Tax-exempt organizations—especially hospitals and health systems—face a new tax reality now that both houses of Congress have voted to pass the final tax reform bill.
Ralph E. DeJong advises clients on the compensation, executive benefits and employee benefits of tax-exempt organizations. He provides counsel on designing and preparing deferred and incentive compensation arrangements, leading governing boards in the review and approval of executive and physician compensation arrangements, negotiating and preparing executive and physician employment agreements, and analyzing the private inurement and intermediate sanctions implications of executive and physician compensation and benefit arrangements. Read Ralph DeJong's full bio.
The Senate’s final tax reform bill contains several troubling provisions for tax-exempt organizations but represents an improvement over last month’s proposed legislation, which caused concern across the nonprofit sector.
On June 22, 2016, the Internal Revenue Service (IRS) issued proposed regulations under Section 457(f) of the Internal Revenue Code of 1986, as amended (Code). These long-awaited regulations were first previewed in IRS Notice 2007-62. In that Notice, the IRS announced its intention to issue proposed regulations that would harmonize the rules for deferred compensation plans of tax-exempt organizations (and state and local governments) under Section 457(f) with the then-new special rules for all deferred compensation arrangements under Section 409A. After nine years, the proposed regulations now issued address three principal issues, although with some unexpected changes and opportunities.
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On June 21, the IRS issued long awaited proposed regulations under Section 457 of the Internal Revenue Code that affect a broad range of compensation arrangements at tax exempt organizations. If a compensation arrangement is subject to Section 457(f), the employee is immediately taxed upon earning a vested right to receive “deferred compensation” that might not be paid until years later. These regulations address important issues under Section 457(f) that were identified by the IRS back in 2007, including whether severance pay is subject to Section 457(f), if changes to a vesting schedule could delay when deferred compensation is taxable and if covenants not to compete would be respected as bona fide vesting conditions
A severance pay arrangement will be treated as deferred compensation under Section 457(f) under the proposed regulations unless (1) the total amount of severance pay is limited to two times total annual compensation; (2) payments are completed within two full calendar years following termination of employment; and (3) the events triggering the right to severance pay are limited to a bona fide involuntary termination, which may include certain types of “good reason” terminations of employment by an employee and failure to renew an employment agreement.
There have been questions as to whether vesting conditions imposed after a compensation arrangement has been established will be respected for tax purposes. In that event, the time for income taxation under Section 457(f) is delayed until the new vesting requirement is met. If certain requirements are met, the proposed regulations provide that additional vesting conditions will be taken into account when determining the time of taxation under Section 457. These conditions include that the deferred amount subject to a new vesting date has to be more than 25 percent greater than the old amount with the former vesting date, the delay in vesting has to be at least two years (except in the case of death, disability or a qualifying involuntary termination), and the change in vesting is entered into sufficiently in advance of the original vesting date under special timing rules.
The proposed regulations also allow for noncompetes to be used as vesting conditions under Section 457(f), but only if:
- The right to payment is expressly conditioned on satisfying the noncompete;
- The noncompete has to be evidenced by an enforceable written agreement between the employer and employee;
- The employer has to make reasonable ongoing efforts to verify compliance with the noncompete;
- When the noncompete agreement becomes binding, the facts and circumstances have to show that both the ability to compete and the harm of competition are genuine and substantial;
- The noncompete must be enforceable under applicable law; and
- The employer must show that the likelihood of enforcement of the noncompete is substantial.
There had been concern that the IRS might not allow any form of noncompete to be a substantial risk of forfeiture under Section 457(f).
These regulations are generally scheduled to go into effect as of January 1 of the calendar year after being finalized. These rule changes under Section 457(f) will affect amounts deferred amounts in earlier years that were not taxed before the Section 457(f) effective date. The IRS has stated that no implication is intended regarding the proper interpretation of Section 457(f) for prior periods. The IRS will be accepting comments on the proposed regulations until early this fall. Taxpayers may rely on these proposed regulations until the applicability date—doing so is likely to be an appropriate compliance approach in many situations.
Click here for a copy of the Section 457 proposed regulation. We will be issuing a detailed review of these regulations. In the meantime, please contact one of the authors or your regular McDermott Will & Emery lawyer if you have questions about the Section 457 regulations.
An appellate court recently issued a favorable ruling for religious employers in a closely watched case relating to the ability of religious employers to provide tax-fee housing allowances to ministers. The court overturned a district court decision declaring unconstitutional Internal Revenue Code Section 107(2), which excludes from gross income a rental allowance paid to a “minister of the gospel” as part of his or her compensation, because the plaintiffs-appellees lacked standing to challenge the provision’s constitutionality. Religious institutions offering such allowances should continue to monitor developments in this area and consider alternative compensation strategies.
A federal court recently declared unconstitutional Internal Revenue Code Section 107(2), which excludes from gross income a rental allowance paid to a “minister of the gospel” as part of his or her compensation, on the grounds that it violates the Establishment Clause of the U.S. Constitution. Religious institutions offering such allowances should closely monitor further developments in this area of the law and consider alternative compensation strategies if federal courts in their jurisdiction adopt similar holdings.
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