Deferred Compensation Plans Under Code Section 409A and Medical Practices

January 31, 2006

Richard O. Jacobs

Holland & Knight, LLP

Introduction

Prior to the passage of Code Section 409A, when an employer promised to pay compensation in the future for services rendered in the past, a taxable event did not occur unless (1) the employee received a current economic benefit or was in constructive receipt (i.e., no substantial limitation on receipt) of the compensation, or (2) the promise was funded or secured in a manner that placed the funds beyond the reach of the employer’s general creditors.

The American Jobs Creation Act of 2004 (the “2004 Act”) drastically changed the taxation of so-called “non-qualified deferred compensation plans.” Newly enacted Code Section 409A subjects all “non-qualified deferred compensation” to income inclusion at the time of deferral, unless it meets certain requirements under the statute and Regulations. Failure to meet Code Section 409A requirements also subjects the participant to the participant’s regular income tax on the deferred amount plus (i) a penalty equal to 20% of the amount of deferred compensation and (ii) an interest charge. The tax and penalties are payable up-front, when the amount is deferred and not in later years when the amount is paid.

The scope of Code Section 409A is extremely broad. The law is also vague. Code Section 409A applies to deferrals of compensation for amounts earned after December 31, 2004 and for plans that are “materially modified” after October 3, 2004. Amounts earned and vested before 2005 are grandfathered under prior law, to the extent they are not under plans that have been materially modified. Otherwise, all deferred compensation plans in existence on December 31, 2004 must be amended to comply with §409A within the time period provided in the Regulations discussed below.

Notice 20005-1, as corrected and reissued by the IRS in January 2005, (the “Notice”) makes clear that Code Section 409A does not change or affect other statutory or common law tax doctrines, including the constructive receipt, economic benefit, cash equivalency, or assignment of income doctrines. Furthermore, even if not captured by Code Section 409A, the compensation may nevertheless be subject to gross income inclusion under Code Sections 83 and 451.

On September 20, 2005, the IRS issued proposed Regulations regarding Code Section 409A (the “Regulations”). The Regulations extend certain of the transitional rules for complying with Code Section 409A to December 31, 2006, and are generally effective January 1, 2007. Previously, the Notice had extended the transitional period to December 31, 2005. The application of the transitional rules to existing deferred compensation plans is complex and requires careful study. Reliance on the Regulations and the Notice (to the extent the Notice does not conflict with the Regulations) is considered to be good faith reliance under the statute.

These comments include our interpretation of the more important provisions of Code Section 409A, the Notice and the Regulations effecting professional practice arrangements.

Non-qualified Deferred Compensation Defined

Code Section 409A(d)(1) defines a non-qualified deferred compensation plan as any plan that provides for deferral of compensation. Any arrangement under which compensation is paid in a tax year later than the tax year in which it is earned is potentially a non-qualified deferred compensation plan. A deferred compensation plan can involve one individual or several individuals.

While the statutory definition of a non-qualified deferred compensation plan is broad, Code Section 409A(d)(1) provides that bona fide vacation leave, sick leave, compensatory time off, disability, or death benefit plans are not deferred compensation plans. Deferred compensation plans also do not include qualified retirement plans, SEPs, SIMPLE-IRAs, and certain non-profit organization deferred compensation arrangements.

The Regulations clarify the vagueness of the broad statutory definition of deferred compensation by providing that:

“…except as provided in paragraph (b)(3) through (b)(9) of this section, a plan provides for the deferral of compensation if, under the terms of the plan, and the relevant facts and circumstances, the service provider has a legally binding right during a taxable year to compensation that has not been actually or constructively received and included in gross income, and that, pursuant to the terms of the plan, is payable to (or on behalf) of the service provider in a later year.”

