Physicians employed by hospital-controlled, tax-exempt entities are often frustrated by their inability to duplicate the opportunities available in the for-profit sector to accumulate significant retirement plan assets during their periods of peak earnings.

In physician-owned, "for profit" professional corporations, physicians often utilize a combination of Section 401(k) elective deferrals and profit sharing plan contributions to annually allocate to each physician's tax-deferred plan account the maximum allocation ($44,000, plus an additional $5,000 for a physician who is 50 years of age or older) permitted by law. The physician is typically fully vested in these contributions (and earnings on the contributions) and the contributions are paid to a trust that is beyond the reach of the creditors of the corporation. The balance in the physician's account grows tax-deferred until the physician elects to have the balance in the account distributed to the physician, typically following the physician's retirement or other termination of employment with the professional corporation.

Physicians employed by hospital-controlled, tax-exempt entities, however, have long been limited in their ability to duplicate these retirement plan benefits by the requirement that tax-qualified retirement plans maintained by the hospital-controlled entity for its physicians and staff must be aggregated with the retirement plans maintained by the hospital for the hospital's employees for purposes of meeting the relevant retirement plan discrimination tests in the Internal Revenue Code. This rule often precludes hospitals from providing "gold plated" tax-qualified retirement plan benefits to the physician employees of the hospital-controlled entity unless the hospital is also willing to provide prohibitively expensive retirement benefits to the hospital's "rank and file" employees.

In addition, Section 457 of the Internal Revenue Code, until recently, sharply limited the amount of compensation which a physician of a hospital-controlled, tax-exempt entity could annually defer under a nonqualified deferred compensation plan. Under Section 457, deferred compensation in excess of specified annual amounts is taxable to the physician in the year in which such deferred compensation is no longer subject to the physician's ongoing employment (i.e., when the physician is "vested" in the deferred compensation).

This provision of the tax laws has been often construed by tax-exempt employers as limiting the deferred compensation opportunity that can be provided to physicians outside of tax-qualified plans to the amount ($15,000 in 2006) that can be provided through an "eligible" (for purposes of Code Section 457) deferred compensation plan.

These rules, taken together, have limited the ability of physicians employed by hospital-controlled, tax-exempt entities to accumulate, during their years of peak earnings, significant retirement benefits.

Two important planning techniques, however, can significantly increase the amount of compensation that a physician employed by a nonprofit, tax-exempt entity may annually defer.

First, changes in the Code, which became effective in 2002, eliminated the offset of amounts deferred under an eligible Code Section 457 plan against deferrals that the physician may make under a tax-sheltered annuity or a 401(k) plan, thereby permitting a physician to "double up" his or her pre-tax deferrals. In 2006, for example, a physician can elect to defer $15,000 under a tax-sheltered annuity or 401(k) plan and also defer $15,000 of otherwise currently taxable income under an eligible Code Section 457 plan. (An additional $5,000 deferral may be made if the physician is at least 50 years old by the end of 2006.)

Second, by carefully tying additional deferrals to the physician's targeted retirement date and inserting appropriate provisions in the physician's employment agreement, the physician can effectively defer significant additional compensation, subject only to a risk of forfeiture in the event that the physician elects to voluntarily terminate employment prior to the targeted retirement date. The physician can be protected against an involuntary termination of employment (other than for "cause"), death, disability, etc., and can even be protected against a risk of forfeiture in the event the employing entity or the hospital becomes insolvent before the additional deferrals are paid to the physician.

For example, assume that a physician employed by a tax-exempt, hospital-controlled entity who is 55 years old and earning $300,000 annually wants to significantly increase his or her deferrals during the next five years, in anticipation of retiring upon reaching age 60. The physician participates in a Section 401(k) Plan (the only retirement-type plan offered by the employing entity), making the maximum deferrals ($15,000 plus the $5,000 "catch up" contribution) permitted for 2006.

By (i) persuading the employing entity (at no cost to the hospital or the employing entity) to implement an eligible Section 457 plan for the physician and (ii) taking advantage of the recent legislative change repealing the coordination of the Section 457 and Section 401(k) limitations, the physician can defer an additional $15,000 in compensation in 2006. Under the applicable rules, the physician can be fully vested in this additional deferral, but the deferred amount (plus earnings on the deferred amounts) must remain unfunded or, alternatively, can be funded by the employer in a "rabbi trust," the assets of which remain subject to claims of the employer's general creditors.

In addition, the physician may defer an unlimited amount of additional compensation pursuant to an "ineligible" Section 457 plan. If the physician elected to defer, for example, an additional $50,000 in 2006, such amount would be deducted from the physician's 2006 salary and invested in a mutual fund, certificate of deposit, etc., as the employing entity and the physician determine. These funds (and their earnings) could be funded in a rabbi trust or even in a trust the assets of which would be beyond the reach of the employer's and the hospital's general creditors. So long as the $50,000 deferral (plus earnings on the deferral) would be subject to forfeiture if the physician voluntarily elects to terminate his or her employment prior to reaching age 60 (the targeted retirement date previously selected by the physician), the deferred amount and its earnings would not be subject to federal income tax until it is actually paid to the physician following the physician's retirement, in accordance with whatever payment arrangements the physician had previously elected. (The employing entity, at a future date, could agree to "vest" the physician in the deferred compensation even if the physician elected to prematurely retire without thereby causing the tax deferral arrangement to fail retroactively, so long as the physician could not, as a legal matter, force the employer to vest the physician in the deferred compensation upon the physician's early retirement.) By carefully addressing these issues in the employment agreement and the Section 457 plan document, the physician can be fully protected against the risk of forfeiture if the physician terminates employment with the hospital prior to reaching age 60 due to the physician's death, disability or involuntary termination by the employing entity other than for cause. (Significant severance protection can be built into the physician's employment agreement to protect the physician against being terminated without cause prior to reaching the physician's target retirement age of 60.)

Section 409A of the Code, enacted in 2004, should also be noted. This provision of the Code adds restrictions regarding the ability of an employer and a physician to change the timing and the form of payments (e.g., lump sum, installments) to be made under an "ineligible" Section 457 plan after those terms have been initially established. Significantly, Section 409A does permit an ineligible Section 457 plan to provide for an accelerated distribution from the plan to the physician at the time the physician becomes vested in his or her account balance, thereby assuring the physician that in the event the physician vests in his or her ineligible Section 457 plan account earlier than originally anticipated, the plan will be permitted to distribute sufficient cash to the physician to cover the income taxes owed by the physician upon becoming vested in his or her account, notwithstanding that the distribution date and form of distribution previously specified by the physician might not otherwise permit such a distribution.

As is apparent, these planning techniques afford physicians employed by hospital-controlled, tax-exempt entities the ability to defer substantial amounts of compensation to the period following their anticipated retirement, creating the potential for significant capital accumulation and tax savings while minimizing, through careful drafting of the relevant employment contracts and plan documents, the "credit risk" relating to the employer's or hospital's solvency, the "employment risk" relating to the physician's premature termination of employment and the impact of the limitations recently imposed pursuant to Code Section 409A.