Hospital Employee Benefits Guide

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 Marcinko
Perry D’Alessio
This chapter examines hospital employee benefits and equity participation, both from the
healthcare organization employer, and employee perspectives. Employee benefits include
employer payment of personal expenses on behalf of employees, as well as methods for
deferring 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 employer
securities without having to deplete cash resources to purchase shares at the time appreciation
begins.
Introduction
When selecting an employer, understanding the value of the benefits offered is critical. Just
because one employer may offer a higher salary doesn’t mean they are offering more total
compensation than other options.
Case Model Example:
So, let’s explore the value of benefits received by a hypothetical 60 year-old hospital based
respiratory 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 in
2012-13.
HOW MUCH ARE EMPLOYER BENEFTIS WORTH?
Payroll Taxes
The value of some benefits is easier to calculate than others. For instance, regardless of your
income, 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 your
income, so you pay 7.65% and your employer pays 7.65% [6.2% for the Social Security portion
and 1.45% for Medicare].
NOTE: This had been reduced by 2% to 4.2% over the past few years as part of a payroll tax
holiday to help with the economic recovery. All of the fiscal cliff discussions did not address this
and the rate has reverted back to what it was 2 years ago.

Social Security
The first $113,700 of wages is taxed at 6.2% for Social Security. Anything above this amount is
not taxed.
Medicare Tax
This is taxed at 1.45% of wages and there is no wage base limit.
New in 2013
Employers must withhold a 0.9% additional Medicare from wages paid to an employee in excess
of $200,000 in a calendar year if single and $250,000 if married. Employers are required to begin
withholding additional Medicare Tax in the pay period in which wages in excess of $200,000 are
paid to an employee and continue to withhold it each pay period until the end of the calendar
year.
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 their
7.65% portion of the payroll tax. Of course, the actual dollar amount they contribute will
increase as your salary rises. Alternatively, self-employed individuals are required to pay almost
the full 15.3% payroll tax themselves, (less a modest reduction, and a deduction for half the self
employment tax as an adjustment to income.) In comparison, a halving of the payroll tax is a
significant 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% of
the 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 days
for vacation, five paid sick days, and seven paid holidays, you get a total of 22 paid days off per
year. 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 days
you don’t work.
Health Care
Notwithstanding the PP-ACA, some benefits, like health care, are much less predictable. Of
course, not all employers offer health care, and it is difficult to determine the value of any
benefits offered. However, according to ehealthinsurance.com, our 60 year-old married
individual with two kids could purchase a health care plan from Select Health with a $1,000
deductible per individual and $2,500 deductible per family for $1,243 per month or $14,916 per
year. 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 cost
effective. Assuming the employer provides life insurance equal to two times your salary, they
would provide $102,034 of coverage. On intelliquote.com, we found a company willing to
provide 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 to
approximately 50% of your salary. On Mutual of Omaha’s website, we found that a long-term
disability policy providing a $2,000 per month benefit (47% of salary) after a 60-day elimination
policy 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 benefits
provided by the employer represent approximately 30% of compensation. This example is
typical – the U.S. Department of Labor reports that benefits are worth 30% of an average
employee’s total compensation.
Clearly, benefits can amount to a significant portion of compensation and should be closely
analyzed 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 a
little 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 employers
typically 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 in
the 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 include
payments for health care insurance, payment to a fund that provides accident and health benefit
directly to the employee, company direct reimbursements for employee medical expenses and
contributions 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). This
saves the employer 7.65% that would otherwise be the “matching” 6.2% Social Security tax and
the 1.45% Medicare Tax components due if these were true wages. The employer also saves the
0.8% FUTA tax, but since FUTA taxes only the first $7,000 of calendar year wages, per
employee, this usually doesn’t factor in.
Calculation:
If you pay the full state unemployment tax, then your FUTA tax = Gross Salary * .08% – The
maximum 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 marginal
tax 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 each
year.
