The Bad News: As a result of stringent new regulations, few physicians or medical executives will want to continue use of “traditional” Non-Qualified Deferred Compensation plans. Business entities have until year-end 2005 to freeze or terminate their current plans, or fall victim to the negative tax implications of the new rules. Doing nothing is not an option! Penalties for those who don’t take action before Dec 31, 2005, include accelerated inclusion of the employee’s income, a 20 percent excise tax, and payment of an interest penalty (at the Applicable Federal Rate) back to the time of deferral.

The Good News: Solutions are available. Many physicians and/or medical executives, particularly those who are employees of “C” corporations, participate in some form of a Non-Qualified Deferred Compensation or “NQDC” arrangement. Historically, these plans (often known as SERPs, or Supplemental Executive Retirement Plans) have enabled participants to defer sizeable amounts of income, delay income taxes due, and accumulate substantial retirement benefits. Sponsors have gravitated toward “traditional” NQDC because of the plans’ flexibility. They allow a provider enough variability within a plan to meet the needs of a number of individuals, while at the same time providing a selective fringe benefit—the ability to single-out specific individuals and treat them uniquely.

The American Jobs Creation Act of 2004 made dramatic changes to the tax rules impacting virtually all NQDC arrangements for all amounts deferred on or after Jan 1, 2005. The Act mandates that all current and prior deferrals of compensation of any sort, by anyone, will be taxed, if the terms of the plan under which the deferrals were made do not comply with the new law. The Act creates limits on payout elections, and imposes substantive restrictions in the event of death, disability, termination, and hardship. Early withdrawals, early distributions, benefits restructures, and plan terminations are expressly prohibited. The new rules do not apply to balances deferred and vested as of Dec 31, 2004, unless the plan was “materially modified” after Oct 3, 2004.

Sponsors should understand that current NQDC plans now are considerably less attractive to participants. Internal Revenue Service reporting requirements, shareholder scrutiny, and directors’ and officers’ liability potential have increased. Further, until the last participant’s retirement is paid, the plan cannot be terminated.

Physician/executive participants must harbor concerns regarding the long-term financial security of the plan sponsor. Given the new regulatory environment, many plans may be discontinued. Retirement planning flexibility has been substantially reduced. Perhaps most importantly, prohibition of “haircut” provisions means early access is no longer an option with “traditional” NQDC.

However, alternatives are available. For example, with the so-called §162 (Internal Revenue Code Section 162) Double Bonus Plan, the sponsor agrees to make an annual bonus of the after-tax amount necessary to pay the premium on a physician/executive-owned life insurance policy. The sponsor also makes a “double bonus” to cover the taxes the participant must pay on the bonus(es). Because the participant is paying taxes on the bonuses, the regulations otherwise applicable to traditional NQDC (and, in particular, the Act) are irrelevant. However, because the sponsor is expected to “gross up” the bonus to cover taxes, this concept is expensive and tax-inefficient. Assuming a 40 percent marginal tax rate, the gross cost to a Practice/IPA is $166,667 to yield an after-tax bonus to the physician/executive of $100,000.

A superior strategy is conceptually similar to the §162 Double Bonus. However, the sponsor doesn’t make a second bonus to cover the entire cost of taxes on the bonuses. Instead, the sponsor makes a much smaller second bonus to cover the interest cost of borrowing an amount that replaces the taxes lost on the first bonus. For example, the practice makes a $100,000 (tax-deductible) bonus to the physician. The physician borrows $35,000 to pay his taxes using an (assumed) 7 percent interest-only loan. A second bonus of $2450 covers the interest cost. Net cost to the practice [($100,000 + $2,450) x (1-0.4)] is only $61,470.

Sponsors should recognize that this strategy is not subject to deferred compensation-related regulation or the Act. In addition, this option uses funds that are currently deductible, which may substantially reduce costs. In practice, tax-deductibility may be more or less important, depending on the ownership interest(s) of the participant(s) and the business entity tax-structure. In virtually every case, however, this concept affords greater flexibility (ease of access) than traditional NQDC. Furthermore, if a plan termination (which generally results in a significant taxable event to participants) is being considered, this idea can be used to “make the participants whole” and avoid a large out-of-pocket expense.

Participants appreciate owning the retirement plan outright. Moreover, unlike traditional NQDC, planned retirement benefits are tax-free. Also, this strategy provides a current death benefit, and may be designed to provide asset protection and/or estate tax planning flexibility when used in conjunction with an Irrevocable Life Insurance Trust.

Mark Boehm, MBA, CWPP, is a Certified Wealth Preservation Planner who helps corporations and individuals protect their assets, reduce their taxes, and increase their net income. He can be reached at 972-395-8464 or alphawealth@verizon.net.