Paragraphs (b)(3) through (b)(9) of Regulation §1.409A-1, provide that deferred compensation does not include:

  • §1.409A-1(b)(3). Compensation arrangements paid under a service provider’s customary compensation timing arrangements (short-term timing differentials).
  • §1.409A-1(b)(4)(i). Short-term deferrals paid within 2.5 months after the close of the later of the service provider’s tax year or the service recipient’s tax year, when the compensation is no longer subject to a substantial risk of forfeiture as defined.
  • §1.409A-1(b)(4)(ii). Delayed payments due to unforeseen events described in the Regulations.
  • §1.409A-1(b)(5). Stock options, stock appreciation rights and other equity-based compensation that meets certain standards in the Regulation, as described later in this article.
  • §1.409A-1(b)(6). Restricted property distributions subject to Code Section 83.
  • §1.409A-1(b)(7). Partner and partnership arrangements, which will be added to the Regulations later (however, the Notice provides interim partnership guidance and most guaranteed payments to partners are deferred compensation arrangements under Code Section 409A).
  • §1.409A-1(b)(8). Foreign deferral arrangements subject to treaty or other agreement, as described in the Regulations.
  • §1.409A-1(b)(9). Separation-pay arrangements described in the Regulations. These include collective bargained arrangements; payments upon involuntary separation, or separation under a “window plan,” capped in each case as provided in the Regulations (described later in this article); timely expense reimbursements; and de minimis payments ($5,000).  Compensation paid following voluntary termination is subject to Code Section 409A.

Regulation §1.409A-1(f) defines “service provider,” an individual performing services for a service recipient in exchange for the deferred compensation. Service providers exclude independent contractors when the conditions of §1.409A-1(f)(3) are met. Essentially, the contractor must be engaged in an active trade or business, must be unrelated, and must provide significant services for two or more unrelated service recipients.

Avoiding Deferred Compensation “Plan Failure”

Code Section 409A(a) provides that when there is a deferred compensation plan failure, the deferred compensation is subject to the 20% of compensation penalty tax and interest, in addition to normal income taxes. The tax is due when the compensation is deferred and not later, when compensation is paid.

A plan failure exists when the deferred compensation arrangement fails to meet each of the requirements of Code Section 409A (a)(2), (3) and (4). Plan-failure avoidance requirements are:

  • §409A(2): deferred compensation arrangements under which the amounts deferred are paid not earlier than the occurrence of the following “trigger events,” as defined in §409A and the Regulations: (i) separation from service (however, if the service provider worked for a public company, the payment must be deferred for six months after separation), (ii) disability, (iii) death, (iv) at a specified time or under a fixed schedule, (iv) change in control or ownership, or (v) an unforeseen emergency;
  • §409A(3): deferred compensation arrangements that do not permit the acceleration of benefits except as provided in the Regulations; and
  • §409A(4): deferred compensation arrangements as to which a deferral election is made, or deemed to be made, by the service provider in accordance with Code Section 409A and the Regulations.

Distributions

Trigger events. As noted above, Code Section 409A permits a plan to make distributions following, and only following, one of the “trigger events,” described in §409A and the Regulations: (1) separation from service, (2) disability, (3) death, (4) at a specified time (or pursuant to a fixed schedule), (5) a change of control of the employing corporation or a change in ownership of a substantial portion of the corporation’s assets, or (6) an unforeseeable emergency. If the participant is a “specified employee,” which is defined as a key employee (defined in Code Section 416(i), except paragraph (B)) of a corporation any stock in which is publicly traded on an established securities market or otherwise, the distributions may not be made until six months after separation of service.

Objectively determined time and amount required for distributions. Schedules for payments and payment amounts of deferred compensation meeting the Code Section 409A requirements must be “objectively determinable” as provided in Regulation §1.409A-3(g)(1), and that means determined in accordance with a non-discretionary formula and methodology. A payment of deferred compensation made following a trigger event must be paid at an “objectively determinable time,” such as three months after disability occurs, or during the calendar year following death (if a date is not specified, the presumption is payment will be made January 1). Payments may also be made in accordance with a fixed schedule following the triggering event (e.g., annually for three years after separation from service). Payment can also provide for alternative payment methods, such as a lump sum payment upon retirement before age 55 and five annual payments following a retirement after age 55. If payment follows the lapse of a “substantial risk of forfeiture” (discussed below) the payment may also be paid over time under a schedule.

Unforeseen emergency. An unforeseen emergency is defined in Regulation §1.409A-3(g)(3) as a severe financial hardship, such as a hurricane loss, a severe illness or similar extraordinary event.

Disability. The disability distribution event is likely to be a problem under many professional practice deferred compensation agreements. “Disability” is defined specially by the new statute (described below) and many deferred compensation agreements for professionals provide for a different definition of disability, usually related to the inability to perform services for the practice.

