Physician deferred compensation arrangements

By Gary J. Gunnett, Esq.

In order to avoid significant tax penalties, physician employment contracts and other agreements may need to be amended before the end of this year.

By way of background, the American Jobs Creation Act of 2004 added a new Section 409A to the Internal Revenue Code. Section 409A imposes new rules governing the taxation of nonqualified deferred compensation plans. The term “nonqualified deferred compensation plan” is defined broadly to include any agreement or arrangement under which an employee or other service provider (e.g., independent contractor) has a right to compensation that is or may be payable in a future year.

Section 409A is largely a response to Enron and other situations in which executives received significant deferred compensation payments from troubled companies, at the expense of the shareholders and other employees. However, in crafting the new law, Congress did not limit its applicability to large, publicly-traded companies. Therefore, small businesses, including physician practices, are subject to the new rules.

Tax-qualified plans such as 401(k), profit sharing and pension plans are specifically excepted from the 409A rules. However, many physician agreements contain provisions for the payment of some form of compensation after retirement or other separation from the practice. Often, these “termination benefits” are defined as a portion of the accounts receivable of the practice, and are generally designed to compensate a departing physician for fees which were generated prior to the end of the employment relationship but will not be collected until after the end of the employment relationship. Although shareholders in a physician practice might tend to view these payments as part of their “buy-out,” they technically fall within the definition of “deferred compensation” under Section 409A.

While the law was passed in 2004, final IRS regulations were not issued under Section 409A until 2007 and are rather complex, consisting of 397 pages. Because of the complexity of the regulations, the deadline for written compliance with the requirements of the regulations was postponed on several occasions, with the last extension running until December 31, 2008. Since no further extensions have been indicated, the 409A rules must be addressed now.

The bulk of the Section 409A rules concern the form and timing of deferred compensation payments. First, deferred compensation payments can only be made following the occurrence of one or more of six specified events: (a) death, (b) disability, (c) separation from service, (d) change in control, (e) unforeseeable emergency, or (f) at a fixed time or pursuant to a fixed schedule. Second, while parties are generally free to determine the amount of deferred compensation pursuant to any method or formula they consider to be appropriate, the timing of deferred compensation payments must be firmly established in the agreement. Amendments to change the form or timing of any payment, and provisions which give the employer or the employee the discretion to determine the form or timing of any payment, are prohibited. These principles are illustrated by the following examples:

Example 1. An employment agreement provides for deferred compensation to be paid to a physician in 24 equal monthly installments commencing upon separation from service. In connection with the employee’s separation from service, the employer and the employee agree to amend the agreement to provide for payment over 12 months. The amendment changes the timing of the payments and therefore violates Section 409A.

Example 2. An employment agreement provides for the payment of deferred compensation to a departing physician “over a period not to exceed 24 months” following separation from service. The agreement does not comply with Section 409A, as the parties could exercise discretion to cause the payments to be made at any times they choose, within the 24 month period. The agreement must be amended by December 31, 2008 in order to achieve compliance with Section 409A.

One particularly tricky aspect of the 409A rules is the concept of “separation from service.” In the context of physician agreements, this event will most often be the event which triggers the payment of deferred compensation. At first glance, it might appear that an agreement which provides for the payment of deferred compensation following “termination of employment” satisfies the IRS rules. However, under the 409A regulations, a “termination of employment” is not the same as a “separation from service.”

The theory behind the distinction between “termination of employment” and “separation from service” is that an agreement which provides for payments following termination of employment leaves room for potential abuses. For example, a retiring physician who prefers to have his deferred compensation paid some years down the road in lieu of currently might agree to perform administrative services for the practice one day per month, for the real purpose of remaining on the payroll and not having a “termination of employment.”

In light of these concerns, the 409A regulations provide that a “separation from service” has occurred only when the employer and the employee reasonably anticipate that no further services will be performed after a certain date, or that the level of bona fide services the employee will perform after such date (whether as an employee or as an independent contractor) permanently decrease to no more than 20 percent of the average level of bona fide services performed over the last three years. Thus, where the level of services decreases to 20 percent or less, the presumption is that a separation from service has occurred. Where the level of services decreases to 50 percent or more, the presumption is that a separation from service has not occurred. No presumption is created for a level of services between 20 percent and 50 percent, and in fact the regulations permit a plan to designate a level between 20 percent and 50 percent which will be treated as a separation from service.

The consequences of a failure to comply with the 409A rules are significant. Individuals entitled to deferred compensation under noncompliant agreements are currently subject to ordinary income tax (even if the deferred compensation has not yet been paid), plus interest and a 20 percent penalty. Therefore, compliance with the new rules is critical in order to avoid rather unpleasant tax results.

A noncompliant agreement can generally be amended in any manner the parties determine to be appropriate, as long as the amended agreement complies with the Section 409A rules and is adopted on or before December 31, 2008. The following are four basic steps that should be taken by physicians, with the assistance of legal counsel, to achieve 409A compliance:

· Identify all those contracts or arrangements that provide for “deferred compensation.”

· Determine the areas of the contracts that need to be amended.

· Make decisions concerning the manner in which non-compliant provisions will be made compliant.

· Prepare and sign compliance amendments no later than December 31, 2008.

In many cases, the initial step (identifying those contracts that need to be amended) may be the most difficult, as physicians in a busy practice tend to focus on daily patient care issues and not on contracts which may have been in place for many years. However, the peace of mind that comes with 409A compliance will be worth the effort

Gary J. Gunnett, Esq., is a Director at Houston Harbaugh, P.C. in Pittsburgh.