IRS restrictions include:
 Certain payments to S Corporation employees who are 2% shareholders are subject to
FICA 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 who
received this amount in cash each year and then paid for his or her own medical coverage would
be 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 insurance
premiums paid by the employer on the employee’s life if the policy proceeds are payable to a
beneficiary named by the employee. However, the cost of providing group term life insurance on
an employee’s life up to $50,000 is excluded from the employee’s gross income. The cost of any
amount over $50,000 provided by the employer is included in the employee’s income. The
amount excludable under this provision for an employee 60 years of age is approximately $500
per 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, $2,500
for 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. The
expenses 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 federal
identification number described on employee’s income tax return or the pretax amounts will be
added back to income on the income tax return level. This can be for a current employee, a sole
proprietor, a leased employee and a partner that performs services for a partnership. It excludes
highly 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 employer
on the business premises of the employer, may be excludable from the gross income of the
employee. Usually lodging is as a condition of employment where the employee must live on the
premises 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, the
maximum credit for adopting a child with special needs is $12,970. The special needs adoption
credit, which typically applies to harder-to-place children, including children in foster care, can
be claimed regardless of your actual adoption expenses. The maximum credit for other adoptions
is 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 you
won’t get a check in the mail for any leftover credits. Also, this credit begins to phase out with a
modified 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 of
such 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-qualified
plan 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. S
Corporation employees who are 2% shareholders are excluded.
Educational assistance
Up to $5,250 of employer paid, qualifying educational assistance can be excluded from the
employee’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 an
employee with assistance exceeding $5,250, you can exclude the value of these benefits from
wages if they are working condition benefits. Property or a service provided is a working
condition benefit to the extent that if the employee paid for it, the amount paid would have been
deductible as a business or depreciation expense.
Qualified employee discounts
Companies can provide discounts on goods and services to employees and exclude the value of
these from gross income. This is limited to 20% of non-employee charges for the same services
and 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 planning
services to the employee and his/her spouse. Advice may include non-employer retirement
issues 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, traditional
holiday gifts of property with a small fair market value, or occasional theater or sporting event
tickets. 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 an
employee: (1) transportation in a commuter highway vehicle if such transportation is in
connection 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 certain
military 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 is
considered taxable to the recipient. It is included in wages for withholding and employment-tax
purposes, at the excess of its fair market value over any amount paid by the employee for the
benefit.
For example, hospitals often provide automobiles for use by employees. Treasury regulations
exclude 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 policy
statement of the employer
 Vehicles not available to an employee for personal use other than commuting (although
in this case commuting is includable)
 Vehicles used in connection with the business of farming [in which case the exclusion is
equal to the value of an arbitrary 75% of the total availability for use, and the value of the
balance 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 minimus
amount 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 the
employee is required to report his personal use as a taxable benefit. The value of the availability
for personal use may be determined under one of several approaches. Under any of the
approaches, the after-tax cost to the employee is substantially less than if the employee used his
or her own dollars to purchase the automobile and then deducted a portion of the cost as a
business 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 for
the 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 employer
reimburses him 34.5 cents per mile for the business-related miles. As a result, the business use of
the 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 employer
9.25 cents per mile ($7,000 – $5,520 = $1,480, $1,480 /16,000 = 9.25 cents). Kurt’s total cost of
ownership 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, pickups
or 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 the
employee 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 economic
benefits currently without having to pay taxes until a later taxable year. Furthermore, some of
these arrangements may even provide for a lower taxation rate at that time. These types of
benefits are not totally excludable from income forever, as are those listed in the first two
sections. 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 of
the formal requirements of these plans are similar. These plans are often referred to as “qualified
retirement 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 held
and accumulated for the benefit of plan participants. The distribution of the funds to a participant
normally 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 of
distribution may be a lump-sum payment of all of the employee’s benefits, an installment
payment over a number of years(usually 10 to 15), an annuity that provides payments over the
employee’s and/or spouse’s lifetime.