All deferred compensation arrangements that trigger payment upon a disability should contain a definition of disability that is identical to the definition provided in Code Section 409A and the Regulations. The §409A statutory definition defines “disability” as the participant’s (i) inability to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or can be expected to last for a continuous period of not less than 12 months, or (ii) receipt of disability benefits for a period of 3 months under an accident and health plan of the employer by reason of the participant’s medically determinable physical or mental impairment which can be expected to result in death or can be expected to last for a continuous period of not less than 12 months.

As a trigger event under Code Section 409A, “disability” is a defined term, distinguishable from the term “separation from service.” If the individual’s employment agreement provides, for example, that his or her employment terminates after a disability, the termination compensation payment follows a disability that is in fact a separation from service; thus the limited disability definition should not apply.

If the deferred compensation is paid because of a disability that is not a separation from service, the §409A disability definition applies (unless the salary continuation payment meets the accident and health plan exception, which involves a short-term payment of non-deferred compensation).

Professional practices frequently provide for salary continuation following a disability for a period of three months, since accounts receivable from services performed are normally collectible over a three-month period. The three-month salary continuation “plan” can be formalized as an employer “accident and health plan,” regulated by Code §105. If payments are made to a disabled individual under the practice’s accident and health plan for a period of three months, compensation deferred can be paid thereafter for a disability that is expected to lead to death or continue for 12 or more months without being bound by the “any substantial gainful activity” limitation. The Regulations provide in §1.409A-3(g)(4) that qualifying for disability payments under Social Security meets the requirements of Code Section 409A.

Separation from Service. Separation pay arrangements are the subject of Regulation §409A-1(b)(9). That section confirms that payments of deferred compensation can be conditioned on separation from service. The section also provides that the following separation from service arrangements are not considered deferred compensation: (i) collectively bargained separation involuntary pay arrangements that apply on window arrangements, and (ii) involuntary separation pay plans that meet the following criteria: (a) the amount of the separation pay does not exceed two times the service provider’s annualized compensation, or if less, two times the maximum amount of compensation that can be taken into consideration for qualified retirement plans under IRC §401(a)(17) [currently, $210,000 annually], and (b) the amount deferred is paid before December 31 of the second year following the involuntary termination. The Regulations also provide that certain expense reimbursements following termination and de minimis payments up to $5,000 are not deferred compensation. All other deferrals of compensation are governed by §409A. Thus, a practice should assume that any payment of compensation to a professional following retirement, death, disability, resignation or other voluntary withdrawal from the practice are potentially deferred compensation payment arrangements regulated by Code Section 409A. Later in this article we discuss payment of termination compensation from post-termination collections of accounts receivable. We believe that these payments can be structured so as not to be deferred compensation.

Regulation §409A-1(b)(9)(h) provides that a “separation from service” occurs when the employee dies, retires or otherwise terminates employment. An employee continuing on a part-time basis, or is available for services, will not meet the separation from service requirements unless the ongoing services are “immaterial.” Generally, if the employee provides services that are at least equal to 20% of the services rendered by the employee during the immediate preceding three calendar year period and the compensation is also equal to at least 20% of the prior compensation, the services rendered are considered “significant” and a separation from service has not occurred. If the continued services are provided in a contractor capacity, the test percentage becomes 50%. For this test, current compensation is measured against the prior “base” compensation.

Accelerated Payout Restrictions

Code Section 409A prohibits acceleration of the time or schedule of any payment under the plan, except as provided in the Regulations. This requirement is aimed at addressing perceived abuses of so-called haircut provisions in which a participant can accelerate his or her interest in the plan by agreeing to pay a 10 percent penalty tax. The use of a haircut and an acceleration election are now clearly prohibited.

Regulation §1.409A-3(h) provides that an “impermissible” acceleration does not occur when the payments are made in accordance with the provisions of the deferred compensation plan or an election made as to time and form of payment when the election is the initial deferral election and the acceleration occurs because of an intervening event described in §1.409A-3(a) of the Regulations (e.g., death, separation of service, disability, change in control, at a plan-specified time or an unforeseen emergency). Also an impermissible acceleration does not include accelerated payments paid:

  • under a domestic relations order;
  • when a conflict occurs and a divestiture must be made;  when the payments are certain de minimis payments less than $10,000;
  • for payment of income taxes under Section 357 plans;
  • for payment of employment taxes applicable to the deferred compensation;
  • upon an unforeseeable emergency if the deferral is thereupon cancelled;
  • following certain discretionary elections by the service provider upon his or her company’s bankruptcy or change of control;
  • at the time the deferred compensation arrangement does not meet the requirements of Code Section 409A for deferral; or
  • upon the occurrence of similar events described in the Regulations.

