If your organization sponsors any 409A-covered arrangements (non-qualified compensation plans), don't consider the latest one-year IRS extension of the deadline for Section 409A of the Internal Revenue Code--it is now due on Dec. 31, 2008--an excuse to postpone your compliance efforts.
Reasonable good faith compliance with Section 409A is now required and has been since 2005. However, taking action to modify some of your Section 409A-covered arrangements this year, rather than waiting until 2008, is a smart strategy. Depending on the circumstances, your organization could save substantial sums of money and reduce tax risks.
What are non-qualified compensation plans? A non-qualified compensation plan, as defined by the IRS, is any elective or nonelective plan, agreement, method, or arrangement to pay the employee compensation some time in the future, and neither employers nor employees receive the tax benefits associated with qualified plans. Non-qualified compensation plans typically fall into four categories:
Salary Reduction Arrangements, which simply defer the receipt of otherwise currently includible compensation by allowing the participant to defer receipt of a portion of his or her salary
Bonus Deferral Plans, which resemble salary reduction arrangements, except they enable participants to defer receipt of bonuses
Top-Hat Plans (aka Supplemental Executive Retirement Plans or SERPs) are plans maintained primarily for a select group of management or highly compensated employees.
Excess Benefit Plans, which provide benefits solely to employees whose benefits under the employer's qualified plan are limited by other tax laws (415)
How can this IRS extension be used? In addition to ensuring that all non-qualified compensation plans are compliant in form and operation with final section 409A regulations, organizations can modify the timing and form of distributions under section 409A-covered arrangements, either unilaterally or with participant consent if permitted under the terms of the arrangement. Executives may also give employees the option to decide whether to modify the time and form of payment they previously selected. Payment provisions can transform some 409A-covered arrangements into exempt arrangements (such as full employment) or even eliminate arrangements that no longer serve current needs. Additionally, after 2008, modifications to the timing or form of benefits paid will be severely restricted, and generally will not be permitted to take effect for at least one year after they are adopted or elected. Organizations will be permitted to terminate deferred compensation arrangements only if they terminate all similar arrangements and refrain from adopting new ones for three years. In other words, unless an organization seizes the window of opportunity provided by the Section 409A transitional relief, the organization may be compelled to maintain a deferred compensation arrangement long after the arrangement has outlived its utility.
Address these sooner rather than later Hospitals and other healthcare organizations should use the opportunity afforded by IRS transitional relief to look closely at the following:
Underwater split dollar arrangements. Many hospitals have used 409A-covered split dollar arrangements to fund deferred compensation. The extension may be particularly useful to a hospital or health system that has entered split dollar life insurance arrangements with executives, in which the premium outlay far exceeds the policy cash value. Unless the arrangements are terminated, good money may continue to be spent on bad investments. Taking action this year can save next year's premium expense.
The arrangement can be terminated without terminating the underlying life insurance policy. Before terminating the policy, consider whether it may be better to roll it out to a covered executive. Some executives may need the life insurance and be willing to fund it on their own to keep the policy in place. Consider also, whether to replace split dollar arrangements with "insurable" executives with other forms of life insurance, or deferred compensation.
Section 457(f) plans subject to IRS challenge. Many hospitals and healthcare systems have adopted Section 457(f) plans that run afoul of guidance the IRS announced in Notice 2007-62 (to be issued sometime in the future). Section 457 (f) plans are non-qualified retirement plans that allow the employer to supplement a retirement plan of a select management group or highly compensated employees by contributing to a plan that will be paid to the executive at retirement. Unless the IRS actually issues the promised Section 457 guidance before Dec. 31, 2008, whether to use the extension to eliminate some or all of these plans will depend on the specific plan design.
According to Notice 2007-62, the Section 457 rules will exempt severance pay plans from coverage under Section 457 only if they meet the standards that separation pay arrangements must satisfy for exemption from Section 409A. Under these standards, an executive will face immediate tax on severance pay available for voluntary terminations.
For involuntary terminations, an employee will be taxed in the year of termination, even if: he or she receives some or all of the pay in a later year; the benefit amount exceeds twice the limit on pay under a qualified plan ($225,000 in 2007 and $230,000 in 2008); and payments extend beyond the end of the second year following the year of termination.
