Review deferred compensation plans in light of IRS rules

A column examining the ins and outs of contract issues

By — Posted June 4, 2007.

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A section of the IRS code that seemed to address Wall Street transactions turns out to be, on literal reading, something that could affect deferred compensation agreements common among medical practices and their owners.

In 2004, Congress made significant changes to the rules relating to nonqualified deferred compensation plans when it passed the American Jobs Creation Act, which added Section 409A to the Internal Revenue Code, effective Jan. 1, 2005. Section 409A subjects all nonqualified deferred compensation plans to income inclusion at the time of deferral unless they meet certain requirements under the statute and regulations.

On Sept. 20, 2005, the IRS issued proposed regulations regarding Section 409A, which extended certain rules for complying with 409A. Those regulations became effective Jan. 1 of this year.

Deferred compensation plans generally include any agreement, contract, or other arrangement which provides for the voluntary deferral of compensation by an employee. They usually call for compensation payments to be made at certain points in the future, typically following termination of employment. They also apply to plans that do not involve the actual deferral of current compensation by employees but simply are funded in the future.

For physicians, deferred compensation plans usually are found in one of two contexts. First, it is common for medical practices to include severance pay plans as a component of a buyout arrangement. The actual amount of the severance pay is typically based on the departing physician's interest in the practice's accounts receivable at the time of leaving the practice. Or, it is based on a liquidated sum that depends upon the physician's compensation and individual collections.

A second common situation in which you might find a deferred compensation plan is when an associate physician buys into a practice. The associate's compensation adjustment, or buy-in, is usually based on a pro rata share of the accounts receivable at the time of the buy-in. This share will then be deferred over the course of a year or years. For tax purposes, many physicians elect to have a compensation shift.

While the 409A regulations do not explicitly address or provide guidance relating to offsets or prepayments, it is highly recommended that if you see a provision in your present contract setting forth a payment structure that gives you discretion over how much deferred money is paid, or a provision that provides for an offset, you should have the provision reviewed by an attorney.

Section 409A prohibits accelerating scheduled payments under the plan. Instead, the payment date and amount must be objectively determinable in accordance with a nondiscretionary formula and methodology. For example, you may include a provision that allows a payment of deferred compensation to be made three months after disability occurs, or during the calendar year following death.

Keep in mind that even if no compensation is actually deferred, for tax purposes it will be treated as being deferred if it otherwise meets certain tests.

Grandfathered plans

The impact of Section 409A on your deferred compensation plan may also depend upon whether your deferred compensation plan was a "grandfathered" plan. A grandfathered deferred compensation plan is one that was in existence as of Dec. 31, 2004, and since then, has not been materially modified.

For example, if the amount payable under the deferred compensation plan has the potential to increase due to various external factors (such as an increase in accounts receivable attributable to your services), then even though the plan would otherwise be grandfathered, it will no longer benefit from such protection.

As a result, if your deferred compensation plan is based upon accounts receivable or your compensation, you should not count on your plan being grandfathered.

Best advice: All agreements in existence on Dec. 31, 2004, should be amended to comply with Section 409A.

You need to take these changes seriously. A violation of Section 409A, like violations of other Internal Revenue Code sections, is serious business. A central problem is that if your deferred compensation plan violates Section 409A and is not grandfathered, or if it was grandfathered at one time but is no longer grandfathered, then the amounts become immediately taxable and, further, are subject to a 20% tax and interest.

To illustrate this, if a medical practice has $1 million of accounts receivable subject to deferred payment obligations, and even inadvertently fails to comply with Section 409A, the result could be taxes, interest and penalties exceeding $700,000.

Going forward, if you enter into an employment contract with a new physician, or if you enter into a new contract with a current employee and the contract includes a new deferred compensation plan for that employee, you need to make sure you identify trigger events like retirement, death, disability or separation.

It is necessary to objectively determine a time and amount required for such distributions.

The key thing to do today is to familiarize yourself with the current IRS developments or contact a professional with such knowledge and immediately determine whether the new 409A regulations have had any impact on your practice agreements.

If you find yourself in a situation where you are considering new ownership or payment for separation, retirement, death or disability, you should consult an expert for help.

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