Deferral Elections

To satisfy the deferral elections requirement under Code Section 409A, the provisions of a nonqualified deferred compensation plan must meet the following two-part test: (1) if the plan provides a participant with an election to defer compensation, the election must be made not later than the close of the participant’s preceding taxable year, and (2) if the plan permits a subsequent election to delay a payment or change the form of payment, the plan must provide that such election cannot take effect for a specified period of time, which is provided in the Regulations.

There are two statutory exceptions to the election requirement in part (1) of the test described above. First, in the year in which a participant first becomes eligible to participate in a plan, the participant may make a deferral election within 30 days after initial eligibility. This election relates only to compensation for services performed after the election is made.

The second exception is for “performance-based compensation.” Regulation §1.409A-1(e) requires that performance-based compensation be based upon preestablished organizational or individual written performance criteria related to a performance period of twelve or more months when the outcome is substantially uncertain at the time the period commences. The criteria must be established within 90 days after services commence. Subjective criteria may be included when the service provider is not a measurer of the criteria. In short, if the participant is entitled to performance-based compensation for services performed over a period of at least twelve months, the election may be made no later than six months before the end of the period.

Note that the deferral election requirement is satisfied at the outset if the participant is not afforded an election opportunity under the agreement. To be effective, the election must be irrevocable by the last day of the time period in which the election must be made. Regulation §1.409A-2(a)(1) provides that preserving the right to elect the time and form of payment in accordance with the methods permitted in the Regulations does not make the election revocable, and an election as to the “medium” of payment (e.g., cash or property) is not a deferral election.

Regulation §1.409A-2(a) amplifies the statutory election procedures and provides other election procedures:

  • §1.409A-2(a)(2),describes the statutory general rule, requiring that a deferral election be made in the service provider’s tax year preceding the year of the deferral.
  • §1.409A-2(a)(3), provides for the initial deferral of short-term deferrals (payments in the next tax year) compliant with §1.409A-2(b).
  • §1.409A-2(a)(4), provides for the initial deferral of certain forfeitable rights (i.e., payment conditioned on working 12 or more months), if election is made within 30 days after obtaining the right.
  • §1.409A-2(a)(5), provides for initial deferral elections when service recipient is on a fiscal year, requiring that the election must be made before the start of the fiscal year.
  • §1.409A-2(a)(6), describes the statutory first year eligibility rule, requiring election within 30 days of eligibility; if the plan does not permit an election, the right must be fixed within the first 30 days. The Regulation provides for pro ration of compensation for the election year.
  • §1.409A-2(a)(7), describes the statutory performance-based compensation rule election and adds that an election cannot be made after the payment of the compensation has become fairly certain (this restriction limits the value of the statutory right to wait until six months before payment to make the election).
  • §1.409A-2(a)(8), provides rules for deferred compensation plans linked to qualified plans.
  • §1.409A-2(a)(9), provides that separation pay arrangements related to involuntary separation from service can be made up to the time the service provider’s rights become legally binding.
  • §1.409A-2(a)(10), provides that commission compensation is considered earning in the year the customer makes payment, and defines commission compensation as a portion of the purchase price for products or services or an amount calculated solely by reference to volume of sales and the payment of compensation is contingent upon the receipt of payment by an unrelated customer. Note, we believe this provision is an important consideration when structuring termination compensation for physicians that is based upon productivity and post-termination collection of accounts receivable.
  • §1.409A-2(a)(11), provides rules for deferral election for compensation paid during the final payroll period of a year that overlaps to the next tax year.
  •  §1.409A-2(a)(12), provides that when deferral arrangements are nonelective, the arrangement must specify the time of payment and the form of the payment no later than the time the service provider first has the legal right to the compensation.
  • §1.409A-2(a)(13), provides for the timing of the payment of earnings on the amounts deferred.

