hr and employee benefits marcinko

HO: February 2010 © iMBA Inc Hospital Employee Benefit Plans and Stock Options

Chapter 4

HOSPITAL H.R. FRINGE BENEFITS PLANS AND STOCK OPTIONS

[Understanding Employer and Employee Perspectives]

© 2014 David Edward MarcinkoPerry D’Alessio

This chapter examines hospital employee benefits and equity participation, both from thehealthcare organization employer, and employee perspectives. Employee benefits includeemployer payment of personal expenses on behalf of employees, as well as methods fordeferring taxation of compensation earned by employees. If a public healthcare entity or hospital,stock options allow employees to benefit from the appreciation in the value of employersecurities without having to deplete cash resources to purchase shares at the time appreciationbegins.

Introduction

When selecting an employer, understanding the value of the benefits offered is critical. Justbecause one employer may offer a higher salary doesn’t mean they are offering more totalcompensation than other options.

Case Model Example:

So, let’s explore the value of benefits received by a hypothetical 60 year-old hospital basedrespiratory therapist [RT] employee who is married and has two children (ages 18 and 15).We’ll assume this individual earns $51,017, which was the median average household income in2012-13.

HOW MUCH ARE EMPLOYER BENEFTIS WORTH?

Payroll Taxes

The value of some benefits is easier to calculate than others. For instance, regardless of yourincome, your employer is required to pay half your FICA – Federal Insurance Contributions Act– taxes (which covers Social Security and Medicare). The combined FICA tax is 15.3% of yourincome, so you pay 7.65% and your employer pays 7.65% [6.2% for the Social Security portionand 1.45% for Medicare].

NOTE: This had been reduced by 2% to 4.2% over the past few years as part of a payroll taxholiday to help with the economic recovery. All of the fiscal cliff discussions did not address thisand the rate has reverted back to what it was 2 years ago.


Social SecurityThe first $113,700 of wages is taxed at 6.2% for Social Security. Anything above this amount isnot taxed.

Medicare TaxThis is taxed at 1.45% of wages and there is no wage base limit.

New in 2013Employers must withhold a 0.9% additional Medicare from wages paid to an employee in excessof $200,000 in a calendar year if single and $250,000 if married. Employers are required to beginwithholding additional Medicare Tax in the pay period in which wages in excess of $200,000 arepaid to an employee and continue to withhold it each pay period until the end of the calendaryear.

Now, assuming a salary of $51,017, your employer’s FICA contribution is $3,903.

It should be noted that any employer you affiliate with will be required to contribution their7.65% portion of the payroll tax. Of course, the actual dollar amount they contribute willincrease as your salary rises. Alternatively, self-employed individuals are required to pay almostthe full 15.3% payroll tax themselves, (less a modest reduction, and a deduction for half the selfemployment tax as an adjustment to income.) In comparison, a halving of the payroll tax is asignificant benefit to non-self employed workers.

Retirement Plan Contributions

Of course, not all employers offer a 401k match, and the amount of the match offered varies.However, let’s assume a fairly common matching policy where the employer will match 50% ofthe first 6% of your salary that you contribute. Assuming you take full advantage of the match,your employer will contribute 3% of your salary to your retirement plan, or $1,530.

Paid Time Off

Most employers offer a mixture of vacation, holidays, and sick days. Assuming you get 10 daysfor vacation, five paid sick days, and seven paid holidays, you get a total of 22 paid days off peryear. If you make $51,017 per year and work 260 days, your daily pay rate is $196($51,017/260). Multiplying the daily rate by 22 paid days off, you actually make $4,312 for daysyou don’t work.

Health Care

Notwithstanding the PP-ACA, some benefits, like health care, are much less predictable. Ofcourse, not all employers offer health care, and it is difficult to determine the value of anybenefits offered. However, according to ehealthinsurance.com, our 60 year-old marriedindividual with two kids could purchase a health care plan from Select Health with a $1,000deductible per individual and $2,500 deductible per family for $1,243 per month or $14,916 peryear. Many employers won’t cover this entire cost, but let’s assume the employer covers 60% of


this cost, leading to a total health care benefit of $8,949 contributed by the employer.

Life Insurance

Life insurance, when provided by an employer, is typically term insurance and fairly costeffective. Assuming the employer provides life insurance equal to two times your salary, theywould provide $102,034 of coverage. On intelliquote.com, we found a company willing toprovide this level of coverage for $41 per month, or $492 per year.

Long-Term Disability

When offered, employers usually provide long-term disability coverage amounting toapproximately 50% of your salary. On Mutual of Omaha’s website, we found that a long-termdisability policy providing a $2,000 per month benefit (47% of salary) after a 60-day eliminationpolicy would cost our 60 year-old employee $175 per month, or $2,100 per year.

Adding It Up

So, how much are the benefits for our hypothetical employee worth?

FICA contributions: $3,903 Retirement plan contributions: $1,530 Paid time off: $4,312 Health care: $8,949 Life insurance: $492 Long-term disability: $2,100

Total employer-paid benefits based on a $51,017 income: $21,290

Consequently, although salary may be $51,017, total compensation is $72,307, and the benefitsprovided by the employer represent approximately 30% of compensation. This example istypical – the U.S. Department of Labor reports that benefits are worth 30% of an averageemployee’s total compensation.

Clearly, benefits can amount to a significant portion of compensation and should be closelyanalyzed when choosing an employer. Even if not currently considering changing employers,knowing how much an employer pays for benefits might help you appreciate your job at least alittle bit more [personal communication, Lon Jefferies MBA, CFP®www.NetWorthAdvice.com]

HOSPITAL EMPLOYEE BENEFITS

Now, let’s drill down a bit deeper. There are three categories of benefits that hospital employerstypically provide to their employees:

Those that are totally income tax-free. Some of these are still taxable for FICA (Social


Security and Medicare). Those that are not taxed at their full economic value, or are taxed at a special preferential

rate. Those in which a tax liability is not incurred until sometime after the employee receives

the benefit.

Tax-free benefits

The following are benefits typically provided by hospitals that are tax-free to employees:

Group term life insurance Accident and health benefits Moving expense reimbursement Dependent care expenses Meals and lodging Adoption expense assistance Use of athletic facilities Employee awards Educational assistance Qualified employee discounts No additional cost services Retirement planning service De-minimus benefits Qualified transportation benefits Working condition benefits General fringe benefits and miscellaneous specialized provisions

All tax-free benefits have varying conditions, which can include:

What constitutes a benefit to qualify (as defined by the IRS) What constitutes an employee to qualify? The most commonly restricted employee types

are S Corporation employees who owned greater than 2% of the corporation’s stock inthe taxable year, highly compensated employees and key employees.

Which employees are excluded Monetary caps IRS reporting requirements Exclusion from what type of taxes (income, FICA and FUTA)

Accident and Health Benefits

These are the most common types of tax-free benefits provided to employees. They includepayments for health care insurance, payment to a fund that provides accident and health benefitdirectly to the employee, company direct reimbursements for employee medical expenses andcontributions to an Archer MSA (medical savings account).

The IRS definition of employee, for health care benefit purposes, is very broad.


Health benefits are exempt from income, FICA and FUTA (Federal Unemployment Tax). Thissaves the employer 7.65% that would otherwise be the “matching” 6.2% Social Security tax andthe 1.45% Medicare Tax components due if these were true wages. The employer also saves the0.8% FUTA tax, but since FUTA taxes only the first $7,000 of calendar year wages, peremployee, this usually doesn’t factor in.

Calculation:

If you pay the full state unemployment tax, then your FUTA tax = Gross Salary * .08% – Themaximum amount is $56 per employee:

$50,000 Salary = ($7,000)*(.8%) = $56.00$5,000 Salary = ($5,000)*(.8%) = $40.00

The hospital employee saves federal income taxes on health benefits received, at their marginaltax rate, and, their components of FICA taxes. Depending on the coverage provided, these plans,when fully funded by the employer, can save the employee thousands of dollars in taxes eachyear.

IRS restrictions include:

Certain payments to S Corporation employees who are 2% shareholders are subject toFICA taxes.

Certain long term care benefits. Certain payments for highly compensated employees.

Example 1: Let’s say the annual cost of providing medical coverage for an employee, age 50,with a spouse and two minor children is $7,500. An employee in the 30% tax bracket whoreceived this amount in cash each year and then paid for his or her own medical coverage wouldbe liable for as much as $2,250 in income taxes. In addition, FICA taxes save another 7.65% or$574, for a total savings to the employee of $2,824. The employer saves $574 in FICA taxes.

Group term life insurance

An hospital employee usually must include in gross income the amount of life insurancepremiums paid by the employer on the employee’s life if the policy proceeds are payable to abeneficiary named by the employee. However, the cost of providing group term life insurance onan employee’s life up to $50,000 is excluded from the employee’s gross income. The cost of anyamount over $50,000 provided by the employer is included in the employee’s income. Theamount excludable under this provision for an employee 60 years of age is approximately $500per year.

Moving expense reimbursements

A company may pay the qualified moving expenses of an employee, except meals, directly or


indirectly, and exclude it from the employee’s gross wages for income tax calculations.

Dependent-care expenses

The first $5,000 of annual dependent care expenses (for married filing jointly employees, $2,500for married filing separately) paid by an employer is exempt from the employee’s gross income.This is limited by the IRS defined earned income for either the employee or spouse. Theexpenses must be made for a qualifying person, and, their care must allow an employee to work.The amount must be expended by the employee to a qualified day care with a federalidentification number described on employee’s income tax return or the pretax amounts will beadded back to income on the income tax return level. This can be for a current employee, a soleproprietor, a leased employee and a partner that performs services for a partnership. It excludeshighly paid employees defined as any employee paid more than $115,000 in the preceding year.

These benefits are reported in Box 10 of the employee’s W-2.Source: http://www.irs.gov/publications/p503/index.html

Meals and lodging

Under very limited circumstances, meals and lodging provided to an employee, by the employeron the business premises of the employer, may be excludable from the gross income of theemployee. Usually lodging is as a condition of employment where the employee must live on thepremises to properly perform their duties. S Corporation employees who are at least 2%shareholders are excluded.

Adoption assistance

If you’re thinking of adopting a child in 2014, you should know about the tax credit. In 2014, themaximum credit for adopting a child with special needs is $12,970. The special needs adoptioncredit, which typically applies to harder-to-place children, including children in foster care, canbe claimed regardless of your actual adoption expenses. The maximum credit for other adoptionsis your qualified adoption expenses (including attorney’s fees, agency fees, travel fees, etc.) up to$12,970. The adoption credit, as of 2013, is not refundable. It’ll reduce your tax liability, but youwon’t get a check in the mail for any leftover credits. Also, this credit begins to phase out with amodified adjusted gross income of $194,580.

Source: http://www.irs.gov/instructions/i8839/ch02.html

Use of athletic facilities

A company may provide employee access to on site athletic facilities, and exclude the value ofsuch a benefit from gross wages, if all employees and their families have equal access to it.

Employee awards

Awards to employees, such as for safety or length of service, are excludable from the employee’s


gross income up to the amount of the cost to the employer, or $1,600, or, $400 for non-qualifiedplan awards. The type of award that qualifies for exemption from gross income is limited.Specifically cash and its’ equivalents and intangible property such as vacations are excluded. SCorporation employees who are 2% shareholders are excluded.

Educational assistance

Up to $5,250 of employer paid, qualifying educational assistance can be excluded from theemployee’s gross pay. Since 2002, qualifying expenses include graduate courses.

Assistance over $5,250: If you do not have an educational assistance plan, or you provide anemployee with assistance exceeding $5,250, you can exclude the value of these benefits fromwages if they are working condition benefits. Property or a service provided is a workingcondition benefit to the extent that if the employee paid for it, the amount paid would have beendeductible as a business or depreciation expense.

