Now is the Best Time to Reconsider Executive Compensation Arrangements
by Irene F. Gallagher, Holme Roberts & Owen LLP, Denver, CO
In the area of compensation and benefits, tax-exempt hospitals and healthcare providers will have special challenges to meet this year. The remaining months of 2008 provide, in many cases, the last chance to redesign programs to comply with complicated tax regulations, and even to retroactively make some executive compensation arrangements comply in form if nothing contradictory has occurred in operation.
Dual Regulation .
Two sections of the Internal Revenue Code (Code) affect executive deferred compensation arrangements for tax-exempt employers: Section 457(f) and Section 409A. Section 409A is a relative newcomer, having only become effective for new arrangements as of January 1, 2005. Yet there is an interaction between the relatively well-known, if not still elusive, Section 457(f) and Section 409A that still plays out rather uncomfortably.
Section 409A is broad, in that it applies to any form of deferred compensation, meaning any compensation that is earned (and vested, or no longer subject to a "substantial risk of forfeiture" as that term is defined under Section 409A) in one year and paid in a later year, excepting only specifically identified arrangements such as Section 457(b) plans for governmental or tax-exempt employers. A violation of Section 409A will result in the imposition of a 20+% penalty on the payee executive, plus interest and acceleration of income recognition for noncompliant arrangements. Once amounts are vested, to avoid taxation under Section 409A, distribution must be limited to a permissible event such as death, disability, separation from service, financial hardship, a specified date or change in control of the employer. Thus, Section 409A arrangements have the flexibility of making an executive vested in his right to payment long before the event causing payment occurs.
Section 457(f) is narrower in scope because it applies only to tax-exempt (and governmental) employers. It also applies to deferred compensation, but applies this term to any compensation that is earned in one year and paid in a later year, even if vesting does not occur until payment. Yet Section 457(f) applies a different tax regime, in that taxation of compensation is no longer deferred once the compensation becomes vested (or no longer subject to a "substantial risk of forfeiture" as that term is defined under Section 457(f)).
Until the two sections of the Code are reconciled, it is difficult to determine which of the sections to apply when and how to comply with both.
Results of Dual Regulation .
The Internal Revenue Service (IRS) has clarified in Notice 2007-62 that Section 409A applies to nonqualified ineligible deferred compensation plans that are already subject to Section 457(f), and that it applies both separately from and in addition to Section 457(f). Thus, the differences between the two statutes create a number of potentially taxable events that were previously unrecognized under Section 457(f). Plans that will be most affected are those that include devices that are commonly used in Section 457(f) plans to defer taxation, but result in taxation under Section 409A, such as...
- "Rolling" vesting, by which the vesting date is periodically pushed back to reflect a continuing employment relationship,
- Elective deferrals being made subject to a vesting schedule,
- Completion of a period of noncompetition prior to distribution, and
- Severance pay for voluntary termination of employment or in excess of two times compensation (up to a maximum of $460,000 in 2008, indexed annually).
Employers using any of the above-described devices to defer the taxation of certain compensation to their executives under Section 457(f) will need to revisit their administration of these plans before the amendment of compliant plans may be finalized. Section 409A has made clear that certain actions will not result in the "substantial risk of forfeiture" commonly practiced by tax-exempt hospitals in the past, specifically:
- Extension of any period during which compensation is subject to a risk of forfeiture,
- Addition of any risk of forfeiture after the right to compensation has arisen, or
- Refraining from the performance of services.
If Section 457(f) plans are made subject to the same definition of substantial risk of forfeiture, commonly applied deferred methods under Section 457(f) will no longer result in effective deferral of taxation.
Known 2008 Changes .
Compliant vesting provisions under Section 409A must provide that entitlement to payment (or the lapse of a substantial risk of forfeiture) is conditioned upon either (1) the performance of substantial future services (from which noncompetition is expressly excluded), or (2) the occurrence of a condition that is related to the purpose of the compensation, of which the possibility of not satisfying is substantial. Expressly excluded from a "substantial risk of forfeiture" were renewing or rolling vesting periods, a period of noncompetition following termination of services, elective deferrals from compensation made subject to vesting, and severance agreements that did not meet narrow exemptions. Such "vested" amounts might still be eligible for deferral of taxation under Section 409A, provided that distribution cannot occur until a statutory permissible event. However, if amounts are vested under both Section 409A and Section 457(f), taxation under Section 457(f) will be required. Plans may be amended to permit distribution to meet the tax obligations associated with the Section 457(f) taxation to avoid the problem of phantom income, accompanied with lack of available funds for tax payments, to the executive.
A number of other unsuspecting compensation arrangements should also be swept into the 2008 review, including employment agreements, reimbursement plans, and paid time off plans. Provided no violative administration of such an arrangement has occurred since Code Section 409A became effective, the arrangement may yet be amended in a manner to permit certain retroactive corrections or compliance for payments that would otherwise trigger the adverse treatment of Section 409A.
Future Changes .
Section 457(f), on the other hand, delays taxation of plan benefits only until the lapse of a substantial risk of forfeiture. To date, Section 457(f) has defined that substantial risk more broadly to include a renewing or rolling vesting period, or completion of a noncompetition period, but now tax-exempt employers must become familiar with the foreign concepts of Section 409A. The IRS has warned in Notice 2007-62 that similar guidance will be released under Section 457(f), closing the planning gap between the two statutes and causing tax-exempt employers to redesign their entire executive compensation package. The new 457(f) guidance will apply prospectively only, so no taxation may result from the new regulations until further information is available, and yet the timing of its release is unknown.
Arrangements that are most likely to be included in the anticipated guidance include alternative vesting arrangements and severance pay plans intended to operate as supplemental retirement benefits.
Coordinating Change .
For today, taxation of deferred compensation under Section 409A is a reality, requiring review and amendment of Section 457(f) arrangements in 2008. Review and possible modification for Section 457(f) guidance will follow in late 2008 or 2009. This period of redesign may also serve to begin the review process by Boards of Directors and Compensation Committees to determine the reasonableness of executive compensation arrangements for reasonableness under the intermediate sanctions rules of Code Section 4958.
The culmination of these challenges in 2008 present tax-exempt employers with a unique and urgent opportunity to revisit their compensation and benefits arrangements, not only for compliance with new guidance, but also for protection from exposure to new types of liability. To take advantage of this transition period for the remainder of 2008, employers should identify all agreements, plans and arrangements that may be deemed deferred compensation plans under Section 409A, analyze the time and form of payment elections under which amounts may be paid, or be desired to be paid, and determine the operational compliance requirements under Section 409A for each arrangement. Anticipation of 409A-like rules being incorporated into Section 457(f) will help simplify the review and amendment of these plans.