Regulation §1.409A-2(b)(1) provides requirements for deferred compensation plans that permit changes in the time and form of the deferred compensation payments. Generally, a change cannot take place for 12 months after the change election, and unless the payment follows death, disability or an unforeseen emergency, the time period for the deferral of compensation must be for a period that is five years after it was originally scheduled to be made. The timing election can be made for all subsequent deferred compensation payments or, if the plan provides that each installment of deferred compensation is a separate payment, for selected deferred compensation payments, such as those payments due during the third year following separation from service. When a plan provides for alternative payments of deferred compensation, such as payment on the earlier of separation from service or age 55, the change rules are applied separately to each permitted event.

The deferred compensation plan may also provide for a delay in payment under certain circumstances. These include: when there is a deduction limitation because of Code §162(m); payment would violate a loan or contractual covenant; payment would violate securities laws or other laws; or when other events occur that are described by the IRS in the Internal Revenue Bulletin.

Trust Funding

Code Section 409A has additional provisions aimed at curbing what Congress believes to be abusive transactions. Under prior law, employers could circumvent the general rule of income inclusion if the employer secured payment by placing assets in a foreign rabbi trust. Alternatively, an employer would often include a provision in the plan providing that assets would be placed beyond the reach of the employer’s creditors if the company’s financial situation deteriorated. In both of these situations the new statute now treats the plan as funded, which will require the participant to include the deferred compensation in gross income.

Substantial Risk of Forfeiture

If the plan constitutes a non-qualified deferred compensation plan and does not meet the requirements outlined above, the compensation deferred is includible in gross income when the employee’s rights are not subject to a substantial risk of forfeiture. “Substantial risk of forfeiture” generally means a requirement that the recipient continue to work for the employer or achieve certain goals over or by the end of a specific period as a condition to receiving the compensation, and the possibility of forfeiture is substantial.

The statute provides that regulations may be issued that provide for disregarding a substantial risk of forfeiture in cases where necessary to carry out the purposes of the statute.

Regulation §1.409A-1(d)(1) expands “substantial risk of forfeiture” beyond the recipient’s continuation of work for his or her employer, as stated in the statute. The Regulations provide that a substantial risk of forfeiture exists when entitlement to the compensation is conditioned upon (a) the performance of substantial future services by any person or (b) the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. For purposes of (b), the condition must relate to the service provider’s performance for the service recipient or the service recipient’s business activities or organizational goals, such as achieving a certain level of profitability.

The Regulations provide that deferred compensation is not subject to a substantial risk of forfeiture merely because the right to it is conditioned on the service provider’s refraining from performing services; thus, a non-compete provision does not itself constitute a substantial risk of forfeiture under Code section 409A.

Regulation §1.409A-1(d)(3) provides that when the service provider who has the deferred compensation arrangement with his or her company has a significant voting power, whether or not the service provider’s compensation will be deemed to be conditioned on a substantial risk of forfeiture is dependent upon the facts and circumstances, including such factors as:

  • The extent of control of the service provider;
  • The position of the service provider in the service organization and whether or not he or she is subordinate to other service providers;
  • Whether the service provider is an officer or director, or related to an officer or director;
  • The person or persons who must approve the service provider’s discharge;
  • The history of the service provider enforcing restrictions.

Thus, the Regulations appear to provide a “road block” for a common medical practice undertaking—that of providing special compensation arrangements for a “senior” or “founding” physician as a form of “goodwill” compensation for his or her start-up activities or for his or her prior “rain-making” abilities. Frequently, this form of compensation continues for a specific period of years, for example, five years, whether or not the senior physician continues to work for the entire period. Since this form of compensation by design is not subject to a substantial risk of forfeiture (i.e., the continued performance of substantial services), the senior physician compensation is deferred compensation under the statute, and will be treated as the payment of compensation under a “failed plan” unless the arrangement meets the requirements of Code Section 409A, notably, §409A(a)(2) [distribution only upon a defined trigger event],(3) [non-acceleration rules] and (4) [election requirements], and the Regulations. Thus, any practice with this arrangement in place should review its plan within the transitional period to bring it into compliance. The difficulty will be in making an election prior to the rendition of services for which the deferred compensation plan is established, as required under §409A(a)(4). If the compensation is for prior services, or insubstantial services, no election can be made prior to the tax year in which the commencement of services began and for which compensation is being deferred.

A related consideration is defining the elements of a productivity compensation plan by a practice for its physician employees. If, for example, the practice defines productivity compensation as the monies available from practice receipts after payment of expenses, debts and establishment of reserves, and the physicians who are being paid compensation are controlling decision-makers, the discretion as to the use of the compensatory elements in the formula (e.g., what are reasonable reserves and what are the reserves “saved” for?) may influence whether or not deferred compensation is present.