Qualified employee discounts

Companies can provide discounts on goods and services to employees and exclude the value ofthese from gross income. This is limited to 20% of non-employee charges for the same servicesand the gross profit margin on merchandise. Stocks and bonds are excluded.

Retirement Planning

If the hospital has a qualified retirement plan, an employer may provide retirement planningservices to the employee and his/her spouse. Advice may include non-employer retirementissues but cannot provide tax preparation, legal, accounting or brokerage services.

Working condition benefits

Examples of working-condition fringes are employer-paid business travel, use of company cars,job related education and business-related security devices.

De-minimus fringe benefits

De minimus fringes include such items as occasional parties or picnics for employees, traditionalholiday gifts of property with a small fair market value, or occasional theater or sporting eventtickets. Cash is never allowed except for occasional meal money or transportation fare.Examples are holiday gifts of low value, limited use of a copying machine, parties, picnics,occasional movie or sports tickets, transportation fare etc.

Qualified transportation benefits

A qualified transportation fringe is any of the following provided by the employer to anemployee: (1) transportation in a commuter highway vehicle if such transportation is inconnection with travel between the employee’s residence and place of employment, (2) a transit


pass, or (3) qualified parking.

Miscellaneous specialized provisions

There are other narrowly focused statutory provisions, such as personage allowances and certainmilitary benefits that allow for exclusion of income. Because of their very limited application,these specialized benefits are not addressed in this Portfolio.

Benefits that are not taxed at full economic value

When a benefit does not qualify for exclusion under a specific statute or regulation, the benefit isconsidered taxable to the recipient. It is included in wages for withholding and employment-taxpurposes, at the excess of its fair market value over any amount paid by the employee for thebenefit.

For example, hospitals often provide automobiles for use by employees. Treasury regulationsexclude from income the value of the following types of vehicles’ use by an employee:

Vehicles not available for the personal use of an employee by reason of a written policystatement of the employer

Vehicles not available to an employee for personal use other than commuting (althoughin this case commuting is includable)

Vehicles used in connection with the business of farming [in which case the exclusion isequal to the value of an arbitrary 75% of the total availability for use, and the value of thebalance may be includable or excludable, depending upon the facts (Treas. Regs. § 1.132-5(g)) involved)]

Certain vehicles identified in the regulations as “qualified non-personal-use vehicles,”which by reason of their design do not lend themselves to more than a de minimusamount of personal use by an employee [examples are ambulances and hearses].

Vehicles provided for qualified automobile demonstration use Vehicles provided for product testing and evaluation by an employee outside the

employer’s work place

If the employer-provided vehicle does not fall into one of the excluded categories, then theemployee is required to report his personal use as a taxable benefit. The value of the availabilityfor personal use may be determined under one of several approaches. Under any of theapproaches, the after-tax cost to the employee is substantially less than if the employee used hisor her own dollars to purchase the automobile and then deducted a portion of the cost as abusiness expense.

COST COMPARISON—EMPLOYER-PROVIDED TRANSPORTATION

Example 1: Kurt purchases an automobile for $15,000.

His hospital business use is 80% and he drives 20,000 total miles per year. Operating costs forthe year, including gasoline, oil, insurance, maintenance, repairs, and license fees, are $4,000. If


Kurt owns the car for five years, ownership will cost $35,000 ($4,000 x 5 = $20,000, $20,000 +$15,000 = $35,000), or $7,000 per year. For, each personal use mile costs $1.75 (100% -80% =20%, 20% x 20,000 miles = 4,000 miles, $7,000/4,000 miles = $1.75). Kurt’s employerreimburses him 34.5 cents per mile for the business-related miles. As a result, the business use ofthe car is only partially reimbursed (16,000 business miles x 34.5 cents = $5,520).

However, the business usage costs Kurt $5,600(80% of $7,000). Kurt subsidizes the employer9.25 cents per mile ($7,000 – $5,520 = $1,480, $1,480 /16,000 = 9.25 cents). Kurt’s total cost ofownership is $1.84 per mile, or $36,850 ($1.88 x 20,000 personal miles over the five-year life).

Example 2: Ben uses a hospital employer-provided vehicle 4,000 miles per year in 2003.

He reimburses the employer 34.5 cents per mile. His cost for five years is $6,900 (5y x 4,000 =20,000 miles, 20,000 miles x 34.5 = $6,900).

Beginning on January 1st 2013, the standard mileage rates for the use of a car (also vans, pickupsor panel trucks) were:

56.5 cents per mile for business miles driven 24 cents per mile driven for medical or moving purposes 14 cents per mile driven in service of charitable organizations

Note the dramatic contrast, from the employee’s perspective, between the above two examples,of the company reimbursing the employee for business use of his personal car, versus theemployee reimbursing the company for personal use of the vehicle.

The business, medical, and moving expense rates decrease one-half cent from the 2013 rates.The charitable rate is based on statute.

Source: http://www.irs.gov/newsroom/article/0,,id=200505,00.html

Tax-deferred benefits

There are several types of arrangements, listed below, that allow employees to receive economicbenefits currently without having to pay taxes until a later taxable year. Furthermore, some ofthese arrangements may even provide for a lower taxation rate at that time. These types ofbenefits are not totally excludable from income forever, as are those listed in the first twosections. Rather, they primarily provide deferral of taxable income.

The classic example is a retirement plan. Employers may establish pension, profit sharing, stock-bonus, or annuity plans, as well as 401(k) and 403 (b) plans. The tax consequences and most ofthe formal requirements of these plans are similar. These plans are often referred to as “qualifiedretirement plans.” (See the portfolio titled “Retirement Accumulations and Plan Distributions”for a more detailed discussion of various types of plans.)

The hospital employer makes contributions on behalf of participating employees. The


contributions are placed in a trust fund, custodial account, or annuity contract. The funds are heldand accumulated for the benefit of plan participants. The distribution of the funds to a participantnormally occurs no sooner than the participant’s termination of service with the employer, and,no later than attainment of normal retirement age, as defined in the plan. The method ofdistribution may be a lump-sum payment of all of the employee’s benefits, an installmentpayment over a number of years(usually 10 to 15), an annuity that provides payments over theemployee’s and/or spouse’s lifetime.

The extremely favorable tax consequences of qualified retirement plans are the reason for theirpopularity. When the hospital makes a contribution on the employee’s behalf to the qualifiedplan, the employer receives a deduction for the amount contributed; however, the employee willnot have to report the contribution as income until the funds are finally distributed. Contributionsto the trust or other qualified fund are accumulated tax-free. Distributions are taxable, but therecipient is generally in a lower marginal tax bracket during retirement than when contributionsto the retirement plan were made. This treatment is a truly startling departure from the normalpractice under the Code.

The following examples demonstrate how the tax-free accumulation of income (contributionsand interest) offers the employee great advantages, even if his or her tax rates are the same at thetime of deferral as at the time of distribution.

Example: Tony, a hospital employee in the 30% tax bracket, decides to place a portion of his$150,000 annual salary for the next five years in a qualified retirement plan that pays an 8%return. He decides to let that deferred income compound for 10 years. Depending on thepercentage he decides to apply to the plan each year, the following table shows the totaleconomic benefit of the deferral he can expect after 10 years:

Tax-Free Compounding

Years of deferral 5Annual investment return 8%Years of compounding 10Tax rate 30%

% of salary deferred 5% 10% 15%Amount of deferral per year $ 7,500 $ 15,000 $ 22,500Total deferred $37,500 $ 75,000 $112,500

Value at end of 10 years $64,650 $129,299 $193,949Income tax due on receipt

19,39 38,790 58,185Value remaining 45,255 90,509 135,764Value remaining, if $ not deferred(tax paid on receipt and oninvestment earnings) 38,554 77,107 115,661Economic benefit of deferral $ 6,701 $ 13,402 $ 20,103


The moral here is twin benefits of the time value of money and deferred taxation, at least with astable investment.

Deferral arrangements (retirement plans) using employees’ salaries to supplement employer-funded qualified plans have become increasingly popular. Such plans are commonly called401(k) plans, after the section of the Code that defines them. Under these plans, an enrolledemployee is permitted to make an elective deferral of a portion of their compensation, or part orall of a year-end bonus, and have the employer contribute such amounts to the plan, rather thanreceiving them directly. If made within the statutory limits, the amounts are not included in theemployee’s income and the earnings from investment of such contributions accumulate tax freeuntil distributed to the employee. Thus, in addition to employer contributions, the employee canget all the qualified benefits on a portion of his or her own salary. These salary deferralarrangements are obviously voluntary and are subject to severe restrictions. See the moredetailed discussion of 401(k) plans in Planning Issue 6.

TAX-FREE BENEFIT RECEIPTS

Many of the special tax-free benefits discussed above only apply to hospital employees, and notto owners of medical clinics, etc. Thus, S Corporation employee/shareholders, and soleproprietors, cannot take full advantage of all of the nontaxable benefits outlined above.

There is some tax relief available to those who do not receive tax-free benefits as employees.100% of healthcare insurance premiums may be deducted as itemized deductions in the medicalexpense section of federal Schedule A, along with other un-reimbursed medical costs. However,only qualified medical expenses over 7.5% of the taxpayer’s AGI are allowed. Thus totalmedical expenses, including the 70% allowable for health care insurance premiums, fallingbeneath the 7.5% AGI threshold produce no tax benefits. Additionally, the total allowableitemized deductions must exceed the IRS standard deduction to produce tax benefits. Third;allowable itemized deductions on Schedule A phase out with higher AGI.S Corporationemployees who own at least 2% of the corporations stock.

Special rules apply to certain employees of S corporations who are also substantial shareholders.Any 2% shareholder of an S corporation is treated as a partner in a partnership for purposes oftaxing certain fringe benefits. Regular rules apply to holders of smaller ownership interests, aswell as to all common-law employees. The following fringe benefits provided by an Scorporation are taxable under these special rules, and the affected shareholder must pay for themwith after-tax dollars:

Accident and health plan benefits Group term life insurance Meals and lodging furnished for the convenience of an employer

The nontaxable benefits providing dependent-care assistance programs and certain general fringebenefits, such as no-additional-cost services or qualified employee discounts, are not subject toany special rules for self-employed individuals and, therefore, are not subject to any special rules


with respect to the shareholder employees of an S corporation, regardless of the amount of stockthey own.

Key Hospital Employees

Effective January 1st 2014, the limitation on the annual benefit under a defined benefit planunder Section 415(b)(1)(A) is increased from $205,000 to $210,000. For a participant whoseparated from service before January 1st 2014, the limitation for defined benefit plans underSection 415(b)(1)(B) is computed by multiplying the participant's compensation limitation, asadjusted through 2013, by 1.0155.

The limitation for defined contribution plans under Section 415(c)(1)(A) is increased in 2014from $51,000 to $52,000.

The Code provides that various other dollar amounts are to be adjusted at the same time and inthe same manner as the dollar limitation of Section 415(b)(1)(A). These dollar amounts and theadjusted amounts are as follows:

The limitation under Section 402(g)(1) on the exclusion for elective deferrals described inSection 402(g)(3) is increased to $17,500.

The annual compensation limit under Sections 401(a)(17), 404(l), 408(k)(3)(C), and408(k)(6)(D)(ii) is increased from $255,000 to $260,000.

The dollar limitation under Section 416(i)(1)(A)(i) concerning the definition of keyemployee in a top-heavy plan is increased from $165,000 to $170,000.

The dollar amount under Section 409(o)(1)(C)(ii) for determining the maximum accountbalance in an employee stock ownership plan subject to a 5-year distribution period isincreased from $1,035,000 to $1,050,000, while the dollar amount used to determine thelengthening of the 5-year distribution period is increased from $205,000 to $210,000.

