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:
- If the timing of bonus payments and documentation of the bonus plan do not meet the new rules, all or part of the bonuses may be taxable to employees in a year before they are actually paid to the employees.
- If the hospital’s severance arrangement allows severance to be paid on both involuntary and voluntary terminations or if it does not meet certain limits on timing and amount, the value of the severance may be taxable to the employee before the year in which it is actually paid to the employee.
- If the hospital’s paid-time-off plan is very generous and allows the employee to roll over PTO from year to year, the PTO may be taxable to the employee when earned (rather than when the PTO is actually paid out to the employee).
Next Steps for Compliance
To ensure compliance with the new rules (and avoid unintentional tax consequences for employees), tax-exempt hospitals should:
- Review employment agreements with bonuses, severance, disability payments, or special vacation arrangements.
- If severance is offered:
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- Make sure a severance plan/policy is in place that meets the applicable payment timing requirements
- Reconsider or redesign any severance plan that allows payment on voluntary terminations
- Review and possibly tweak (or more clearly document) bonus plans to ensure they clearly meet the rules.
- Review any supplemental retirement plan or incentive plan, and, if necessary, redesign the plan to meet the new requirements.
- Review vacation and paid-time-off arrangements for compliance with the new rules.
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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