Gross Income Inclusion

If the statute’s requirements are not satisfied and the participant’s rights are not subject to a substantial risk of forfeiture, all compensation deferred under the plan for the taxable year and all preceding taxable years is includible in the Participant’s gross income for the taxable year, less any portion that has previously been included in gross income. The determination of the appropriate value to be included in gross income can be difficult in certain circumstances and it is anticipated that future Treasury Regulations will address this issue. The Internal Revenue Service as reserved Regulation  §1.409A-4 for this purpose.

Result of Gross Income Inclusion

There are three basic effects of failing to satisfy the requirements of Code Section 409A: (1) gross income inclusion for all compensation deferred under the plan for the taxable year and all prior taxable years, less any portion that has previously been included in gross income (to be taxed at ordinary income rates), (2) 20 percent of the amount of the compensation as a penalty tax, and (3) an interest charge at the underpayment rate plus 1 percent for the period beginning with deferral or, if later, vesting. The penalties for noncompliance with the statute are severe.

Employer Deductions

The general rule that matches employer deductions with participant inclusion is not affected by Code Section 409A. Therefore, if the employee is forced to include deferred compensation in gross income, the employer will be entitled to a corresponding deduction under Code Section 162.

Effective Date

Code Section 409A applies to amounts deferred after December 31, 2004; that is, to compensation that is earned in 2005 or later. Deferrals of compensation before December 31, 2004 are subject to prior law with one exception. If a plan or arrangement is “materially modified” after October 3, 2004, deferrals under the plan are treated as post-2004 deferrals. Notice 2005-1 provides that a material modification occurs if a benefit or right existing as of October 3, 2004 is enhanced or a new benefit or right is added. Amending the plan to comply with Code Section 409A is not treated as a material modification as long as there is no enhancement or new benefit or right added. The Conference Report states that “an amount is considered deferred before January 1, 2005 if the amount is deferred and vested before such date.” Plans adopted after October 3, 2004 are subject to Code Section 409A from inception. A re-deferral in accordance with Code Section 409 A (a) (4) (C) is not treated as a post-2004 deferral if the plan is not otherwise materially modified. Regulation §1.409A-6 provide that if amounts deferred prior to January 1, 2005 are subject to a substantial risk of forfeiture, as defined in §1.83-3(c) of the regulations or a service requirement, the amounts will not be considered vested. That Regulation also provides methodology for the calculation of grandfathered deferred compensation, a broader description of plan modifications and new arrangements.

Reporting Requirements

The 2004 Act also provides that amounts deferred, whether or not included in a participant’s income, are required to be reflected on the participant’s W-2 Form. The IRS is, however, permitted to establish de minimis thresholds which would be an exception to this rule. Income tax must be withheld from deferred amounts that are includible in the participant’s gross income under the 2004 Act. If this occurs the employer must determine a way to obtain from the employee the taxes required to be withheld. The legislative history indicates that IRS Regulations are to allow the employer to withhold the participant’s portion of the withholding from the participant’s interest under the plan without violating the prohibition on acceleration of payments. If the employer does not have a trust with assets set aside, it will have to use its current cash to pay the withholding. Alternatively, the amount could be withheld from income that is currently paid to the Participant. Future guidance is likely to address this requirement in greater detail. Note that the Act did not change the rules that determine when deferred compensation is includible in FICA wages and subject to employment taxes.

Important Applications: Options to Buy into a Practice

When a medical practice employs a new physician, more often than not, the physician’s employment agreements provides that the physician will have the right to “buy” an ownership interest in the practice after he or she satisfies a specified period of active employment, usually one or two years. If the physician has a legally enforceable right to buy into the practice, the physician has a stock option — in tax terms a “non-statutory” stock option. Frequently, the practice and the physician will negotiate for the physician to receive credit for his or her “sweat equity.” In other words, the actual buy-in price for the stock interest purchased at the end of the agreed upon period is something less than its “fair market value,” and the price difference is intended to reward the physician for working in the practice and contributing to its value.