The limitation used in the definition of highly compensated employee underSection 414(q)(1)(B) is increased from to $115,000.

The dollar limitation under Section 414(v)(2)(B)(i) for catch-up contributions to anapplicable employer plan other than a plan described in Section 401(k)(11) orSection 408(p) for individuals aged 50 or over is increased from $5,000 to $5,500. Thedollar limitation under Section 414(v)(2)(B)(ii) for catch-up contributions to anapplicable employer plan described in Section 401(k)(11) or Section 408(p) forindividuals aged 50 or over remains unchanged at $2,500.

The annual compensation limitation under Section 401(a)(17) for eligible participants incertain governmental plans that, under the plan as in effect on July 1, 1993, allowedcost-of-living adjustments to the compensation limitation under the plan underSection 401(a)(17) to be taken into account, is increased from $380,000 to $385,000.

The compensation amount under Section 408(k)(2)(C) regarding simplified employeepensions (SEPs) is increased from $500 to $550.

The limitation under Section 408(p)(2)(E) regarding SIMPLE retirement accounts isincreased from to $12,000.


The limitation on deferrals under Section 457(e)(15) concerning deferred compensationplans of state and local governments and tax-exempt organizations is increased to$17,500.

The compensation amounts under Section 1.61-21(f)(5)(i) of the Income Tax Regulationsconcerning the definition of “control employee” for fringe benefit valuation purposes isincreased from $100,000 to $105,000. The compensation amount underSection 1.61-21(f)(5)(iii) is increased from $205,000 to $210,000.

The Code also provides that several pension-related amounts are to be adjusted using thecost-of-living adjustment under Section 1(f)(3). These dollar amounts and theadjustments are as follows:

The adjusted gross income limitation under Section 25B(b)(1)(A) for determining theretirement savings contribution credit for married taxpayers filing a joint return isincreased from $35,500 to $36,000; the limitation under Section 25B(b)(1)(B) isincreased from $38,500 to $39,000; and the limitation under Sections 25B(b)(1)(C) and25B(b)(1)(D), from $59,000 to $60,000.

The adjusted gross income limitation under Section 25B(b)(1)(A) for determining theretirement savings contribution credit for taxpayers filing as head of household isincreased from $26,6250 to $27,000; the limitation under Section 25B(b)(1)(B) isincreased from $28,875 to $29,250; and the limitation under Sections 25B(b)(1)(C) and25B(b)(1)(D), from $44,250 to $45,000.

The adjusted gross income limitation under Section 25B(b)(1)(A) for determining theretirement savings contribution credit for all other taxpayers is increased from $17,750 to$18,000; the limitation under Section 25B(b)(1)(B) is increased from $19,250 to $19,500;and the limitation under Sections 25B(b)(1)(C) and 25B(b)(1)(D), from $29,500 to$30,000.

The applicable dollar amount under Section 219(g)(3)(B)(i) for determining thedeductible amount of an IRA contribution for taxpayers who are active participants filinga joint return or as a qualifying widow(er) is increased from $95,000 to $96,000. Theapplicable dollar amount under Section 219(g)(3)(B)(ii) for all other taxpayers (otherthan married taxpayers filing separate returns) is increased from $59,000 to $60,000. Theapplicable dollar amount under Section 219(g)(7)(A) for a taxpayer who is not an activeparticipant but whose spouse is an active participant is increased from $178,000 to$181,000.

The adjusted gross income limitation under Section 408A(c)(3)(C)(ii)(I) for determiningthe maximum Roth IRA contribution for married taxpayers filing a joint return or fortaxpayers filing as a qualifying widow(er) is increased from $178,000 to $181,000. Theadjusted gross income limitation under Section 408A(c)(3)(C)(ii)(II) for all othertaxpayers (other than married taxpayers filing separate returns) is increased from$112,000 to $114,000.

Administrators of defined benefit or defined contribution plans that have receivedfavorable determination letters should not request new determination letters solelybecause of yearly amendments to adjust maximum limitations in the plans.

Source: http://www.irs.gov/newsroom/article/0,,id=187833,00.html


3. WHAT IS A HOSPITAL CAFETERIA PLAN?

Under cafeteria plans, each eligible employee may choose to receive cash or taxable benefits, or,or an equivalent of qualified, non-taxable, fringe benefits. The amounts contributed by theemployer are not taxable to the employee. In effect, the employee pays for the benefits withbefore-tax dollars. They remain non-taxable even though the employee could have elected toreceive those amounts in cash. An additional benefit for both employee and employer is thatnontaxable cafeteria plan benefits are not subject to FICA taxes, thus saving 7.65% on amountsthat would otherwise be under the Social Security wage base. However, if the employee does notuse all of the monies that are diverted into the cafeteria plan, the unused amounts are forfeited.

The essence of a hospital cafeteria plan is that it permits each participating employee to chooseamong two or more benefits. In particular, the employee may “purchase” non-taxable benefits byforgoing taxable cash compensation.

This ability of participating employees, on an individual basis, to select benefits fitting their ownneeds, and to convert taxable compensation to non-taxable benefits, makes the cafeteria plan anattractive means of offering benefits to employees. Other qualified employee benefits, describedabove, are excluded from cafeteria plans.

Cafeteria plans may include the following non-taxable benefits:

401 (k) retirement plan health and accident insurance adoption assistance dependent care assistance group term life insurance including premiums for coverage over $50,000.

Cafeteria plans and healthcare

It is always to the tax advantage of an employee to receive employer-provided health andaccident benefits in a tax-free form, rather than paying them with after tax money. Note there isthe potential draw back of employees thinking of health care benefits as an implicit condition ofemployment instead of true non-cash compensation.

Because of increases in healthcare costs, employers are not always willing or able to providecoverage for all of an employee’s medical expenses. This means many employees must often payfor a portion of their medical costs under a co-pay provision. If an employee is fortunate, theemployer may establish a cafeteria plan to allow the employee to fund the co-pay healthcarecosts with before-tax dollars.

For example, if an employee must spend $3,000 annually to provide healthcare coverage for hisor her dependents, then the income-tax savings to the employee could be as much as $1129.50annually, if the employee is in the 30% tax bracket ($900 in income taxes and $229.50 of FICAtaxes). The employer saves $229.50, the 7.65% of gross pay “matching” FICA taxes.


Cafeteria plans and other nontaxable benefits

A cafeteria plan may be expanded to cover more than just medical benefits. It may offerparticipants a choice between one or more nontaxable benefits, and cash resulting from theemployer’s contributions to the plan or the employee’s voluntary salary reduction. Participants incafeteria plans are sometimes given a choice of using vacation days, selling them to the employerand then getting cash for them, or, buying additional vacation days. Some cafeteria plans alsoinclude one or more reimbursement accounts, often referred to as “flexible spending accounts” or“benefit banks.” Under these plans, cash that is forgone by an employee, by means of a salaryreduction agreement or other agreement, is credited to an account and drawn upon to reimbursethe employee for uninsured medical or dental expenses, or for dependent-care expenses. Manycafeteria plans include both insurance coverage options and reimbursement accounts.

ELECTIONS REGARDING BENEFITS UNDER A CAFETERIA PLAN?

A hospital employee given the opportunity to participate in a cafeteria plan should consider thefollowing.

Healthcare

If the employee is married and has a spouse who also works, and, the employer-provided healthbenefits are better under the spouse’s plan, then the employee should elect to be covered by thespouse’s plan and choose another nontaxable benefit or a cash benefit that would be taxableunder his or her own cafeteria plan, such as dependent-care coverage or group term insurancecoverage. Switching health insurance requires planning t eliminate potential gaps in coveragecreated by insurance enrollment criteria. If the employee does not need the salary or cafeteria-plan benefits to meet current expenses, he or she should consider contributing the cash to a401(k) plan and defer the tax liability.

If the employee has no working spouse and the employee’s plan is the only source for certainhealth benefits, the employee should consider what type of benefits he or she really needs for hisor her family. In other words, can the employee get the necessary benefits under the companyplan cheaper than he or she could individually, after taking into account that individual coveragewill be paid with after-tax dollars, whereas under a cafeteria plan such benefits can be paid withbefore-tax dollars? For example, if an employee who is in the 30% tax bracket is provided a$6,000 plan by her employer. He or she would have to be able to get a comparable planindependently for only $3,741 to be in the same position on an after-tax basis. ($6,000 minusincome taxes of $1,800 = $4,200, or, $4,200 minus $459 of avoided FICA

Dependent-care costs

An employee who has a choice of including dependent-care costs may be entitled to an income-tax credit for such expenses if, the employer does not reimburse them. Thus, if a credit is worththe same or more than the payment under the cafeteria plan, the employee may choose tocontribute those dollars toward additional health or life insurance.


SHOULD AN EMPLOYEE USE A TAX CREDIT OR EMPLOYER-SPONSOREDBENEFITS TO OFFSET DEPENDENT-CARE COSTS?

A tax credit is available to qualified individuals to help offset expenses, such as child anddependent-care costs, that enable them to be gainfully employed. The question then ariseswhether it is to the employee’s advantage to opt out of any employer-sponsored dependent-carebenefit program and take the tax credit, or vice versa.

As shown above, an employer-sponsored reimbursement plan is usually more advantageous thanthe tax credit, but, employees whose marginal tax rate is 15% may be better off taking the credit.As a taxpayer has increasing amounts of income in the 25% bracket, however, the exclusionunder an employer-provided program will be more attractive than the credit.

EMPLOYEE ELECTIONS REGARDING DEFERRALS UNDER A HOSPITAL 403(B)PLAN

Code § 403(b) authorizes a special type of funded deferred compensation arrangement that isgenerally available to employees of tax-exempt hospital organizations. This also includes entitiesorganized and operated exclusively for religious, charitable, scientific, public safety testing,literary, or educational purposes, or to foster national or international amateur sportscompetitions, or for prevention of cruelty to children or animals, subject to certain restrictionsprohibiting political action. These arrangements are called 403(b) plans.

Much like a 401(k) plan for profit-making organizations, these plans provide for salary-reduction(deferral) contributions to be made by employees. If made within the statutory limits, theamounts are not included in the employees’ income and the earnings from investment of suchcontributions accumulate tax free until distributed to the employee. Although there are technicaldifferences between 403(b) plans and 401(k) plans, and the limits on the amount that may bedeferred may be different, the effect on the employee is the same. Thus, the same analysis usedby an employee under a 401(k) plan should also be applied to an employee who participates in a403(b) plan.

INCOME TAXE REDUCTIONS ON RETIREMENT PLAN DISTRIBUTIONS

A hospital employee has alternatives to consider when attempting to reduce income taxes ondistributions from qualified retirement plans. To help understand the choices, an advisor mustunderstand not only the income-tax implications but also the federal estate-tax implications ofeach alternative and the distribution requirements imposed by law.

Generally, all payments received from a qualified retirement plan that are payable over morethan one year are taxed at ordinary income rates. IRS Publication 575, Pension and AnnuityIncome, defines the allowed methods for structuring distributions. The five-year averagingoption was repealed in 2002. Distributions are reported to the IRS and the taxpayer via a Form1099R.

An additional 10% penalty is applied to withdrawals from a qualified plan before death,


disability, or attainment of age 59½. SIMPLE plans may incur a 25% penalty. Insufficientwithdrawal, per IRS guidelines, can incur a 25% excise tax penalty.

However, the additional tax does not apply to distributions in the form of an annuity payableover the life or life expectancy of the participant (or the lives or joint life and last-survivorexpectancy of the participant and the participant’s beneficiary), or to distributions made after theparticipant has attained age 55, separated from service, and satisfied the conditions for earlyretirement under the plan.