The extremely favorable tax consequences of qualified retirement plans are the reason for their
popularity. When the hospital makes a contribution on the employee’s behalf to the qualified
plan, the employer receives a deduction for the amount contributed; however, the employee will
not have to report the contribution as income until the funds are finally distributed. Contributions
to the trust or other qualified fund are accumulated tax-free. Distributions are taxable, but the
recipient is generally in a lower marginal tax bracket during retirement than when contributions
to the retirement plan were made. This treatment is a truly startling departure from the normal
practice under the Code.
The following examples demonstrate how the tax-free accumulation of income (contributions
and interest) offers the employee great advantages, even if his or her tax rates are the same at the
time 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 the
percentage he decides to apply to the plan each year, the following table shows the total
economic benefit of the deferral he can expect after 10 years:
Tax-Free Compounding
Years of deferral 5
Annual investment return 8%
Years of compounding 10
Tax rate 30%
% of salary deferred 5% 10% 15%
Amount of deferral per year $ 7,500 $ 15,000 $ 22,500
Total deferred $37,500 $ 75,000 $112,500
Value at end of 10 years $64,650 $129,299 $193,949
Income tax due on receipt
19,39 38,790 58,185
Value remaining 45,255 90,509 135,764
Value remaining, if $ not deferred
(tax paid on receipt and on
investment earnings) 38,554 77,107 115,661
Economic 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 a
stable investment.
Deferral arrangements (retirement plans) using employees’ salaries to supplement employer-
funded qualified plans have become increasingly popular. Such plans are commonly called
401(k) plans, after the section of the Code that defines them. Under these plans, an enrolled
employee is permitted to make an elective deferral of a portion of their compensation, or part or
all of a year-end bonus, and have the employer contribute such amounts to the plan, rather than
receiving them directly. If made within the statutory limits, the amounts are not included in the
employee’s income and the earnings from investment of such contributions accumulate tax free
until distributed to the employee. Thus, in addition to employer contributions, the employee can
get all the qualified benefits on a portion of his or her own salary. These salary deferral
arrangements are obviously voluntary and are subject to severe restrictions. See the more
detailed 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 not
to owners of medical clinics, etc. Thus, S Corporation employee/shareholders, and sole
proprietors, 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 medical
expense 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 total
medical expenses, including the 70% allowable for health care insurance premiums, falling
beneath the 7.5% AGI threshold produce no tax benefits. Additionally, the total allowable
itemized deductions must exceed the IRS standard deduction to produce tax benefits. Third;
allowable itemized deductions on Schedule A phase out with higher AGI.S Corporation
employees 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 of
taxing certain fringe benefits. Regular rules apply to holders of smaller ownership interests, as
well as to all common-law employees. The following fringe benefits provided by an S
corporation are taxable under these special rules, and the affected shareholder must pay for them
with 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 fringe
benefits, such as no-additional-cost services or qualified employee discounts, are not subject to
any 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 stock
they own.
Key Hospital Employees
Effective January 1st 2014, the limitation on the annual benefit under a defined benefit plan
under Section 415(b)(1)(A) is increased from $205,000 to $210,000. For a participant who
separated from service before January 1st 2014, the limitation for defined benefit plans under
Section 415(b)(1)(B) is computed by multiplying the participant's compensation limitation, as
adjusted through 2013, by 1.0155.
The limitation for defined contribution plans under Section 415(c)(1)(A) is increased in 2014
from $51,000 to $52,000.
The Code provides that various other dollar amounts are to be adjusted at the same time and in
the same manner as the dollar limitation of Section 415(b)(1)(A). These dollar amounts and the
adjusted amounts are as follows:
 The limitation under Section 402(g)(1) on the exclusion for elective deferrals described in
Section 402(g)(3) is increased to $17,500.
 The annual compensation limit under Sections 401(a)(17), 404(l), 408(k)(3)(C), and
408(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 key
employee 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 account
balance in an employee stock ownership plan subject to a 5-year distribution period is
increased from $1,035,000 to $1,050,000, while the dollar amount used to determine the
lengthening of the 5-year distribution period is increased from $205,000 to $210,000.
