Deferred compensation for tax-exempt entities - employer-sponsored, non-qualified deferred compensation plans; planning alternatives

Healthcare Financial Management, Oct, 1993 by Christopher Rich, Gary E. Jenkins

ADMINISTRATION/MANAGEMENT

Many executives in tax-exempt organizations, including healthcare executives, find their tax-advantaged savings opportunities dramatically reduced today compared to previous years. The benefit of employer-sponsored, "qualified" retirement and savings programs has been severely limited by ever-increasing tax restrictions on such plans when they are offered by tax-exempt organizations. And the opportunity for tax-sheltered personal investments has virtually disappeared.

One of the last remaining opportunities for tax-advantaged savings in tax-exempt organizations is an employer-sponsored, nonqualified, deferred compensation plan, an option that appears increasingly attractive in light of the recently enacted increased personal tax rates.

While over 90 percent of Fortune 500 companies sponsor some form of nonqualified, deferred compensation plan, few tax-exempt healthcare organizations do because of an additional layer of tax restriction imposed on deferred compensation plans of tax-exempt employers.

In the case of for-profit organizations, the Internal Revenue Service (IRS) views employers and executives at opposite ends of the bargaining table when it comes to deferring compensation. The employer receives a deduction for compensation paid and the executive reports salary and bonuses as taxable compensation when received. If an executive elects to defer compensation, the employer forgoes a current deduction for the deferral and, assuming that individual and corporate tax rates are similar, the U.S. Treasury loses nothing in tax revenue.

In tax-exempt organizations, however, the IRS believes the employer and the executive are sitting on the same side of the bargaining table. Since the employer pays no Federal income tax, it does not have to give up a deduction if the executive elects to defer compensation. The IRS, therefore, has imposed an additional level of tax restrictions on deferred compensation plans sponsored by tax-exempt organizations.

Legislative history

The special tax treatment of deferred compensation plans offered by tax-exempt employers has a long history. With the Revenue Act of 1942, Congress created special rules for employees of tax-exempt employers with regard to annuity contracts. Under these rules, premiums paid by a tax-exempt organization on an annuity contract for an employee of a religious, educational, or charitable organization were not taxable. These rules led to the enactment of Internal Revenue Code Section 403(b) concerning tax sheltered annuities and custodial accounts.

In 1978, proposed IRS regulations were issued that affected the deferral of compensation by both private sector and public sector employees. Once again, Congress stepped in and enacted the Revenue Act of 1978 to prevent the IRS from applying the proposed regulations to private employers--but not to tax-exempt employers.

At the same time, Internal Revenue Code (IRC) 457 was enacted to allow a limited deferral of income by employees of governmental tax-exempt organizations. In the Tax Reform Act of 1986, Congress extended IRC 457 to all tax-exempt organizations. Today, IRC Sections 403(b) and 457 provide the framework for the taxation of deferred compensation of employees of tax-exempt entities.

Tax sheltered annuities; IRC Section 403(b)

A tax sheltered annuity (TSA) is a form of retirement program available to employees of tax-exempt charitable, educational, or religious organizations and to employees of public schools or state or local educational institutions.

TSAs include annuity contracts, custodial accounts, or retirement income contracts. Prior to the Tax Reform Act of 1986, employees of tax-exempt entities could elect to defer 25 percent of their compensation up to a maximum of $30,000. In addition, the employer could contribute to employees' TSA accounts on a selective basis. Since 1986, however, the maximum elective deferral amount has been limited to $9,500, and various nondiscrimination rules apply which preclude selective employer contributions. The result of these changes is that the value of a TSA program to most executives has been greatly diminished.

Section 457: "Eligible" 457 plans

IRC Section 457 ("Deferred Compensation Plans of State and Local Governments and Tax-Exempt Organizations") deals with the issue of the timing of payment of taxable income. It addresses the question of when deferred compensation is to be included in the employee's income. The question seems simple enough, but the answer--as is often the case in tax law--is "it depends." Specifically, it depends on whether the compensation was deferred under an "eligible" or an "ineligible" deferred compensation plan.

An eligible 457 plan is an unfunded, nonqualified deferred compensation plan for employees of a state or political subdivision, an independent agency of a state or political subdivision, or any other organization exempt from tax under Code Section 501. An eligible 457 plan offers employees the opportunity for pre-tax deferral of compensation up to a maximum of $7,500. The sponsoring organization can make matching contribution on an optional and selective basis. Distributions from the plan may not be made to participants or beneficiaries earlier than the time of separation from service or when the employee reaches age 70 1/2, with a limited exception for hardship withdrawals.