Lump-sum distributions from a qualified retirement plan, like when an employee leaves thesponsoring company, may be rolled over, tax free, by the employee or surviving spouse of theemployee to an IRA or another qualified retirement plan. This must occur within 60 days,however, as always, there are exceptions. In 2002, the definition of a qualified plan wasexpanded to include 403(b) and section 457 deferred compensation plans. This applies to directrollovers, where the recipient has no physical control of the funds. 20% with holding is requiredon distributions made to employees pending rollover.

Note that for some clients, this may allow a 60-day loan of 80% of their retirement funds. Inaddition, distributions of less than the balance to the credit of an employee, as well asdistribution of the entire balance, under a qualified retirement annuity may now be rolled over,tax free, by the employee (or surviving spouse of the employee) to an IRA, as long as they arenot one of several installment payments.

Income-tax issues

Rollovers

In many cases, it may be more financially beneficial to defer receipt of benefits as long aspossible, assuming the client’s cash flow is sufficient. Under the Economic Growth and TaxRelief Reconciliation Act of 2001 [EGTRRA], marginal tax brackets dropped. Income taxes arepayable only as and when the benefits are received, so deferring the receipt of benefits meansthat the payment of tax is deferred. If the recipient’s income tax liability is deferred, there maybe a greater amount left to invest during the period over which distributions are being made.Benefits retained in a qualified plan or individual retirement account (IRA), pending distribution,continue to earn income on a tax-deferred basis. Payment in installments also results in a naturalaveraging effect, and may push some income over into retirement years of the beneficiary, whenhis or her tax bracket may be lower.

There are still several potential income-tax benefits that are available on rollovers ofdistributions to a traditional IRA or Keogh (HR 10) plan because of special rules. Lump-sumdistributions that are rolled over are excluded from gross income for the year in which they aremade. This can avoid imposition of the special 10% penalty on early distribution.

Amounts rolled over are also exempted from the requirement that lump-sum treatment be electedand that only one such election may be made. As a result of the election exemption, a rollovercan be used in certain situations to avoid having to include the value of an annuity in a special


10-year averaging calculation when two dissimilar plans are involved, one of which wouldordinarily distribute an annuity. For example, an employee who desires an annuity from herpension plan, and a lump-sum distribution from her profit-sharing plan, could avoid the tax-rateincrease that comes from having to include the value of an annuity in the special 10-yearaveraging calculation by taking a lump-sum distribution from the pension plan and rolling it overinto an IRA annuity.

In situations involving multiple lump-sum distributions in the same year from dissimilar plans, ordistributions that might involve a look back calculation, the election exemption may result inlower overall taxation by rolling over one or the other distribution, thus deferring the tax on theaggregated lump-sum distribution to subsequent years, when the comparative effective ratemight be lower.

The relative value of a rollover as compared to a lump sum depends first on what the individualwants to do with the money. If he has an immediate need for consumption and not investment,the rollover option is generally not appropriate. But if he or she does not need to consume all thefunds in a short period of time, and will invest it in the same type of assets whether it is rolledover or taken in a lump sum, then it is appropriate to compare the financial differences betweenthe two strategies. The table below compares the results of rolling over a distribution to atraditional IRA compared to taking it as a lump-sum distribution. The figures are based on a 30%income-tax rate and an 8% annual return on all invested amounts.

A retiree can roll over his or her distribution into as many traditional IRAs as desired, ifdiversification of the funds is an objective.

It is sometimes advantageous to roll over distributions to a Keogh plan rather than to a traditionalIRA because a subsequent lump-sum distribution from a Keogh plan may qualify for favorable10-year income tax averaging. Unlike traditional IRAs, Keogh plans are available only to theself-employed. However, an employer-participant might have outside self-employment income(e.g., director’s fees or freelance activities) or an employee may be expecting to receive self-employment income in the form of consulting fees from the employer following retirement.Where an employee’s distribution is imminent, and the employee has self-employment income, aKeogh plan rollover may be the best alternative.

In deciding whether a tax-free rollover to a traditional IRA is preferable to the various taxableoptions discussed above, retirees should understand that later distributions out of the traditionalIRA do not qualify for either the capital-gains or 10-year averaging rules that apply to lump-sumdistributions from the qualified retirement plans.

IRA ROLLOVER v. PAYING THE LUMP-SUM TAX

Example: Ron, an RN, receives a lump-sum distribution qualifying for 10-year averagingtreatment. The amount of distribution is $1,500,000. Since Ron will not need to use the funds forthe next 20 years, he should elect a rollover that will yield annual cash flow of $106,945, insteadof 10-year averaging, which will yield annual cash flow of $72,737.


Distribution amount $1,500,000Death benefit exclusion 0Form 1099-R Box 2 (capital gain portion) 0Form 1099-R Box 9 (current actuarial value) 0Marginal income tax rate 30.0%Expected investment return (before taxes) 8.0%How many years will you need income? 20Risk tolerance Low

IRA Rollover

Required annual withdrawals $152,778Less income tax 45,833Net annual cash flow $106,945

10-Year Averaging

Invested funds after paying income tax $867,790Net annual cash flow $ 72,737

Rollover to Roth IRA

Another option is to transfer the lump-sum distribution to a Roth IRA. The advantage of such aconversion is that future earnings on the Roth IRA will be tax free, possibly for futuregenerations as well. Unfortunately, however, current taxes would be paid on the lump sum whenthe transfer takes place. These taxes would reduce the amount of funds available forreinvestment. Allowable Roth IRA annual contributions are $5,500 if under the age of 50 or$6,500 for those that are age 50 or over.

Roth Conversions Allowed for High-Income Individuals after 2009

A taxpayer ordinarily may not convert any part of an IRA to a Roth IRA if (1) the taxpayer’smodified “adjusted gross income” for the tax year exceeds $100,000 or (2) the taxpayer ismarried filing a separate return.

Extension of Roth Conversions to Eligible Retirement Plans

Taxpayers have long been able to convert their regular IRAs to Roth IRAs. However, to convertfunds in an employer retirement plan to a Roth IRA, taxpayers have generally had to roll thefunds over first to a regular IRA and then convert the regular IRA to a Roth IRA. By contrast,after 2007, a taxpayer may directly convert all or part of an “eligible plan” to a Roth IRA withoutusing a regular IRA as an intermediary. For this purpose, an eligible plan is a qualified retirementplan, a section 403(b) tax-sheltered annuity (TSA), or an eligible state and local governmentplan.

Conversions of eligible plans to Roth IRAs will be subject to the same conditions that apply to


regular IRA conversions. That is, before 2010, a taxpayer may generally make the conversiononly if (1) the taxpayer’s modified “adjusted gross income” for the tax year does not exceed$100,000 and (2) the taxpayer is not a married individual filing a separate return. After 2009, ataxpayer will be able to make the conversion regardless of the level of his or her income – andregardless of a separately filed return. Of course, conversions to Roth IRAs are taxable(exclusive of return of investment) whether the converted funds come from a regular IRA or aneligible plan (Tax Increase Prevention and Reconciliation Act of 2005, Pub. L. No: 109-455, §512 - Pension Protection Act of 2006, Pub. L; No. 109-280, § 824(a), (b), (c); I.R.C. § 408A)

HOSPITAL EMPLOYEE STOCK OWNERSHIP PLANS

The growth over the past few decades of plans that give employees a stake in the ownership oftheir company has been a significant development in the area of employee compensation andcorporate finance. Though there are many forms of employee ownership, the employee stockownership plan (ESOP) has achieved widespread application. The rapid growth in the number ofESOPs being created has important ramifications for employees, corporations, and the economyat large.

An ESOP is a special kind of qualified retirement plan in which the sponsoring employerestablishes a trust to receive the contributions by the employer on behalf of participatingemployees. The trust then invests primarily in the stock of the sponsoring employer. The plan’sfiduciaries are responsible for setting up individual accounts within the trust for each employeewho participates, and the company’s contributions to the plan are allocated according to anestablished formula among the individual participants’ accounts, thus making the employeesbeneficial owners of the company where they work.

Like all qualified retirement plans, ESOPs must be defined in writing. Further, in addition to theusual rules for qualified deferred compensation plans, ESOPs must meet certain requirements ofthe Internal Revenue Code with respect to voting rights on employer securities. In general,employers that have “registration class securities” (publicly traded companies) must allow planparticipants to direct the manner in which employer securities allocated to their respectiveaccounts are to be voted on all matters. Companies that do not have registration class securitiesare required to pass through voting rights to participants only on “major corporate issues.” Theseissues are defined as merger or consolidation, re-capitalization, reclassification, liquidation,dissolution, sale of substantially all of the assets of a trade or business of the corporation, and,under Treasury regulations, similar issues. On other matters, such as the election of the Board ofDirectors, the shares may be voted by the designated fiduciary unless the plan otherwiseprovides. In regard to unallocated shares held in the trust, the designated fiduciary may exerciseits own discretion in voting such shares.

As owners, hospital employees may be more motivated to improve corporate performancebecause they can benefit directly from company profitability. A growing company showingsignificant increases in the value of its stock can mean significant financial benefits forparticipating employees. However, because the assets of the ESOP trust are invested primarily inthe stock of one company, there is a higher degree of risk for the employee.


An ESOP is the only employee-benefit plan that may also be used as a technique of corporatefinance. Thus, in addition to the usual tax benefits of qualified retirement plans, studies haveshown that ESOPs provide employers with significant amounts of capital, which often result infinancial benefits far superior to other employee-benefit plans, while employees can share in thebenefits realized through corporate financial transactions. Until January 1, 2003 the employeedid not incur FICA tax on exercised stock options.

ESOPs, like all qualified deferred compensation plans, must meet certain minimum requirementsspelled out in Code § 401(a) in order for the contributions to be tax deductible to the sponsoringemployer. Many employers who set up ESOPs do so not to take advantage of the very substantialtax incentives they can receive, but rather to provide their employees with a special kind ofemployee benefit—one with many implications for the way a company does business.

HOW DO ESOPS BENEFIT EMPLOYEES AND THEIR EMPLOYERS?

When participants in an ESOP terminate their employment, they are entitled to receive the sharespreviously allocated to their account. The employee may then hold or sell them, but for taxpurposes these shares are treated like any other distribution from a qualified deferredcompensation plan; that is, upon distribution of employer stock the employee is not taxed on anunrealized appreciation until the shares are sold.

However, to ensure that there is a market for the stock distributed by closely held companies,such companies are required to provide a put option to the recipient. For lump-sum distributionsfrom an ESOP that are then put to the employer, the employer (or the ESOP) must pay the fairmarket value of such shares to the terminated participant, in substantially equal payments over aperiod not exceeding five years. The following table shows how the gain on stock from an ESOPdistribution is taxable when the stock is later sold.

Value of stock when purchased by ESOP $2,500 100 shares x $25/shareValue of stock when distributed $5,000 100 shares x $50/shareYears held after distribution, until sale 3 5 10Value in later year of sale $6,613 $8,745 $17,589Gain on sale 4,113 6,245 15,089Tax on sale (20%) –823 –1,249 –3,018Value remaining $5,790 $7,496 $14,571

For the purpose of broadening the ownership of capital and providing employees with access tocapital credit, Congress has granted a number of specific incentives meant to promote increaseduse of the ESOP concept. These ESOP incentives provide numerous advantages to thesponsoring employer and can significantly improve corporate financial transactions. Chiefamong these incentives is the leveraged ESOP, which provides for a more-accelerated transfer ofstock to employees. The sponsoring employer of a leveraged ESOP can deduct contributions torepay the principal as well as interest on the debt. This allows the employer to reduce the costs ofborrowing and enhance cash flow and debt financing. The contribution limits are increased foremployers to allow them to repay any ESOP debt.