The extension can be used to modify an arrangement that fails to meet these standards to pay benefits in the year of termination (assuming termination in 2008 or later), so the terminated executive is taxed in the year severance is paid, and not sooner. To take advantage of the transition relief for any terminations that may occur in 2008, action must be taken in 2007, despite the extension. Further, hospitals should not adopt new nonqualified deferred compensation arrangements that attempt to suspend taxes through salary deferral or vesting re-deferral, or through a non-competition agreement.
For existing plans, you should consider whether the current plan design provides value to employees and is consistent with a reasonable, good faith interpretation of current law. For example, the IRS has been challenging the Section 457(f) plans that allow frequent re-deferrals, or use a non-compete agreement that is unenforceable under local law. For a plan with these features, take advantage of IRS extension to terminate the arrangement by the end of 2007 and distribute benefits in 2008.
Melissa Rasman, Esq. is a senior consultant and director of research for the Hay Group in Philadelphia. Ron Seifert is a senior consultant and leader of Hay Group's Healthcare Executive Compensation practice.
Pittsburgh-based health insurer Highmark Inc. has agreed to a $10 million settlement with a doctors group. The group had alleged unfair business practices against Highmark, and the total cost to Highmark could swell to $14 million or more once legal fees and other expenses are tallied.
Deborah Zastocki is CEO of Chilton Memorial Hospital in Pompton Plains, NJ, but for the purposes of this interview, I focused on her prior career as a registered nurse. I recently spoke with Deborah about a shift in thinking whereby healthcare executives are now seeing nurses not as overhead but as rainmakers. What that means is that given their greater interactive roles with patients, nurses will be increasingly important to the hospital's financial health as doctors do more work outside the hospital and nurses become the primary touchpoint for patients. Since nurses have more opportunities than ever before to influence quality, and since most people believe incremental gains in hospital reimbursement are beginning to hinge on quality measures, nurse morale and retention will be increasingly important.
As the credit crunch facing much of the economy refuses to fade, and in fact grows stronger, one sector seems somewhat immune. You guessed it: healthcare. While consumers and even banks seem to need a fresh infusion of capital that isn't coming, hospitals and healthcare companies are finding the spigot is still open--if a little more pricey.
While the price of money may have risen, at least hospitals can get it. Homeowners and many corporations that need debt are going wanting. But as our politicians and celebrities remind us ad nauseam through their actions, just because you can do something doesn't necessarily mean you should. As grandma and nationally syndicated personal money manager Dave Ramsey says, the borrower is slave to the lender. In the world of nonprofit finance, the borrower is also slave to the rating agencies. And the rating agencies--perhaps stung by their role in inflating the creditworthiness of esoteric collateralized debt obligations--are watching hospitals' balance sheets more closely than ever.
I listened to a conference call a couple of weeks back hosted by the healthcare analysts at Standard & Poor's. Turns out the ratio of credit quality downgrades to upgrades has risen dramatically for hospitals in the last quarter, by a count of 2-1. Why? Hospitals continue to take on additional debt.
Of the 11 hospital or system downgrades in the last quarter at S&P, seven were driven by additional debt or large capital plans on top of existing debt. Most of these organizations were rated highly to begin with, and in most of these cases, these organizations are expected to do well operationally going forward. But at some debt amount, the burden is too heavy to maintain a given rating. Still, hospitals seem to be getting their hands on that debt while the getting is still (relatively) good.
Analysts at S&P say that as a result of the continued borrowing, the hospital building boom may go on for the next couple of years as hospitals add fat for an expected long winter once government-led healthcare "reform" finally happens. Reform means a lot of things to a lot of people, but when you hear pundits and credit analysts talk about it, they're talking largely about reimbursement cuts. No one expects that before the next election, and predictions for cost cutting in healthcare are notoriously unreliable. But hospitals are voting with their borrowed dollars that now is a good time to start building the war chest in the form of updated bricks and mortar that will carry them through the next decade.
Rates for debt are still reasonable, and operationally, hospitals are doing much better, the analysts agreed. But operational improvements--at least as far as they translate to the bottom line--have essentially peaked.
The key takeaway from all of this? The rating agencies, rightly, wrongly, or late, are keeping a close eye on healthcare because of their mistakes in other sectors, and if you don't complete your anticipated borrowing soon, you're all going to have to pay a higher price.
Philip Betbeze is finance editor with HealthLeaders magazine. He can be reached at pbetbeze@healthleadersmedia.com.