Deferred Compensation Arrangements for Tax-Exempt Hospital Executives

A strong compensation package is an important tool for recruiting and retaining top talent, but tax-exempt hospitals are limited in the types of compensation they can offer in light of a number of practical and legal limitations.  These include:

• Excise taxes for compensation paid in excess of $1,000,000 under Internal Revenue Code (“Code”) Section 4960.
• Excise taxes on executives, directors, and trustees under the intermediate sanction rules of Code Section 4958 and the potential loss of tax-exempt status due to private inurement in the event more than reasonable compensation is paid to executives.
• The inability to offer equity-based options (e.g., stock options and restricted stock).
• The public disclosure of executive compensation amounts and practices on the Form 990, subjecting the compensation to scrutiny and potential public criticism.

While each of these issues must be carefully considered when determining the amount and type of compensation package a tax-exempt hospital will offer its executives and highly-paid staff members (such as physicians), this article focuses specifically on deferred compensation arrangements available to tax-exempt hospitals.

Tax-exempt organizations may offer Section 457(b) plans and/or 457(f) plans.  (Note: specific rules apply for 457 plans offered by governmental entities; this article focuses on the rules applicable to tax-exempt employers.)  Both plan types must be “unfunded,” meaning the benefits are paid out of the employer’s general assets (unlike, for example, a 401(k) or 403(b) plan, where the benefits are paid out of a trust protected from creditors).  In light of this requirement, Section 457 deferred compensation plans may not be offered to employees on a broad basis because, under the Employee Retirement Income Security Act of 1974 (“ERISA”) – which applies broadly to any employer-sponsored benefit plan or program offered to one or more employees – retirement plans must be “funded” by a trust and protected from creditors.  That said, certain “top hat” plans providing deferred compensation to only a select group of management or highly compensated employees are exempt from this requirement.

Section 457 plans are complex, but employers generally have wide latitude to structure the plan to best meet their (and their executives’) goals. 

Section 457(b) Plans

Section 457(b) plans are similar to traditional Section 401(k) (or 403(b)) plans in that compensation deferred under the plan – and income on those amounts – are not included in the employee’s income until paid (typically, upon retirement).  Contributions to 457(b) plans are subject to an annual cap: for 2025, the limit is $23,500, which includes both employee and employer contributions.  But for employers that offer both a 457(b) plan and another, “qualified,” retirement plan (such as a 401(k) or 403(b) plan), nonprofit executives are able to defer double the amount of taxable income as retirement savings when compared to employees of a for-profit company.

Section 457(f) Plans

Section 457(f) plans offer greater flexibility than 457(b) plans in that there is no limit to the amount that may be deferred, but only employers may contribute to a 457(f) plan.  However, taxes may not be deferred under a 457(f) plan beyond the time the benefits “vest.”  In other words, compensation deferred under a 457(f) plan is subject to tax in the year that the compensation vests (i.e., is no longer subject to a “substantial risk of forfeiture”), even if the benefit is not paid until later.  Section 457(f) plans must accordingly be carefully structured to avoid adverse tax consequences to the executive in the year in which the benefit vests.

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Ultimately, a Section 457 plan can add significant value to a tax-exempt hospital’s total benefit package for its executives and highly paid employees, but the plan must be carefully drafted to comply with the rules under Code Section 457(b) or (f), as applicable.  Further, the hospital must consider the potential practical concerns and tax implications of offering a 457 plan.  Baird Holm’s Health Care team and Employee Benefits team frequently work together to ensure tax-exempt organizations are considering all of these implications.