 The limitation used in the definition of highly compensated employee under
Section 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 an
applicable employer plan other than a plan described in Section 401(k)(11) or
Section 408(p) for individuals aged 50 or over is increased from $5,000 to $5,500. The
dollar limitation under Section 414(v)(2)(B)(ii) for catch-up contributions to an
applicable employer plan described in Section 401(k)(11) or Section 408(p) for
individuals aged 50 or over remains unchanged at $2,500.
 The annual compensation limitation under Section 401(a)(17) for eligible participants in
certain governmental plans that, under the plan as in effect on July 1, 1993, allowed
cost-of-living adjustments to the compensation limitation under the plan under
Section 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 employee
pensions (SEPs) is increased from $500 to $550.
 The limitation under Section 408(p)(2)(E) regarding SIMPLE retirement accounts is
increased from to $12,000.

 The limitation on deferrals under Section 457(e)(15) concerning deferred compensation
plans 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 Regulations
concerning the definition of “control employee” for fringe benefit valuation purposes is
increased from $100,000 to $105,000. The compensation amount under
Section 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 the
cost-of-living adjustment under Section 1(f)(3). These dollar amounts and the
adjustments are as follows:
 The adjusted gross income limitation under Section 25B(b)(1)(A) for determining the
retirement savings contribution credit for married taxpayers filing a joint return is
increased from $35,500 to $36,000; the limitation under Section 25B(b)(1)(B) is
increased from $38,500 to $39,000; and the limitation under Sections 25B(b)(1)(C) and
25B(b)(1)(D), from $59,000 to $60,000.
retirement savings contribution credit for taxpayers filing as head of household is
increased from $26,6250 to $27,000; the limitation under Section 25B(b)(1)(B) is
increased from $28,875 to $29,250; and the limitation under Sections 25B(b)(1)(C) and
25B(b)(1)(D), from $44,250 to $45,000.
retirement 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 the
deductible amount of an IRA contribution for taxpayers who are active participants filing
a joint return or as a qualifying widow(er) is increased from $95,000 to $96,000. The
applicable dollar amount under Section 219(g)(3)(B)(ii) for all other taxpayers (other
than married taxpayers filing separate returns) is increased from $59,000 to $60,000. The
applicable dollar amount under Section 219(g)(7)(A) for a taxpayer who is not an active
participant 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 determining
the maximum Roth IRA contribution for married taxpayers filing a joint return or for
taxpayers filing as a qualifying widow(er) is increased from $178,000 to $181,000. The
adjusted gross income limitation under Section 408A(c)(3)(C)(ii)(II) for all other
taxpayers (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 received
favorable determination letters should not request new determination letters solely
because 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 the
employer are not taxable to the employee. In effect, the employee pays for the benefits with
before-tax dollars. They remain non-taxable even though the employee could have elected to
receive those amounts in cash. An additional benefit for both employee and employer is that
nontaxable cafeteria plan benefits are not subject to FICA taxes, thus saving 7.65% on amounts
that would otherwise be under the Social Security wage base. However, if the employee does not
use 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 choose
among two or more benefits. In particular, the employee may “purchase” non-taxable benefits by
forgoing taxable cash compensation.
This ability of participating employees, on an individual basis, to select benefits fitting their own
needs, and to convert taxable compensation to non-taxable benefits, makes the cafeteria plan an
attractive means of offering benefits to employees. Other qualified employee benefits, described
above, 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 and
accident benefits in a tax-free form, rather than paying them with after tax money. Note there is
the potential draw back of employees thinking of health care benefits as an implicit condition of
employment instead of true non-cash compensation.
Because of increases in healthcare costs, employers are not always willing or able to provide
coverage for all of an employee’s medical expenses. This means many employees must often pay
for a portion of their medical costs under a co-pay provision. If an employee is fortunate, the
employer may establish a cafeteria plan to allow the employee to fund the co-pay healthcare
costs with before-tax dollars.