Employers are also permitted a tax deduction for dividends paid on ESOP stock to the extent thedividends are paid to employee participants or are used to reduce the principal or pay interest onan ESOP loan. Certain lenders may exclude from this taxable income 50% of the interest earnedon loans made to ESOPs for the purpose of acquiring shares.

UNDER WHAT CIRCUMSTANCES CAN A SHAREHOLDER DEFER INCOMETAXES ON THE SALE OF EMPLOYEE SECURITIES TO AN ESOP?

An additional ESOP incentive, provided by the 1984 Tax Reform Act, allows shareholders of aclosely held company to sell their stock to the company’s ESOP and defer all taxes on the gainfrom the sale.

In order for shareholders to qualify for this so-called ESOP rollover, the ESOP must own at least30% of the company’s stock immediately after the sale, and the shareholder must reinvest theproceeds from the sale in “qualified replacement property”—generally, the stocks and bonds ofdomestic operating corporations; government securities do not qualify—within a 15-monthperiod beginning three months before the date of the sale. The seller, certain relatives of theseller, and 25% shareholders in the company are prohibited from receiving allocations of stockacquired through an ESOP rollover, and the ESOP generally may not sell the stock acquiredthrough a rollover transaction for three years.

An ESOP rollover may be attractive to a selling shareholder for a number of reasons. Normallythe owner of stock in a closely held company may either sell his or her shares back to thecompany, if such a transaction is feasible; sell to another company or individual, if a willingbuyer can be found; or exchange a controlling block of stock with another company. Rollingover the same stock to the company’s ESOP, on the other hand, allows the stockholder to sell allor only a part of his or her stock and defer taxes on the gain. In addition to the favorable taxtreatment, selling to an ESOP also preserves the company’s independent identity, whereas otherselling options may require transferring control of the company to outside interests. A sale to anESOP also provides a significant financial benefit to valued employees and can assure thecontinuation of their jobs. In the case of owners retiring or withdrawing from a business, anESOP allows them to sell all or just part of the company, and withdraw from involvement withthe business as gradually or suddenly as they like.

Employer securities that can be sold to an ESOP for purposes of the tax-free rollover arecommon stock with the greatest voting and dividend rights, issued by a domestic corporationwith no stock outstanding, and readily tradable on an established securities market. In addition,the securities must have been held by the seller for six months and must not have been receivedby the seller in a distribution from a qualified employee-benefit plan or a transfer under an optionor other compensatory right to acquire stock granted by or on behalf of the employer corporation.

The seller’s gain on a sale of stock to an ESOP will be retained by adjusting the seller’s basis inthe qualified replacement property. If the replacement securities are held until death, however, astepped-up basis for the securities is allowed. The tax-free rollover must be elected in writing onthe seller’s tax return for the taxable year of the sale.


Careful documentation of ESOP rollover transactions is required, and the transactions mustconform to regulations developed by the IRS, but if constructed properly an ESOP rollover canprovide significant benefits to the selling shareholder, the employees, and the company itself.

HOW MAY A HOSITAL EMPLOYEE RECEIVE EMPLOYER SECURITIES?

There are a number of different methods, other than qualified retirement plans, by which stockmay be transferred to hospital employees.

The first and simplest method is a stock bonus, whereby the employer makes an outright grant ofshares to the employee. In this case, the employee immediately owns his or her shares and hasfull voting and dividend rights. The employee is taxed at ordinary income rates on the full valueof the stock when it is received. This sort of arrangement is very beneficial to the employee,since he or she is able to acquire stock for a cost of the income tax payable on receipt of thestock. Of course, cash flow may not be sufficient to support increased income taxes due for non-cash compensation. Thus, if the employee receives $10,000 worth of stock, he or she hasessentially acquired the stock for $3,000, if he or she is in the 30% marginal tax bracket.

The employer may insist that when the shares are granted the employee satisfy certain conditionseither relating to continued employment for a period of time or attainment of certain performancegoals. Until the restrictions are met, the shares cannot be sold and remain subject to forfeiture.Using restriction periods ensures that employees will hold their shares and helps supportemployee retention. Moreover, because grants can be made contingent on meeting specific goals,employers can create a stronger performance linkage than stock price alone.

As soon as the rights to the stock are not subject to a substantial risk of forfeiture, the employeeis subject to ordinary income taxation. The amount to be included in income is the excess of thefair market value of the stock at the time it is no longer subject to the risk of forfeiture.

EMPLOYEE-OWNED STOCK WITH RESTRICTIONS

Example: The Olympia Hospital granted stock to one of its executives on July 1, 1998, when thestock is trading at $10 per share. The stock is not freely transferable and must be forfeited if theexecutive ceases to be employed prior to July 1, 2001. In 2001, the stock is worth $20 per shareand the executive is still with the company. The executive ultimately sells the stock in 2005 for$30 per share. The executive is not subject to taxation in 1998, since the stock is subject to asubstantial risk of forfeiture and is not freely transferable. In 2001, when the restriction lapsed,the executive recognizes ordinary income of $20 per share. When the executive ultimately sellsthe stock in 2005 for $30, he recognizes a capital gain of $10.

If the stock had been sold to the executive for $5 per share rather than given as a bonus, the basicanalysis would not change. The executive would simply reduce any total gain by the amountpaid, and the gain would be $15. This represents the excess of the fair market value of the stockat the time of the transfer minus the amount paid.


The following table demonstrates the tremendous economic benefit an employee can realizethrough such a program.

ADVANTAGES OF A STRAIGHTFORWARD STOCK BONUS PLAN

Value of shares granted $50,000Years until restrictions lapse 3 5 10Value (assume 10% growthrate)

$66,125 $87,450 $175,894

Income tax due (assuming30%)

–19,837 –26,235 –52,768

Economic benefit remaining $46,288 $61,215 $123,126

A program allowing stock to be purchased at a discount can also provide greatadvantages to the employee.

Value of shares purchased $50,000Years until exercised 3 5 10Value (assume 10% growthrate)

$66,125 $87,450 $175,894

Cost of shares = 75% 37,500 37,500 37,500Taxable portion 28,625 49,950 138,394Income tax due oncompensation (assume 30%rate)

–8,588 –14,985 –41,518

Economic benefit remaining $20,037 $34,965 $96,876

WHAT IS A SECTION 83(B) ELECTION, AND HOW IS IT BENEFICIAL TO ANEMPLOYEE?

Code § 83(b) allows a hospital employee who receives employer stock on a tax-deferred basis tobe taxed immediately in the year the stock is transferred, regardless of the presence of asubstantial risk of forfeiture. If the employee makes such an election, any subsequentappreciation is not taxable as compensation. Once made, the IRS must approve any change youmay want to make. There are several reasons why a taxpayer might want to make such anelection.

First, absent a Section 83(b) election, any appreciation in the value of the stock that occurs aftertransfer will then be subject to ordinary income taxation at the time of vesting for the full amountby which the then-appreciated fair market value exceeds the amount paid, if any. If a Section83(b) election is made, any post-transfer appreciation will not be taxed until the stock is sold andwill only be subject to capital gain taxation on its ultimate sale.

If one expects the restricted property to appreciate substantially before vesting and one plans tohold the property for a long time after it vests, such delay in taxation of the appreciated amount


may be a significant benefit. If the taxpayer holds the property until death, any post-transferappreciation will escape income taxation entirely.

The main disadvantage of the Section 83(b) election is the triggering of current taxation for theexcess of fair market value (without regard to any restrictions or risk of forfeiture) over theamount paid. In addition, the Code provides that, if a Section 83(b) election is made before thelapse of the restrictions and such property is subsequently forfeited due to the failure to meet theconditions, no deduction can be made.

Furthermore, if a Section 83(b) election is made and the property later declines in value; only acapital loss is allowed. Finally, the employer receives no deduction for any later appreciationbefore vesting, nor will the company be able to take a deduction in the case of transferred stockon any dividends after the transfer that are paid to the employee. The following example showsthe benefit of electing Section 83(b) in certain circumstances.

Example: In 1995, Horizon Hospital Corp., a newly founded and highly promising hospitalnetwork, grants restricted stock worth $10,000 to Anne, a senior executive, conditioned upon herremaining with Horizon for the next five years. In 2002, when the stock vests, its' value is$100,000. Anne has no immediate intention of selling the stock. If she makes a Section 83(b)election on transfer, she will recognize $10,000 of ordinary income for that year, and thesubsequent $90,000 of appreciation will be subject to the lower capital-gains rate only if andwhen she sells the stock. If she does not elect to use Section 83(b), she would not recognize anyincome for 1995, but, in 2001 she would have recognized ordinary income in the full amount of$100,000.

The election consists of a written statement, mailed to IRS center where you file your return,within 30 days of the triggering transaction. It must include everything about the transaction.

HOW MAY AN EMPLOYEE ACQUIRE HOPSITAL SECURITIES WITHOUT ANYCURRENT CASH ACTIVITY?

To alleviate cash-flow problems of their employees, hospitals who want their employees to takepart in a discounted stock-purchase program may lend the money to the employees to pay anytaxes due and any purchase price for the stock.

However, it is important that any such loan be subject to a full recourse liability; if the loan issecured by the stock on a non recourse basis, the transaction may be treated as if it were a grantof an option, and thus there would be no transfer of property until the loan is paid.

The rationale for treatment as an option is that if the property drops in value below the amount ofthe debt, the employee will not pay the debt and walk away from the property, as he would anoption. Thus, until the note is paid, no transfer has occurred. This could negate the effect of aSection 83(b) election.

The following example demonstrates how the use of employer loans, in connection with aSection 83(b) election, can be used to great advantage to an employee. The employer in the


example on Section 83(b) election (above) lends the employee the cash necessary to meet theincome tax liability of the $10,000 grant at 30%, or $3,000. The employee gives the employer apromissory note for $3,000, bearing interest at 8%. Thus, the employee acquires $100,000 worthof employer stock ownership after five years with no out-of-pocket cost at the date of the grantand an interest cost of approximately $1,300, payable over five years.

Of course, in lieu of making a loan to the employee, the employer can simply agree to give theemployee, as a bonus, sufficient cash to cover the tax liability. This is obviously more costly tothe employer, as it results in the employee acquiring stock at no out-of-pocket cost.

HOW MAY AN EMPLOYEE PARTICIPATE IN THE EQUITY OF A HOSPITALWITHOUT OWNING VOTING STOCK?

Many closely held hospitals or healthcare organizations may not wish to transfer actual shares ofstock but may wish to give their employees an interest that parallels actual equity ownership.There are two ways to do this: phantom stock plans and stock appreciation rights (SARs).

Phantom stock plans

As an alternative to granting an interest in stock or awarding stock options, an employer mayestablish a so-called phantom stock or shadow stock plan. Under these arrangements theemployee is treated as if he or she had received a certain number of shares of the company stock,but instead of actually issuing shares, the employer establishes an account for the employee. Theemployer then issues “units” to the employee’s account. The number of units that the employeereceives under such a contractual arrangement is pegged to the price or value of the company’sstock. Once the units have been credited to the employee, the equivalent of dividends on theseunits are generally paid to the employee and are reinvested to purchase additional units ordeferred with interest. The plan normally provides for appropriate adjustment in the value ofunits if changes are made in the capitalization of the stock with respect to which the units arepriced. Benefits under such a plan are usually deferred for a specific period of time or an eventsuch as death or retirement. When benefits are payable, they may be paid in cash, either in alump sum or installments, or in the form of stock.

