful to nonprofit hospitals in both recruiting and keeping executive talent.

“If I am on the compensation committee of a nonprofit’s board of directors, I always want some non-qualified deferred compensation in the mix for executive compensation because it can act like a handcuff to retain the executive,” said Alden Bianchi of Mintz Levin in Boston.

“If my rock-star CEO goes elsewhere and there wasn’t some kind of deferred compensation aspect that could have motivated him to stay put, the rest of the board is going to wonder why not,” he added.

Bianchi who provides tax advice to nonprofit organizations said the proposed deferred compensation plan regulations also provide a benefit for the executives who voluntarily defer their compensation through 457(f) plans.

“Everyone wants retirement income, and these rules provide an avenue toward providing that for executives,” he said. He pointed to the portions of the regulations that allow employers to defer compensation for up to two years as part of a severance agreement or in return for an agreement by the executive not to compete with the employer.

“The proposed regulations make recruiting and retaining talent different and, generally, easier than they were before,” Karen Field, principal in Washington National Tax Compensation & Benefits at KPMG told Bloomberg BNA. “Because of certainty on severance treatment, a nonprofit can now tell key employees who are considering a severance package that ‘we can give you a better deal if you stay,' with all parties understanding what a severance arrangement is under the regs,” she added.

Bianchi said the tax benefits for executives who deferred compensation also could be a motivator. “The compensation can be paid and taxed at the beginning of the next tax year, which would presumably be taxed at a lower marginal rate than it would have been had it been paid out when the services were performed,” he said.

However, the deferred compensation agreements won’t be embraced by all executives. Longstanding executives who haven’t voluntarily deferred any of their own compensation subject to a substantial risk of forfeiture will likely not be interested in starting it now, Samsa said.

“Those executives are already receiving benefits which do not require their own base salary be at risk and are unlikely to want to change that,” she added.

“However, the elective deferral feature is a way to redesign your plan so that the new people coming in have skin in the game in exchange for receiving an employer contribution,” she said.

“In addition to retention, we have seen this be construed as some sort of recruitment as well,” added David Cohn a principal in the compensation consulting firm of Sullivan Cotter and Associates Inc. in Atlanta. “Particularly if you are hiring from the for-profit world where this sort of elective deferred compensation is very commonplace,” he added.

Noncompete Agreements

A key difference between the proposed 457(f) regulations and the 409A regulations comes from the use of noncompete agreements as a substantial risk of forfeiture.

Under the tax code, deferred compensation is only tax-exempt in the year that it is deferred if there is a substantial risk of forfeiture. That is, if there is a substantial risk that the employee could lose the compensation by violating some term of the deferral agreement.

Previous IRS guidance said that a noncompete agreement wouldn’t be considered a substantial risk of forfeiture under Section 409A. IRS Notice 2007-62 then stated that the 457(f) regulations on substantial risk of forfeiture would likely track the 409A guidance.

According to Samsa, when this was announced, many tax professionals believed that nonprofits would no longer be able to use noncompete provisions for purposes of achieving tax deferral.

However, the proposed regulations allow noncompete agreements to be used as a condition for deferral as long as the noncompete period is specifically spelled out in the agreement and the agreement is enforceable under applicable law of the state in which the plan participant resides.

But Cohn warned that noncompete agreements won’t necessarily be useful for all 457(f) plan participants because of the restrictions that the IRS has placed on their use. “The employer has to show that they have a bona fide interest in that person competing,” he said. He indicated that it is not yet clear how to meet that standard.

Pitfalls for Setting Up 457(f) Plans

The new regulations also present a number of challenges to nonprofits seeking to set up their own 457(f) deferred compensation plans. According to Samsa, one of the primary difficulties comes from the requirement that the compensation voluntarily deferred by the executive when eventually paid out exceed the amount deferred by more than 25 percent.

“You might be thinking that you could just give the executive an investment return on the deferral that is greater than 25 percent, but you can’t do that,” Samsa said. She pointed to a statement in the proposed regulations that makes any unreasonable rate of return currently taxable to the executive. “Essentially, it is going to be a requirement that the employer put more dollars in to get over the 25 percent threshold,” she said.

The proposed regulations require that the executive either provide substantial services to the nonprofit for two years or at least agree not to compete with the organization for that time period. This would satisfy the tax code’s requirement that deferred income be subject to a substantial risk of forfeiture to qualify under Section 457(f).

According to Samsa, whether the services provided rise the level of substantial is a factual question that the IRS will likely explore in its audits and investigations. “What the IRS will be looking at is what the person is actually doing during that time period to earn the compensation that you are giving them,” she said.

She said that independent contractor agreements or consulting agreements where the executive might not be required to provide any services at all for the entire two year period—they are simply “on call” in the event they are needed—would likely be seen by the IRS as not qualifying for 457(f) deferral treatment.

The key to a valid 457(f) plan is having the right policies in place and following them, according to Field. “It is really about making sure that your policies follow the regulations and making sure that the board knows to follow them when setting up compensation arrangements, not promising what you can’t deliver,” she said.

Double Reporting Dangers

A troubling aspect of the proposed regulations for many nonprofit employers involves how the deferred compensation is recorded on their Form 990 returns. The Form 990 is an annual information return required to be filed with the IRS by most organizations exempt from income tax under section 501(a) of the tax code, and it is a public document.

Under the regulations, deferred compensation paid through 457(f) plans must be reported twice and highlighted on Schedule J of Form 990, the document that details compensation information for certain officers, directors, trustees, key employees and the organizations' highest compensated employees.

The compensation amount must be reported initially as “retirement and other deferred compensation” in the year the deferral arrangement started and throughout the term of the agreement even though it is subject to substantial risk of forfeiture. Then the compensation must be reported again as “other reportable compensation” in the tax year that it is actually earned and included in the Form W-2.

“This has been very difficult for nonprofit executives to accept,” Greg Goller, the managing director in charge of Washington National Tax for Tax-Exempt Organizations at KPMG, told Bloomberg BNA. “The executives haven’t yet actually earned the compensation and may never receive the funds, so they don’t understand why they have to initially report it,” he said.

Goller added that the Schedule J includes a column for the nonprofit organization to show that the deferred compensation was already reported on an earlier tax return. “This reduces the effect of the double reporting, but it is lost on the causal reader of a Form 990,” he said.

To contact the reporter on this story: Matthew Loughran in Washington at

To contact the editor responsible for this story: Peyton M. Sturges at

For More Information

The proposed 457(f) regulations are at

Copyright © 2016 The Bureau of National Affairs, Inc. All Rights Reserved.

Request Health Care on Bloomberg Law