Historically, it has been relatively easy to structure a Medical Practice Deferred Compensation Arrangement (DCA) so that retiring doctors could defer recognizing income for their buy-out until they actually received payments under the plan, often many years later.  Physicians, dentists and other professionals have often used DCAs to provide retirement income without having to fund a plan in advance and/or to sell their practices over a period of time without requiring the purchaser or the remaining physicians to come up with the entire purchase price up front.

But, Congress felt that some organizations were abusing their DCAs and as a result passed new, more restrictive legislation late in 2004.  If DCAs don’t meet the new requirements,  retiring physicians can be forced to recognize income when the income is deferred (i.e., right now) rather than when the payments are received.  In addition, the new law contains harsh penalty provisions.

Example 1

In 2005, Physician A enters into a DCA with his practice, and the plan does not meet the new law’s requirements.  Under the terms of the plan, the physician retiring has a legally enforceable right to future compensation in the amount of $75,000 a year for five years, beginning in 2005. 

Under the new law, the entire amount deferred under the plan ($375,000) would be included in Retiring Physician A’s gross income in 2005.  In addition to the tax on this income, there will be a penalty of $75,000 (20% of $375,000).

Although the new law generally applies to amounts deferred after December 31, 2004, so that many plans existing before that date are not subject to its provisions, the new rules do apply to amounts deferred earlier if a plan is materially modified after the effective date of the new law (October 2, 2004) so i.e., if your plan was amended between October 1, 2004 and December 31, 2004.

Example 2

Assume the same facts as in example 1, except that the amounts deferred were determined under an agreement that was completed in 2003.  The new rules would not apply to these amounts.

If, however, Physician A and his practice materially modify their practice agreement in 2005, the new law applies, and the entire $375,000 deferred would be taxable to Departing Physician A in 2005.  The twenty percent penalty (an additional $75,000 in tax) would also apply in 2005, and Physician A would also be liable for interest on the $375,000 from 2003 until 2005.

Clearly, the costs of failing the deferral requirements of the new law are an unacceptable event for your practice.  And in most cases, DCAs can still be structured to avoid current income recognition and penalties with relative ease and some forethought.  It is important, however, to recognize situations where the penalties might apply.  Essentially, a DCA will be subject to the penalty provisions where all three of the following criteria apply:

1.  A participant has a legally binding right during a taxable year to
    compensation that has not been received and  included in the
    participant’s income and that  is payable to  the participant in a later year;

2.  The DCA fails to meet the specific statutory requirements
     of the new law; and

3.  The deferred compensation is not subject to a substantial risk of forfeiture.

The statutory requirements of the new law are especially complex, and much of the expected guidance has still not been issued.  Of the many requirements, the one that is most likely to trip practices up is that for an existing plan.  The deferral election must be made by the end of the year before the year the services giving rise to the deferred compensation are performed.  Generally, for example, to defer income earned in 2006, the employee must have elected to defer 2006 income by December 31, 2005. 

All of the provisions of the new law are subject to some interpretation and to additional qualifications and exceptions, and there is, as yet, only minimal guidance from the Service.  We have had conversations with the IRS personnel responsible for drafting the guidance, and they tell us that the rules are only meant to apply to abusive situations.  They admit, however, that the rules are broadly drawn, and some DCAs that were not meant to be penalized could be subject to the new law.  Because of this possibility and because in practice, the IRS sometimes enforces rules more aggressively than the people who wrote the rules intended, we are advising that practices who have or wish to set up DCAs exercise extreme caution.

We have the following general advice for clients who want to avoid undesirable tax consequences associated with their DCAs:

1.         Don’t modify existing agreements.  Most agreement
            entered into in 2004 and earlier are grandfathered and
            protected from the new rules.  If, however, such agreements
            are materially modified in 2005 and beyond, they lose this
            protection.  Some minor modifications are allowed, but any
            thing that adds an additional plan feature usually isn’t.  If your
            existing plan is inadequate for other reasons, it may make
            more sense to add a second plan rather than amending the
            first plan, since only the amounts deferred under the second
            plan would have to meet the new law’s requirements.

2.         Early action.  The earlier you set up a plan, the easier it is to
            successfully defer compensation under that plan.  Don’t wait
            until you’re ready to retire.  As retirement gets closer, the
            chances of running afoul of the penalty provisions increase.

3.         Talk to us about your DCA.  The costs of running afoul of the
            new DCA provisions are prohibitive.  We can
            help you avoid these costs by reviewing any proposed DCAs
            prior to their implementation.  Please give us a call if you
            would like to discuss your current or upcoming plan.

Robert J. Salvitti, CPA is a member of the Healthcare Services Group at Margolis & Company. If you would like to learn more about the topic or related topics Bob can be reached at bsalvitti@marg.com.