For example, if an employee must spend $3,000 annually to provide healthcare coverage for his
or her dependents, then the income-tax savings to the employee could be as much as $1129.50
annually, if the employee is in the 30% tax bracket ($900 in income taxes and $229.50 of FICA
taxes). 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 offer
participants a choice between one or more nontaxable benefits, and cash resulting from the
employer’s contributions to the plan or the employee’s voluntary salary reduction. Participants in
cafeteria plans are sometimes given a choice of using vacation days, selling them to the employer
and then getting cash for them, or, buying additional vacation days. Some cafeteria plans also
include 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 salary
reduction agreement or other agreement, is credited to an account and drawn upon to reimburse
the employee for uninsured medical or dental expenses, or for dependent-care expenses. Many
cafeteria 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 the
following.
Healthcare
If the employee is married and has a spouse who also works, and, the employer-provided health
benefits are better under the spouse’s plan, then the employee should elect to be covered by the
spouse’s plan and choose another nontaxable benefit or a cash benefit that would be taxable
under his or her own cafeteria plan, such as dependent-care coverage or group term insurance
coverage. Switching health insurance requires planning t eliminate potential gaps in coverage
created 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 a
401(k) plan and defer the tax liability.
If the employee has no working spouse and the employee’s plan is the only source for certain
health benefits, the employee should consider what type of benefits he or she really needs for his
or her family. In other words, can the employee get the necessary benefits under the company
plan cheaper than he or she could individually, after taking into account that individual coverage
will be paid with after-tax dollars, whereas under a cafeteria plan such benefits can be paid with
before-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 plan
independently for only $3,741 to be in the same position on an after-tax basis. ($6,000 minus
income 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 worth
the same or more than the payment under the cafeteria plan, the employee may choose to
contribute those dollars toward additional health or life insurance.

SHOULD AN EMPLOYEE USE A TAX CREDIT OR EMPLOYER-SPONSORED
BENEFITS TO OFFSET DEPENDENT-CARE COSTS?
A tax credit is available to qualified individuals to help offset expenses, such as child and
dependent-care costs, that enable them to be gainfully employed. The question then arises
whether it is to the employee’s advantage to opt out of any employer-sponsored dependent-care
benefit program and take the tax credit, or vice versa.
As shown above, an employer-sponsored reimbursement plan is usually more advantageous than
the 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 exclusion
under 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 is
generally available to employees of tax-exempt hospital organizations. This also includes entities
organized and operated exclusively for religious, charitable, scientific, public safety testing,
literary, or educational purposes, or to foster national or international amateur sports
competitions, or for prevention of cruelty to children or animals, subject to certain restrictions
prohibiting 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, the
amounts are not included in the employees’ income and the earnings from investment of such
contributions accumulate tax free until distributed to the employee. Although there are technical
differences between 403(b) plans and 401(k) plans, and the limits on the amount that may be
deferred may be different, the effect on the employee is the same. Thus, the same analysis used
by an employee under a 401(k) plan should also be applied to an employee who participates in a
403(b) plan.
INCOME TAXE REDUCTIONS ON RETIREMENT PLAN DISTRIBUTIONS
A hospital employee has alternatives to consider when attempting to reduce income taxes on
distributions from qualified retirement plans. To help understand the choices, an advisor must
understand not only the income-tax implications but also the federal estate-tax implications of
each alternative and the distribution requirements imposed by law.
Generally, all payments received from a qualified retirement plan that are payable over more
than one year are taxed at ordinary income rates. IRS Publication 575, Pension and Annuity
Income, defines the allowed methods for structuring distributions. The five-year averaging
option was repealed in 2002. Distributions are reported to the IRS and the taxpayer via a Form
1099R.
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. Insufficient
withdrawal, 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 payable
over the life or life expectancy of the participant (or the lives or joint life and last-survivor
expectancy of the participant and the participant’s beneficiary), or to distributions made after the
participant has attained age 55, separated from service, and satisfied the conditions for early
retirement under the plan.