Regulation §1.409A-1(b)(5) provides that a non-statutory stock option, such as a right granted a physician to buy an interest in the medical practice employing the physician, is excluded from the reach of §409A only when (i) the amount required to purchase the stock under the option is never less than fair market value when the right is granted (i.e., when the physician and the practice enter into the employment agreement providing the right to buy into the practice at a future date), (ii) the exercise of the option is subject to income tax under IRC §83 (i.e., the value of the stock at the time of purchase in excess of the purchase price is reported as income by the physician when the stock is purchased), and (iii) the stock option does not include any other form of deferral.

When determining the value of the stock purchasable under the stock option Regulation 1.409A-1(b)(5)(iv) provides that fair market value is to be determined by the “reasonable application of a reasonable method.” An appraisal is not required; however the Regulation states that “The use of a valuation method is not reasonable if such valuation method does not take into consideration … all of the available information material to the value of the corporation.” The Regulations further point out that information occurring after the valuation formula is set for the option must be updated for subsequent factors and information. The Regulations also provide that a company’s consistent use of a valuation formula is a factor in ascertaining the reasonableness of valuation methodology.

The stock option pricing formula has the presumption of reasonableness if it is used consistently even though it includes a “non-lapse” restriction under §83 of the Code. In other words, if the formula is used at the time of a buy-in and a buy-out for every stock transaction, in accordance with §1.83-3(h) of the income tax regulations, the formula, though value-restricted will be considered to be a fair market value pricing formula. For example, if the stock buy-in price in the physician’s employment agreement option is valued at “book value” (with no goodwill allowance) and the stock is also subject to the same book value “non-lapse” restriction when the stock is sold back to the practice, or to the other physician shareholders, at death or retirement of the physician, the valuation will create a presumption that it is a fair market value determination.

However, a “non-lapse” restriction only creates the presumption of being fair market value when it is used in all compensatory and non-compensatory circumstances. If the valuation methodology differs under the practice’s buy-sell agreement when the stock is sold in the future, the valuation methodology for the buy-in option will not be considered fair market value and the arrangement will “fail” to meet the deferral requirements of Code Section 409A. (A differing valuation methodology also will not meet the health law requirements under Stark, 42 USC §1395nn. If the buy in price exceeds the formula price for a stock buyout, the formula can also be viewed as producing an illegal kickback.)

Ownership shares in a practice that are transferred to a physician directly, and not optioned, are not considered deferred compensation merely because the shares are not fully vested or are subject to forfeiture. The immediate transfer of ownership shares to a physician in connection with the physician’s services are generally taxable under IRC §83, not §409A.

Important Applications: Termination Compensation

Introduction

The impact of Code Section 409A on so-called “termination compensation” is of particular importance to physician practices. The following discussion reflects our current understanding of how typical termination compensation arrangements will be affected by Code Section 409A. Unfortunately, the issues we discuss below are not adequately treated in the statute, the Notice or the Regulations; thus, for certainty, we must await future guidance.

Termination compensation is typically paid by medical practices to a terminating professional upon a “trigger event” (e.g., the professional’s death, retirement, or other termination). Practices typically use one of three basic options when deciding on an appropriate form of termination compensation.

Payment of termination compensation from post-termination receipts  as collected. Under Option 1, which is the most common, salary continuation compensation paid following a trigger event is paid to the participant from accounts receivable, as collected, usually over a six to twelve month time period. The risk of collection rests with the terminating professional, since if the accounts are not collected within the agreed time period, no payments are made.

Payment of termination compensation measured by the fair market value of accounts receivable upon termination. Under Option 2, the value of the accounts receivable produced by the terminating professional are determined at the time of the trigger event and the salary continuation compensation paid following termination is paid out based upon the estimated collectible accounts receivable value (as opposed to being paid out on the basis of collections). Under this method, the practice is taking the risk that the receivables may not be collected.

Payment of an agreed amount of compensation with or without payments from accounts receivable collections. Finally, under Option 3, the salary continuation compensation is paid following the trigger event according to either Option 1 or Option 2, but in addition (or in lieu of an accounts receivable payout), the terminating professional is paid a supplementary fixed dollar amount following termination (e.g., $3,000 a month for thirty-six months). Since the amount is fixed, the practice is the primary risk taker in regard to the payments.

Option 1—payment from accounts receivable collections as collected

Under Option 1, termination compensation is paid from accounts receivable as collected following a trigger event. Code Section 409A is likely not applicable to an Option 1 plan prior to a trigger event occurring because there is no “deferral of compensation.” For there to be a deferral of compensation the participant must have a legally binding right during a taxable year to compensation that has not been received. Under Option 1, the participant does not have a legally binding right to any particular amount of compensation until (or if) a termination of employment occurs. Nothing earned prior to termination is payable after termination.

