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The IRS has proposed new rules that will require tax-exempt hospitals (and other tax-exempt entities) to review a variety of compensation arrangements to avoid unintended tax consequences. This article will provide a brief overview of the potential impact of these new rules and steps that tax-exempt hospitals can take now to avoid problems later.

What Compensation Arrangements Are Affected?

Special rules (often referred to as “457 rules”) apply to “deferred” compensation of tax-exempt entities, including nonprofit and governmental hospitals. Deferred compensation can come in a wide variety of forms, including paid time off, death and disability benefits, severance benefits, bonuses, and retirement benefits. Deferred compensation from a tax-exempt entity will be taxed to the employee as soon as it is vested (even if the employee won’t receive the money in that year!) unless the amount is deferred under certain retirement plans or under a “bona fide” severance, disability, death benefit, or sick leave and vacation leave plan.

Changes to the Rules

Recent changes proposed by the IRS modify many of these special 457 rules, including changing when an amount is considered deferred (and thereby subject to the accelerated taxation), when an amount is considered vested (which may be earlier than you would imagine), and what types of arrangements are considered bona fide severance, disability, death benefit, and sick leave and vacation leave plans.

Here are just a few examples of how the modified rules may affect a tax-exempt hospital’s compensation arrangements:

Next Steps for Compliance

To ensure compliance with the new rules (and avoid unintentional tax consequences for employees), tax-exempt hospitals should:

The new rules will be effective after final regulations are published. We expect the rules to be effective beginning January 1, 2018, and they will apply to new arrangements and to current arrangements that continue after the effective date.

Every tax-exempt hospital should review its employment agreements and any deferred compensation arrangements as soon as possible; modifying these arrangements can take a significant amount of time due to the required approval process. We also recommend budgeting for the review and modification of other affected arrangements (such as paid-time-off policies, severance policies, bonus plans, and deferred compensation arrangements) in the next year. We can help with this process by providing customized estimates – please don’t hesitate to ask.

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