Lump-sum distributions from a qualified retirement plan, like when an employee leaves the
sponsoring company, may be rolled over, tax free, by the employee or surviving spouse of the
employee 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 was
expanded to include 403(b) and section 457 deferred compensation plans. This applies to direct
rollovers, where the recipient has no physical control of the funds. 20% with holding is required
on distributions made to employees pending rollover.
Note that for some clients, this may allow a 60-day loan of 80% of their retirement funds. In
addition, distributions of less than the balance to the credit of an employee, as well as
distribution 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 are
not 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 as
possible, assuming the client’s cash flow is sufficient. Under the Economic Growth and Tax
Relief Reconciliation Act of 2001 [EGTRRA], marginal tax brackets dropped. Income taxes are
payable only as and when the benefits are received, so deferring the receipt of benefits means
that the payment of tax is deferred. If the recipient’s income tax liability is deferred, there may
be 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 natural
averaging effect, and may push some income over into retirement years of the beneficiary, when
his or her tax bracket may be lower.
There are still several potential income-tax benefits that are available on rollovers of
distributions to a traditional IRA or Keogh (HR 10) plan because of special rules. Lump-sum
distributions that are rolled over are excluded from gross income for the year in which they are
made. 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 elected
and that only one such election may be made. As a result of the election exemption, a rollover
can 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 would
ordinarily distribute an annuity. For example, an employee who desires an annuity from her
pension plan, and a lump-sum distribution from her profit-sharing plan, could avoid the tax-rate
increase that comes from having to include the value of an annuity in the special 10-year
averaging calculation by taking a lump-sum distribution from the pension plan and rolling it over
into an IRA annuity.
In situations involving multiple lump-sum distributions in the same year from dissimilar plans, or
distributions that might involve a look back calculation, the election exemption may result in
lower overall taxation by rolling over one or the other distribution, thus deferring the tax on the
aggregated lump-sum distribution to subsequent years, when the comparative effective rate
might be lower.
The relative value of a rollover as compared to a lump sum depends first on what the individual
wants 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 the
funds in a short period of time, and will invest it in the same type of assets whether it is rolled
over or taken in a lump sum, then it is appropriate to compare the financial differences between
the two strategies. The table below compares the results of rolling over a distribution to a
traditional 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, if
diversification of the funds is an objective.
It is sometimes advantageous to roll over distributions to a Keogh plan rather than to a traditional
IRA because a subsequent lump-sum distribution from a Keogh plan may qualify for favorable
10-year income tax averaging. Unlike traditional IRAs, Keogh plans are available only to the
self-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, a
Keogh plan rollover may be the best alternative.
In deciding whether a tax-free rollover to a traditional IRA is preferable to the various taxable
options discussed above, retirees should understand that later distributions out of the traditional
IRA do not qualify for either the capital-gains or 10-year averaging rules that apply to lump-sum
distributions 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 averaging
treatment. The amount of distribution is $1,500,000. Since Ron will not need to use the funds for
the next 20 years, he should elect a rollover that will yield annual cash flow of $106,945, instead
of 10-year averaging, which will yield annual cash flow of $72,737.

Distribution amount $1,500,000
Death benefit exclusion 0
Form 1099-R Box 2 (capital gain portion) 0
Form 1099-R Box 9 (current actuarial value) 0
Marginal income tax rate 30.0%
Expected investment return (before taxes) 8.0%
How many years will you need income? 20
Risk tolerance Low
IRA Rollover
Required annual withdrawals $152,778
Less income tax 45,833
Net annual cash flow $106,945
10-Year Averaging
Invested funds after paying income tax $867,790
Net 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 a
conversion is that future earnings on the Roth IRA will be tax free, possibly for future
generations as well. Unfortunately, however, current taxes would be paid on the lump sum when
the transfer takes place. These taxes would reduce the amount of funds available for
reinvestment. 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’s
modified “adjusted gross income” for the tax year exceeds $100,000 or (2) the taxpayer is
married 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 convert
funds in an employer retirement plan to a Roth IRA, taxpayers have generally had to roll the
funds 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 without
using a regular IRA as an intermediary. For this purpose, an eligible plan is a qualified retirement
plan, a section 403(b) tax-sheltered annuity (TSA), or an eligible state and local government
plan.