Because a phantom stock plan does not require the actual issuance of shares of the employer’sstock, it may enable the employer to offer much of the practical benefit of stock ownershipwithout causing dilution of equity, securities law problems as to stock that would otherwise havebeen issued, or other problems such as risking the loss of S corporation status.

The phantom stock is taxed like any other nonqualified deferred compensation plan. Thegranting of the phantom stock units is not taxable to the employee. When the cash or stock isdistributed to the employee, it is taxed as ordinary income, equal to the amount of cash receivedor the value of the stock. If the stock distributed is subject to a substantial risk of forfeiture, itwill be subject to taxation when such risk lapses in accordance with Code § 83(b).

Hospital stock appreciation rights


Another alternative to the actual transfer of shares to an employee is the issuance of so-calledstock appreciation rights (SARs). This is a contractual arrangement that, when exercised, entitlesan employee to receive, in either stock, cash, or a combination of the two, an amount equal to theappreciation in the employer’s stock subsequent to the date the SARs were granted (or related tosuch appreciation, if the SARs are valued higher than the FMV of the stock when the SARs weregranted). The grant of SARs does not constitute the constructive receipt of income even thoughthe option is immediately exercisable, because the exercise of the option means that the granteewill not get the benefit of additional appreciation of the stock on which the value of the SARs isbased.

Any declarable income with SARs occurs at the sale, not acquisition. Income received from theexercise of SARs is ordinary, and is equal to the amount of cash received or the value of theappreciated stock received. This amount will generally be reportable in the income of theemployee in the year of receipt; however, if the SARs are exercised for stock and the stock issubject to a substantial risk of forfeiture, it will be subject to tax when the substantial risk offorfeiture lapses pursuant to Code § 83, as discussed above.

When the SARs are exercised, a deduction is available to the employer.

The income from the SARs is also subject to withholding and employment taxes on the employerand employee. As a practical matter, if the individual is an employee at the time the tax isdetermined, there will often be very little additional payroll taxes to pay because he or she willalready have exceeded the Social Security taxable wage base.

WHAT ARE HOSPITAL STOCK OPTIONS, AND WHY ARE THEY SO POPULAR?

Hospital stock options require a special contractual arrangement that gives employees the right,for a designated period, to purchase stock in their hospital at a set price.

For example, a hospital employer grants to an employee the right, at any time over the next 10years, to purchase stock of employer at a price of $10 a share. Thus, if the stock value increasesto $20 a share and the employee exercises the option he will pay $10 for an asset worth $20. Onthe other hand, if the stock value decreases to $5 the employee simply does not exercise theoption and the option lapses. This arrangement allows the employee in effect to enjoy the riskfree benefits of an increase in value without any economic cost.

Stock options are so popular because they offer advantages to both employees and employers.Employees can share in the growth of a company’s equity just like a shareholder, but withoutany immediate cash outlay. They can acquire stock at less than fair market value, and, undercertain conditions, obtain the economic benefit of the excess of the stock’s fair market value overthe option price without an immediate tax gain (which will be reported only on the subsequentsale of the stock).

Options have simultaneous advantages to employers. First, they can provide incentives toemployees without a cash outlay. In fact, the employer receives cash when the employeeexercises the option. Also, if properly structured under current accounting rules, there is no


change to the employer’s earnings for financial reporting purposes, either on the grant or theexercise of the option.

HOW DO ISOs WORK, AND HOW DO THEY BENEFIT HOSPITAL EMPLOYEES?

There are two basic types of stock options: the nonqualified stock option (NQSO) and statutorystock options. Statutory stock options include incentive stock options (ISO) and employee stockpurchase plans (ESPP). ESPPs are discussed below.

An ISO is similar in operation to other compensatory options. However, there are restrictions onhow the option may be structured and when the option may be transferred, and there is specialincome-tax treatment given to both the employee and the employer.

An ISO must satisfy the following statutory requirements:

The option is granted pursuant to a plan that states the aggregate number of shares thatmay be issued under options and the employees (or class of employees) eligible toreceive options, which is approved by the stockholders of the granting corporation within12 months before or after the date the plan is adopted.

The option is granted within 10 years from the date the plan is adopted, or the date theplan was approved by the shareholders, whichever is earlier.

The option by its terms is not exercisable after the expiration of 10 years from the date itis granted.

The option price is not less than the FMV of the stock at the time the option is granted.

The option by its terms is not transferable by the employee (except upon death pursuantto a will or the laws of descent and distribution) and is exercisable only by the employeeduring his or her lifetime.

The employee, at the time the option is granted, does not own more than 10% of the totalcombined voting power of all classes of stock of the corporation, its parent, or itssubsidiary.

The aggregate fair market value of the stock for which options may be granted to anemployee in the calendar year in which the options are first exercisable may not exceed$100,000, determined as on the date the option is granted. This limitation appliesautomatically to ISOs in the order of their grant dates. This does not mean the ISO mustbe limited to $100,000; rather, to the extent the value of the stock exceeds $100,000 inthe year in which it first becomes exercisable, the excess will not be considered an ISO.

If an option specifies that it is not an incentive stock option, it will not be treated as oneeven though it satisfies all of the above requirements.


Under special stock ownership attribution rules, for purposes of the percentage limitations, theemployee will be considered as owning the stock owned, directly or indirectly, by or for his orher brothers and sisters (whether by the whole or half blood), spouse, ancestors, and linealdescendants. Stock owned, directly or indirectly, by or for a corporation, partnership, estate, ortrust shall be considered as being owned proportionately by or for its shareholders, partners, orbeneficiaries.

Under an ISO, no gain is recognized when the option is granted; nor is any income recognizedwhen it is exercised. Gain is recognized by the employee only upon disposition of the stock,provided the IRS holding period requirement is met. The gain recognized on the disposition istaxed at long-term capital-gains rates. The gain may be taxed as ordinary income if the holdingperiod requirement is not met. The employer is not entitled to any deduction at any time. Thedifference between the option price and the fair market value of the stock at the exercise date is atax preference and could cause imposition of the alternative minimum tax (AMT).

ECONOMIC BENEFIT OF INCENTIVE STOCK OPTION

Example: Nurse Joyce is granted an option to purchase $50,000 of her hospital employer’sstock at a price equal to the fair market value of the stock at the date of grant. The economicbenefit is shown in the following table.

FMV of stock when option granted $50,000Years until option exercised 2 4 9Value when exercised $57,500 $76,044 $152,951Cost of exercising option –50,000 –50,000 –50,000Remaining value of option $ 7,500 $26,044 $102,951Years until stock sold 3 5 10Value when sold (assumed) $66,125 $87,450 $175,894Capital gain on sale 16,125 37,450 125,894Income tax due on capital gain (18-month hold) –3,225 –7,490 –25,197Economic benefit of option remaining*

$12,900 $29,960 $ 100,697

*Value when sold – Income tax due on capital gain

The favorable income tax treatment of an ISO is available to the employee only if he or she doesnot dispose of the shares within two years of the date of the grant of the option, or within oneyear after the exercise of the option. This is the IRS required holding period.

Further, the grantee must be an employee of the granting corporation or its parent or subsidiaries,or of a corporation issuing or assuming a stock option continuously during the period from theday of the granting of the option until three months before the option is exercised. Terminationof employment may occur up to one year before exercise if the grantee of the option is disabled.If the option is exercised after the death of the employee by the decedent’s estate or by a person


who acquired the right to exercise such option by bequest or inheritance or by operation of law,the holding and employment requirements listed in this paragraph do not apply.

If the employee disposes of the stock received in less than two years from the date the option wasgranted, or less than 12 months after the option is exercised and the stock is received, any gainmust be reported as ordinary income.

In such a case, however, the employer may be able to claim a deduction equal to the amount ofordinary income reported, whereas ordinarily the employer would be able to claim no deductionat all.

If an individual who has acquired stock through an ISO disposes of it at a loss (i.e., a price lessthan the exercise price) within two years from the date of the granting of the option, or one yearfrom the date of the exercise of the option, the amount includable in the gross income of theindividual, and the amount that is deductible from the income of the employer [pursuant to Code§ 83(h)] as compensation attributable to the exercise of the option, will not exceed the excess(normally zero) of the amount realized on the disposition over the adjusted basis of the stock.

HOW DO NQSOS WORK, AND HOW DO THEY BENEFIT HOSPITAL EMPLOYEES?

Non-Qualified Stock Options (NQSOs) are options that do not satisfy the requirements for anISO or options not granted under a qualified employee stock-purchase plan. Most hospitalemployee options fit into this category.

When an NQSO is granted to an employee, there is no tax effect at the time of the grant,assuming the option does not have a readily ascertainable fair market value. When a NQSO has areadily discernable FMV, the employee must include it as income for the year received. Almostall employee options are nontransferable and therefore they are not considered to have a readilyascertainable value. Upon exercise of the option the employee will usually recognize income tothe extent of the difference between the fair market value of the stock and the option price.However, if the stock received on exercise of the option is subject to a substantial risk offorfeiture, no gain is recognized until the risk lapses. Any future appreciation realized on thestock will be taxed as capital gain at the time the stock is sold. The hospital receives a taxdeduction equal to the amount of the gain recognized by the employee on option exercise.

ECONOMIC BENEFIT OF NONQUALIFIED STOCK OPTION

Example: Dr. Hilary is granted an option to purchase $50,000 of her hospital employer’s stockat a price equal to the fair market value of the stock at the date of grant. The economic benefit ofthe NQSO is shown in the following table.

FMV of stock when option granted $50,000Years until option exercised 3 5 10Value when exercised (assume a 10%increase per annum) $66,125 $87,450 $175,894Cost of shares –50,000 –50,000 –50,000


Compensation element $16,125 $37,450 $125,894Income tax due on compensation* –4,838 –11,235 –37768Economic benefit remaining** $11,287 $26,215 $ 88,126

* 30% marginal tax bracket **Value when exercised – Cost of shares – Income tax due oncompensation

Greater flexibility in the pricing, permissible time of exercise, employment status, and othermatters is possible with an NQSO than with an ISO or an option granted under a qualifiedemployee stock-purchase plan.

For example, an NQSO could be offered that would permit the grantee to purchase stock at aprice of $5 per share even though the stock was worth $10 a share at the date of the grant of theoption. The option could be granted to a consultant who was not an employee, and the optioncould be exercisable for a period in excess of 10 years. None of these terms would be possiblewith an ISO.

Some companies will grant a “discounted stock option,” under which the exercise price isintended to be substantially below the value of the stock at the time of grant. When used, thisform of option is typically offered to officers or directors in lieu of bonuses or directors’ fees.

For example, suppose the directors’ fee for a company was $10,000 per year and the company’sstock was selling at $100 per share. At the beginning of the year, the director might be offeredthe choice of the customary $10,000 directors’ fee, or an option to purchase 100 shares ofcompany stock at $5 per share. The advantage to the director of the option is that, assuming noconstructive receipt, there will be a deferral of recognition of income until the option isexercised.

IS A HOSPITAL ISO MORE ADVANTAGEOUS THAN AN NQSO?

The difference in tax treatment between an ISO and an NQSO can be crucial in determiningwhich stock option is more advantageous to an employee.

For a designated amount of shares, an ISO is usually more beneficial to a hospital employee thanan NQSO. The employee can defer recognition of all gain until he or she sells the shares and canreport all his or her gains at long-term capital-gains rates. The following table shows how an ISOusually provides a greater advantage than an NQSO to an employee exercising the option.

FMV of stock when option granted $50,000Years until option exercised 2 4 9Value when exercised $57,500 $76,044 $152,951Economic benefit remaining*ISO (see Example, Planning Issue 17) $12,900 $29,960 $ 100,697NQSO (see Example, Planning Issue $11,126 $25,841 $ 86,867


18)Difference $ 1,774 $ 4,119 $ 13,830

*Value when exercised – Exercise cost – Income tax due on sale

Note that in the above example the ISO had an option price equal to the fair market value at thedate of grant.