The position of the physician under these circumstances is similar to that of a commission sales person whose compensation is only paid when the customer pays for the services or products provided. Regulation 1.401A-2(a)(10) indicates that there is no deferral when compensation is paid from receipts as collected. Although we do not normally think of physicians or other professionals as commission earners, the payment of cash-basis productivity compensation is in fact that.

However, an Option 1 plan may be subject to Code Section 409A after the occurrence of a trigger event. This results from the fact that the participant becomes entitled to compensation without an obligation to provide further services, and the post-termination compensation is paid out over a stated period of time, usually from 6-12 months, but in some cases longer (i.e., at this time there is a “deferral of compensation”). If the compensation is payable in the tax year of termination and within 2.5 months thereafter, there would be no deferral. If the termination compensation plans provides for a longer payout period, there is a deferral and the requirements of Code Section 409A must be met.

Assuming Code Section 409A is applicable to an Option 1 plan in regard to the payment of salary continuation following termination, these plans can typically be easily conformed to the requirements of Code Section 409A. Again, there are three main requirements under Code Section 409A: (1) deferral election requirements, (2) distribution requirements, and (3) a no acceleration requirement. Termination compensation plans typically satisfy the deferral election requirement because the terminating professional has no deferral election to make. Termination compensation plans also typically meet the “no acceleration” requirement since payment is made when collection is made and there is no possibility to accelerate payment prior to collection. Under the distribution requirement, the statute provides that payment can only be made upon the occurrence of one or more of the following “trigger events”: (1) separation from service, (2) disability (as defined in the statute), (3) death, (4) a specified time (or pursuant to a fixed schedule) laid out in the plan, (5) change of control of the employing corporation or change in ownership of a substantial portion of the corporation’s assets, or (6) an unforeseeable emergency.

Under most termination compensation plans, payments are only made upon termination because of death, retirement, or other termination. Most termination compensation plans will therefore satisfy the distribution requirement of Code Section 409A. The one problem area again is the “disability” trigger event. The statute has its own particular definition of disability and the compensation plan must comply with this definition in order to satisfy the requirements of the statute if the deferred compensation is extended and is paid following a disability that is not a termination of service.

Plans that fail to meet the requirements outlined above are still “safe” if the salary continuation payments following termination are subject to a substantial risk of forfeiture. The payment of salary continuation under Option 1 following a termination is, arguably,  subject to a substantial risk of forfeiture. This stems from the fact that if there is no collection from accounts, there is no payment, so the payment is conditioned upon the future business activities of the practice—the collection of its accounts.

Option 1 plans providing disability benefits should be reviewed to ensure that they define “disability” in the same manner as the statute. If Code Section 409A is held applicable, the requirements of the statute will be met and the negative implications of the statute will be avoided.

Option 2—termination compensation based upon value of accounts receivable, valued at termination

Under Option 2, salary continuation is paid based on an estimated value of accounts receivable and not on the basis of collections. The analysis above with respect to Option 1 plans is applicable to Option 2 plans, with the following modifications. Under Option 1, whether a participant actually receives payment is dependent upon the receivables actually being collected. Under an Option 2 plan, no such risk is present.

As a result, Option 2 plans must conform to the requirements of Code Section 409A, discussed above, which are the (1) deferral election requirements, (2) distribution trigger event requirements, and (3) a no acceleration requirement.

Option 3—termination compensation that includes a fixed compensation element

Option 3 may combine either Option 1 or Option 2 with the payment of a fixed sum of money, or may provide only for the payment of a fixed sum of money, such as $3,000 a month for a particular number of months following the occurrence of a trigger event. The analysis above with respect to Option 1 and Option 2 plans, as appropriate, is applicable to Option 3 plans, with the following modifications. Option 3 plans differ from the other two compensation plans in that in addition to, or in lieu of, salary continuation compensation from accounts receivable or collections, a fixed amount of termination compensation is paid to the participant. The termination compensation would be nonqualified deferred compensation under Code Section 409A and thus subject to its requirements described above. The substantial risk of forfeiture exception to Code Section 409A is likely not applicable to this supplementary compensation.

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