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 conversion
only 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, a
taxpayer will be able to make the conversion regardless of the level of his or her income – and
regardless 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 an
eligible 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 of
their company has been a significant development in the area of employee compensation and
corporate finance. Though there are many forms of employee ownership, the employee stock
ownership plan (ESOP) has achieved widespread application. The rapid growth in the number of
ESOPs being created has important ramifications for employees, corporations, and the economy
at large.
An ESOP is a special kind of qualified retirement plan in which the sponsoring employer
establishes a trust to receive the contributions by the employer on behalf of participating
employees. The trust then invests primarily in the stock of the sponsoring employer. The plan’s
fiduciaries are responsible for setting up individual accounts within the trust for each employee
who participates, and the company’s contributions to the plan are allocated according to an
established formula among the individual participants’ accounts, thus making the employees
beneficial owners of the company where they work.
Like all qualified retirement plans, ESOPs must be defined in writing. Further, in addition to the
usual rules for qualified deferred compensation plans, ESOPs must meet certain requirements of
the Internal Revenue Code with respect to voting rights on employer securities. In general,
employers that have “registration class securities” (publicly traded companies) must allow plan
participants to direct the manner in which employer securities allocated to their respective
accounts are to be voted on all matters. Companies that do not have registration class securities
are required to pass through voting rights to participants only on “major corporate issues.” These
issues 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 of
Directors, the shares may be voted by the designated fiduciary unless the plan otherwise
provides. In regard to unallocated shares held in the trust, the designated fiduciary may exercise
its own discretion in voting such shares.
As owners, hospital employees may be more motivated to improve corporate performance
because they can benefit directly from company profitability. A growing company showing
significant increases in the value of its stock can mean significant financial benefits for
participating employees. However, because the assets of the ESOP trust are invested primarily in
the 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 corporate
finance. Thus, in addition to the usual tax benefits of qualified retirement plans, studies have
shown that ESOPs provide employers with significant amounts of capital, which often result in
financial benefits far superior to other employee-benefit plans, while employees can share in the
benefits realized through corporate financial transactions. Until January 1, 2003 the employee
did not incur FICA tax on exercised stock options.
ESOPs, like all qualified deferred compensation plans, must meet certain minimum requirements
spelled out in Code § 401(a) in order for the contributions to be tax deductible to the sponsoring
employer. Many employers who set up ESOPs do so not to take advantage of the very substantial
tax incentives they can receive, but rather to provide their employees with a special kind of
employee 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 shares
previously allocated to their account. The employee may then hold or sell them, but for tax
purposes these shares are treated like any other distribution from a qualified deferred
compensation plan; that is, upon distribution of employer stock the employee is not taxed on an
unrealized 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 distributions
from an ESOP that are then put to the employer, the employer (or the ESOP) must pay the fair
market value of such shares to the terminated participant, in substantially equal payments over a
period not exceeding five years. The following table shows how the gain on stock from an ESOP
distribution is taxable when the stock is later sold.
Value of stock when purchased by ESOP $2,500 100 shares x $25/share
Value of stock when distributed $5,000 100 shares x $50/share
Years held after distribution, until sale 3 5 10
Value in later year of sale $6,613 $8,745 $17,589
Gain on sale 4,113 6,245 15,089
Tax on sale (20%) –823 –1,249 –3,018
Value remaining $5,790 $7,496 $14,571
For the purpose of broadening the ownership of capital and providing employees with access to
capital credit, Congress has granted a number of specific incentives meant to promote increased
use of the ESOP concept. These ESOP incentives provide numerous advantages to the
sponsoring employer and can significantly improve corporate financial transactions. Chief
among these incentives is the leveraged ESOP, which provides for a more-accelerated transfer of
stock to employees. The sponsoring employer of a leveraged ESOP can deduct contributions to
repay the principal as well as interest on the debt. This allows the employer to reduce the costs of
borrowing and enhance cash flow and debt financing. The contribution limits are increased for
employers to allow them to repay any ESOP debt.