If the employer is willing to set the option price substantially below the fair market value at thedate of the grant of the option, the NQSO may be more beneficial, notwithstanding the less-favorable tax treatment.

The following table shows how an NQSO involving a deep discount in the price of the stock maybe to the employee’s advantage:

FMV of stock when option granted $50,000Years until option exercised 2 4 9Value when exercised $57,500 $76,044 $152,951Cost of exercising option –25,000 –25,000 –25,000Compensation element $32,500 $51,044 $127,951Income tax due on compensation –10,075 –15,824 –39,665Economic benefit remaining $22,425 $35,220 $ 88,286

Because corporate tax rates are presently higher in general than individual tax rates, there may bea net tax advantage to the corporation and the employee to using an NQSO over an ISO. Becausean employer gets no tax deduction for the ISO, the employer may be willing to grant NQSOsconsisting of more shares after considering the after-tax cost of the program.

Example: Healthorama Corporation, (a C corporation), grants an NQSO to its employee, Alex,entitling him to purchase 1,000 shares of stock at $10 per share, the current price of the stock.Healthorama simultaneously grants an ISO to another employee, Beth, entitling her also to buy1,000 shares of Healthorama stock at $10 per share. A year later, the stock rises to $20 per shareand both Alex and Beth exercise their options in full, receiving $20,000 of stock (not subject to arisk of forfeiture) for $10,000. Alex will recognize $10,000 of ordinary income at that time(taxable at 27%), and Healthorama will be entitled to a $10,000 deduction (at its 34% rate). Thusthere is a net aggregate tax savings of $700 (Alex’s tax of $2,700 minus Healthorama’s tax of$3,400).

If Healthorama were to give $3,857 to Alex as a bonus (enough to pay Alex’s $2,700 tax costsand the additional tax cost to Alex of the bonus), Healthorama would have a total net tax savingsof $4,711 (34% of 3,857 = 1,311, 3400 +1,311 = 4,711). Alex would have no net loss (except forthe issuance of the stock), and he would pay no net taxes. In contrast, Beth will not recognizeany income at the time of exercise, and Healthorama will have no deduction. Subsequentappreciation in Healthorama’s stock will be treated as a capital gain to either Alex or Beth ondisposition of the stock, assuming that Beth holds the stock at least a full additional year andmeets the other requirements for an ISO.


However, Alex’s basis will be $20,000 (the $10,000 paid and the $10,000 recognized as ordinaryincome when the option was exercised), and Beth’s will be $10,000 (the $10,000 paid). Thus, ifthe stock acquired through exercise of NQSO is sold at $20,000, no further gain will berecognized.

HOW ARE EXERCISES OF HOPSITAL STOCK OPTIONS FUNDED?

The holder of a stock option may encounter financial difficulty in exercising the option andholding the stock. Unless the exercise price is nominal, the employee will need funds to purchasethe stock, and, if the option is an NQSO, there will be a need for cash to pay the tax on thetaxable income in the year of exercise.

The optionee could sell the stock immediately following the exercise of the option under a so-called cashless exercise and sell program. Using this method, an optionee finances the exerciseof an option and sells the underlying shares on the same day. By using the optionee’s exercisenotice as collateral, a brokerage firm can finance the exercise of the option, plus any applicablewithholding taxes. As an alternative, the optionee may sell only the number of shares required tocover the costs of the exercise (including withholding taxes and brokerage fees).

The immediate sale of the stock acquired by exercising the option is normally undesirable fromthe employer’s viewpoint, since the employer wants the employee to continue to have the equityinterest. Instead, the company might permit the employee to pay the option exercise price withstock already owned, but then grant the employee additional options equal to the number ofshares tendered and at an exercise price equal to the value of the stock at the time of such tender.

Suppose an employee owned 1,000 shares of the company and had been granted an option topurchase 500 more shares at $10 per share. When the price is $30 per share, the employeeexercises the option. The exercise price is paid by transferring 334 shares to the employer. Theemployer issues the 500 shares resulting from the option and grants an additional 334 shares tothe employee, exercisable at $30 per share. This takes the cash bite out of exercising the option(assuming the employee already owns shares) but permits the employee effectively to retain thesame equity interest as before. However, it also reduces the potential for the employee to gain onthe stock, since the employee will end up with fewer shares than if he or she had used cash toexercise the option.

If an optionee does not have other employer stock available to use in exercising the option, anemployer could simply allow the employee to surrender a portion of the option grant asconsideration for exercising the remaining shares. This option reduces the potential gains on thestock by reducing the total number of shares held by the employee. An alternative to this method,which is conceptually the same, is the use of stock appreciation rights (SARs) issued in tandemwith options.

SARs can be granted in connection with stock options. If the SARs are granted in connectionwith a stock option, cash received on the exercise of the SARs will help the employee pay for thestock when he or she exercises the options.


For example, a key hospital employee might be granted an NQSO to buy 1,000 shares of stockand SARs on another 1,000. The SARs would entitle the employee to be paid by the companythe difference between the fair market value of those shares at the time of exercise of the SARs,over the fair market value of the stock at the time the SARs were granted, or, to receive thatamount in shares of company stock. Thus, if the stock option and SARs both were granted whenthe stock is $10 per share, and the NQSO is exercised when the fair market value is $25 pershare, the key employee will have to provide $10,000 to purchase the stock and then must paytax on ordinary income of $15,000. By exercising the SARs and electing to take $15,000 cash(which will also be taxable), the employee will be better able to afford the cash-flow problemscaused by purchase of the stock and the payment of taxes and will, therefore, be more likely tohold the stock.

Sometimes when a stock option and SARs are issued together, the exercise of the SARs isautomatic on the exercise of the stock option, and vice versa. The SARs and the stock optionmay be issued in tandem so that the exercise of the SARs for cash reduces the amount of stockoptions that may be exercised. For example, if SARs for 1,000 units were issued, and therecipient exercised 750, that recipient could purchase only 250 shares of stock through the stockoption. In this case, the SARs can be written to be exercisable in stock, in cash, or in acombination of the two.

The SARs can be issued in conjunction with an ISO (as well as an NQSO) as long as the ISO isnot thereby made subject to conditions or granted other rights inconsistent with an ISO.

In some instances the optionee can finance the exercise of an option and hold the underlyingshares through the use of a margin account with a broker.

Again, the hospital may lend the employee the funds necessary to finance the exercise price andany income-tax withholding requirements. It is important to reiterate that the debt must be fullrecourse and must bear interest.

Finally, a hospital employer can simply give enough cash to the optionee as a bonus to cover thecosts of exercising the option.

WHEN SHOULD HOSPITAL EMPLOYEE OPTIONS BE EXERCISED?

The decision of when to exercise an option depends on whether the employee is going to holdthe stock following the exercise, or is going to sell the stock immediately. If the employeeintends to sell the stock, then he or she should try to time the exercise so that the stock is at itshighest value. If the employee is going to hold the acquired stock for future investment, then heor she should exercise the option as late as possible. The employee thus enjoys all upsidepotential without any investment and has nothing at risk.

There are two exceptions to the general rule. First, if the rate of dividends is sufficient to coverthe financing cost, or is at least equal to other investment returns, then exercise of the optionsmakes sense.


HOW DIVIDENDS CAN AFFECT DECISIONS ABOUT EXERCISING STOCK OPTIONS

NQSO ISOValue of stock $87,450 $87,450Cost of option 50,000 50,000Income tax due on exercise 11,610 0Total cash cost of exercise $61,610 $50,000Annual cost of borrowing at 8% $4,929 $4,000Dividend rate necessary to exceed costs ofborrowing

5.6% 4.6%

Second, if the option is an ISO, the potential application of the alternative minimum tax (AMT)rules may force the employee to stagger the exercise, as shown in the following table.

HOW THE AMT CAN AFFECT STOCK OPTIONS

Regular TaxwithoutExercise

AMT: Exercise1,000 Sharesin Year 7

AMT: Exercise500 Shares inYear 7

AMT: Exercise500 Shares inYear 8

Adjusted gross income $175,000 $175,000 $175,000 $175,000Itemized deductions –28,000 –23,000 –23,000 –23,000Exemptions (4) –10,000 n/a n/a n/aTax preference* n/a 65,653 32,827 41,500AMT exemption amount n/a –28,087 –36,293 –34,125Taxable amount $137,000 $189,566 $148,533 $159,376Tax $41,324 $49,579 $38,089 $41,125AMT due n/a 8,255 none noneTotal tax paid $41,324 $49,579 $41,324 $41,324

*Difference between fair market value and option price at the date of exercise [IRC § 56(b)(3)]

HOW DO HOSPITAL EMPLOYEE STOCK-PURCHASE PLANS WORK, AND HOWDO THEY BENEFIT EMPLOYEES AND THEIR HOSPITAL EMPLOYERS?

An employee stock-purchase plan qualified under Code § 423 allows eligible employees topurchase stock of an employer under special tax rules and favorable prices.

An employee stock-purchase plan is intended to benefit virtually all employees, not justexceptional ones or limited groups. Because the granting of options to purchase employer stockunder an employee stock-purchase plan cannot discriminate in favor of key employees, usuallythe plan will appeal only to an employer who simply wants to provide, as a general benefit ofemployment, the right to buy employer stock, or believes that owning employer stock will act asan incentive to employees to perform well. A hospital employee stock-purchase plan must meet


the following requirements:

Options may be granted only to employees of the employer corporation, or its parent orsubsidiary corporations, to purchase stock in the employer, parent, or subsidiary.

The stockholders must approve the plan within 12 months before or after the date theplan is adopted.

The plan must provide that an employee cannot be granted an option if the employee,immediately after the option is granted, owns 5% or more of the total voting power orvalue of all classes of stock of the employer corporation, or its parent or subsidiary,computed using special attribution rules.

The plan must require that the options be granted to all employees on a nondiscriminatorybasis. However, the options granted to different employees may bear a uniformrelationship to the total compensation or the basic or regular rate of compensation ofemployees. The plan may also provide for a ceiling on the amount of stock to bepurchased by any employee.

The exercise price must be at least 85% of the fair market value of the stock on the datethe option is granted.

The broad participation requirements of employee stock-purchase plans mean that the stock islikely to be widely owned. Problems of marketing the employer stock and the securitiesproblems inherent in issuing shares of stock to a number of employees will probably discourageemployers who do not have an established market for their stock, and who do not want to facethe securities problems related to public trading in their stock. Nonqualified stock options andthe direct transfer of stock are both available to the employer as potentially less cumbersomemeans of obtaining the results of an employee stock-purchase plan. Since a nonqualified plan isnot subject to the restrictions of the qualified plan, normally the main reason for the employerchoosing to implement an employee stock-purchase plan is to gain for the employees thefavorable tax consequences of such a plan and thereby create a widespread base of companystock ownership among employees.

On receipt of an option to purchase stock under an employee stock-purchase plan, the employeedoes not report any income, even though the exercise price of the stock may be less than the fairmarket value at the time; nor will the employee recognize income on the exercise of the optionand acquisition of the stock at a subsequent date. Only on disposition of the stock will theemployee recognize taxable income. As long as the disposition occurs two years or more afterthe date the option is granted to the employee, and the employee has held the stock at least 12months after exercising the option, any profit will be treated as capital gains.

There is a minor exception to this favorable tax treatment. Upon disposition of stock purchasedunder the plan, a portion of the gain will be treated as ordinary income equal to the discount of0% to 15%.


HOW CAN “RABBI” AND SECULAR TRUSTS BE USED TO PROVIDE SECURITYAND TO DEFER INCOME TAX ON NONQUALIFIED DEFERRED COMPENSATIONCONTRACTS AND PLANS?

An employer may establish a nonqualified deferred compensation contract, which can provideneeded tax and retirement advantages and in some cases enable the employer to offer much ofthe practical benefit of stock ownership. Although they lack the tax advantages of tax-qualifiedplans, nonqualified deferred compensation arrangements are used today to retain key employeeswhile often permitting the employer greater flexibility than do qualified plans, which are subjectto participation, vesting, and funding requirements under the Code and Title I of the ERISA.Because they are not necessarily subject to the funding requirements that apply to qualifiedplans, nonqualified deferred compensation arrangements may be an attractive option for newbusinesses with potential but which have limited cash resources.

A traditional reason for establishing a nonqualified deferred compensation plan has been topermit an employee to reduce his or her taxes by deferring payments for service rendered untilsuch time as he or she is in a lower tax bracket.

Nonqualified plans can be found in a variety of forms. They may offer hospital employees anopportunity to elect to defer current compensation or provide for additional deferredcompensation contingent upon the employee’s remaining with the employer for a certain lengthof time, and perhaps on meeting certain performance goals. Benefits under such agreements may,for example, be expressed in specific dollar amounts, correlated with other compensation, orrelated to the value of the employer’s stock. Nonqualified deferred compensation plans mayprovide for retirement payments that supplement retirement income provide by a qualifiedretirement plan—which is particularly important with the increasing cutbacks in such tax-favored plans in benefits for the highly compensated.

Thus, the trade-off for deferral for the employee is that the amounts due from the employerremain subject to some risk.

Rabbi trusts

To help provide some additional security for the hospital employee, and at the same time defertaxation, an employer may establish a so-called Rabbi trust to hold the assets set aside to meet itsobligations under a deferred compensation arrangement. Such a trust simply restricts the use ofthe funds solely to meeting its obligations to the employee, and rights to benefits under the trustcannot be sold, transferred, assigned, or otherwise alienated. However, if the employer should bebankrupt or insolvent, the trust assets will be subject to the claims of the employer’s creditor.

To provide additional security for an employee will result in the arrangement being considered“funded” for tax purposes and therefore taxable to the employee when set aside.

Secular trusts

A secular trust is typically an irrevocable trust designed so that creditors of the hospital


employer, including bankruptcy creditors, cannot attach its funds. Consequently, the employer’scontributions to an irrevocable trust, often means the trust’s earnings are taxable income to theemployee. Benefits are normally payable to the employee upon the occurrence of specific events,such as the passage of a certain number of years, retirement, disability, or death. Because theyprotect against a loss of benefits if the employer becomes insolvent, secular trusts may bepreferred to Rabbi trusts by executives.

If corporate tax rates exceed an individual’s tax rate, and if the employee is regarded as thegrantor of the trust, secular trusts can produce a tax savings in comparison to Rabbi trusts.

For example, if a corporation’s marginal tax rate is 34% and an individual’s marginal tax rate is30%, then for each $1,000 of income that the corporation contributes to the trust, the corporationreceives a deduction of $340 while the individual pays tax of $300. An employer may also payan additional bonus to cover the taxes owed by the individual. The net effect on the corporationis about the same as if it had received no deduction and was in the 34% tax bracket.

In contrast, if a Rabbi trust is used, the corporation does not get a current deduction, but ratherpays tax of $340 on each $1,000 of income. Once the taxpayer includes the contribution in his orher income, the corporation gets a deduction - but until that occurs - the earnings on pastcontributions are taxed at a rate of 34%. If the employee is not treated as the grantor of the trust,the tax results are much less clear. In such cases it is possible that a secular trust will result in agreater total tax burden than a Rabbi trust.

Secular annuities

A secular annuity is an alternative to a secular trust. One approach that is sometimes used is forthe hospital to purchase single-premium deferred annuities to fund executive benefits that accrueduring the year. The executive receives ownership of the annuity, and income earned on amountscontributed to secular annuities is postponed until such amounts are distributed.

A hospital employee is taxed on the value of the annuity contract when his rights under thecontract are no longer subject to a substantial risk of forfeiture. [IRC § 403(c)] Although theemployee is taxed on the amount of premium payments made by the employer, the employer canmake supplemental cash payment to cover the tax. If the rights of an employee becomesubstantially vested, the value of the annuity contract on the date of the change is included in theemployee’s gross income.

Employee Benefits Liability Insurance

As we have seen, virtually each medical practice, hospital or healthcare facility has employeenon-cash benefits in addition to their payroll. These benefits usually include group insuranceand some form of retirement plan (403(b), for example).

However, each of these benefit packages exposes the employer to liabilities under state andfederal statutes. Employee Benefits Liability Insurance covers an employer, or if so stipulatedby some policies, the employees who act on behalf of the employer, against liability claims


involving alleged errors or omissions, or improper advice or administration of the employeefringe benefit plans.

For example, an employer may be liable for not enrolling an employee on a timely mannerresulting in no medical coverage. Frequent litigation also arises out of violations of theEmployee Retirement Income Security Act (ERISA) of 1974. Since 1974, the provisions andreach of this Act has become massive and errors can occur.

Assessment

Voluntary Health Benefits Market by Seller:

Benefits Brokers 55% Career Agents 21% Traditional Worksite Brokers 14% Enrollment Companies 8% Occasional Producer 2%

Source: Employee Benefit Advisor, March 2013

CONCLUSION

This chapter examined hospital employee benefits from the perspective of all stakeholders. Ifavailable, from a public hospital, stock options allow employees to benefit from appreciationwithout having to expend cash to purchase shares upon receipt.

COLLABORATE: Discuss this chapter online with others at: www.MedicalExecutivePost.com

Acknowledgements: To the late LaVerne L. Dotson JD CPA; Thomas P. McGuiness; CPA,CVA of Reimer, McGuinness & Associates, PC in Houston, TX and Thomas Bucek CPA CVAin Houston, Texas.

SAMPLE NEW PHYSICIAN LETTER OF EMPLOYMENT INTENT

Dear Dr. [Name of Physician]

On behalf of [Name of medical practice or clinic] (hereinafter called the “practice”), this lettersets out a proposed agreement for your initial employment in Dr. [Name of physician]’s medicalpractice. After both you and Dr. [Name of physician] have agreed upon all issues related to youremployment, a formal physician employment agreement will be prepared for your review andsignature.

1. Term: You will be an employee of the practice for an initial [Duration]-month period starting[Month, Date, Year]. Should you and the practice want to proceed past this initial employmentperiod, an offer of co-ownership may be made to you as described in item nine below.


Your employment with the practice will essentially be “at will,” since you or the practice mayvoluntarily terminate it at any time upon 30 days’ written notice to the other. However, thefollowing are conditions under which the practice may terminate your employment immediately:(a) upon your death or disability for three (3) consecutive months; (b) upon the suspension,revocation, or cancellation of your right to practice medicine in the State of [State]; (c) if youshould lose privileges at any hospital at which the practice regularly maintains admissionprivileges; (d) should you fail or refuse to follow reasonable policies and directives establishedby the practice; (e) should you commit an act amounting to gross negligence or willfulmisconduct to the detriment of the practice or its patients; (f) if you are convicted of a crimeinvolving moral turpitude, including fraud, theft, or embezzlement; and (g) if you breach any ofthe terms of your employment contract.

2. Compensation: Your salary for the initial 12-month period will be $[dollar value] and $[dollarvalue] in the second 12-month period, each year payable in monthly installments. You will alsobe entitled to an incentive bonus calculated as follows: [Percentage] % of your collectedproduction when such collections exceeds $[dollar value] in the first year and $[dollar value] inthe second year. The bonus each year will be calculated and paid on a semiannual basis. You willalso be entitled to receive a one-time signing bonus of $[dollar value] if you sign youremployment contract before [Month, Date, Year].

A portion of your compensation may be paid for by proceeds received from [Name of hospital]under the terms and conditions of a hospital recruitment agreement. The parties to this agreementwill be the hospital and the practice only. However, forgiveness of any advances made by thehospital will be directly contingent upon the length of time you remain with the practice.Therefore, should your employment terminate for any reason, the practice will require you torepay to it any amounts the practice repays the hospital, in no matter what form, per the termsand conditions in the hospital recruitment agreement. [Note: Use this if the practice signs ahospital recruitment agreement with the hospital.]

3. Benefits: In addition to your base compensation and incentive bonus, the practice will pay for thefollowing: (a) health insurance, (b) malpractice insurance, (c) continuing medical education(CME) costs, (d) medical license fee, (e) board certification exam fee, (f) reasonable cellularphone costs, and (g) a pager. You will also be entitled to a moving cost allowance for relocatingto [Location.] You will be entitled to two weeks of paid vacation, 10 working days as paid sickleave, and four days paid time off for CME or the board certification exam.

4. Disability Leave: In case of absence because of your illness or injury, your base salary willcontinue for a period not exceeding 30 days per calendar year, plus any unused vacation time andsick leave. You will be entitled to any incentive bonus payments that may be due to you ascollections are received on your prior production. Absence in excess of 30 days would bewithout pay. Unused sick leave cannot be carried over to succeeding years, nor will it be paid forat any time.

5. Exclusive Employment: As an employee, you will be involved full-time in the practice and youmay not take any outside employment during the term of your employment agreement without


the practice’s written approval. However, you will be entitled to keep compensation fromhonorariums, royalties, and copyrights if approved by the practice in writing. If the practice doesnot give approval, then the income from such activities shall remain the property of the practice.

6. Termination Compensation: Should your employment terminate for any reason, you will beentitled to accrued but unpaid base compensation, earned but unpaid incentive bonus, and unusedvacation leave.

7. Non-Solicitation: During the course of your employment, the practice will introduce and makeavailable to you its contacts and referring physician relationships, ongoing patient flow, generalhospital sources, business and professional relationships, and the like. Since you have not been inprivate practice in the area previously, you acknowledge that you currently have no establishedpatients following you. If there should be a termination, the practice will not restrict your abilityto practice medicine in the area; however, it will require you to enter into a nonsolicitationagreement in which you agree not to solicit the employees of the practice nor its patients tofollow you into your new medical practice. [Note: Insert Covenant Not to Compete here, ifapplicable.]

8. Employee-Only Status: During the term of your employment, you will not be required tocontribute any money toward the practice’s equipment or operations, but likewise your work willgive you no financial interest in the assets of the practice. However, the practice intends to offeryou the opportunity to buy into the ownership of the practice as set forth in item 9 below.

9. Ownership Opportunity: At the end of your employment period, the practice will evaluate yourrelationship and may offer you the opportunity to become a co-owner in the practice (or enterinto an office-sharing relationship). This offer is not mandatory and is at the total discretion ofthe practice. Should an offer not be tendered for some reason, the practice will wait until the endof your next 12-month employment period to decide whether to tender an offer of co-ownership.If an offer of co-ownership is made, Dr. [Name of physician] will discuss with you thefollowing: (a) what percentage of the practice you will be allowed to acquire, (b) how best tovalue such interest, and (c) how you will pay for the acquisition of such interest. The practicehopes to achieve mutually agreeable solutions to these ownership issues.

We hope this offer meets with your approval. If so, please contact Dr. [Name of physician] assoon as possible. This letter is not intended to be a legally binding agreement; it is, rather, a toolto be used to prepare your formal physician employment agreement. If you should have anyquestions, please do not hesitate to contact myself or Dr. [Name of physician] at yourconvenience.

Sincerely,

Atlantic Physicians GroupMEDICAL GROUP PRACTICE, LLCLantana FLA

THE END

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