Employers are also permitted a tax deduction for dividends paid on ESOP stock to the extent the
dividends are paid to employee participants or are used to reduce the principal or pay interest on
an ESOP loan. Certain lenders may exclude from this taxable income 50% of the interest earned
on loans made to ESOPs for the purpose of acquiring shares.
UNDER WHAT CIRCUMSTANCES CAN A SHAREHOLDER DEFER INCOME
TAXES ON THE SALE OF EMPLOYEE SECURITIES TO AN ESOP?
An additional ESOP incentive, provided by the 1984 Tax Reform Act, allows shareholders of a
closely held company to sell their stock to the company’s ESOP and defer all taxes on the gain
from the sale.
In order for shareholders to qualify for this so-called ESOP rollover, the ESOP must own at least
30% of the company’s stock immediately after the sale, and the shareholder must reinvest the
proceeds from the sale in “qualified replacement property”—generally, the stocks and bonds of
domestic operating corporations; government securities do not qualify—within a 15-month
period beginning three months before the date of the sale. The seller, certain relatives of the
seller, and 25% shareholders in the company are prohibited from receiving allocations of stock
acquired through an ESOP rollover, and the ESOP generally may not sell the stock acquired
through a rollover transaction for three years.
An ESOP rollover may be attractive to a selling shareholder for a number of reasons. Normally
the owner of stock in a closely held company may either sell his or her shares back to the
company, if such a transaction is feasible; sell to another company or individual, if a willing
buyer can be found; or exchange a controlling block of stock with another company. Rolling
over the same stock to the company’s ESOP, on the other hand, allows the stockholder to sell all
or only a part of his or her stock and defer taxes on the gain. In addition to the favorable tax
treatment, selling to an ESOP also preserves the company’s independent identity, whereas other
selling options may require transferring control of the company to outside interests. A sale to an
ESOP also provides a significant financial benefit to valued employees and can assure the
continuation of their jobs. In the case of owners retiring or withdrawing from a business, an
ESOP allows them to sell all or just part of the company, and withdraw from involvement with
the business as gradually or suddenly as they like.
Employer securities that can be sold to an ESOP for purposes of the tax-free rollover are
common stock with the greatest voting and dividend rights, issued by a domestic corporation
with 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 received
by the seller in a distribution from a qualified employee-benefit plan or a transfer under an option
or 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 in
the qualified replacement property. If the replacement securities are held until death, however, a
stepped-up basis for the securities is allowed. The tax-free rollover must be elected in writing on
the seller’s tax return for the taxable year of the sale.

Careful documentation of ESOP rollover transactions is required, and the transactions must
conform to regulations developed by the IRS, but if constructed properly an ESOP rollover can
provide 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 stock
may be transferred to hospital employees.
The first and simplest method is a stock bonus, whereby the employer makes an outright grant of
shares to the employee. In this case, the employee immediately owns his or her shares and has
full voting and dividend rights. The employee is taxed at ordinary income rates on the full value
of 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 the
stock. 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 has
essentially 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 conditions
either relating to continued employment for a period of time or attainment of certain performance
goals. 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 support
employee 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 employee
is subject to ordinary income taxation. The amount to be included in income is the excess of the
fair 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 the
stock is trading at $10 per share. The stock is not freely transferable and must be forfeited if the
executive ceases to be employed prior to July 1, 2001. In 2001, the stock is worth $20 per share
and 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 a
substantial 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 sells
the 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 basic
analysis would not change. The executive would simply reduce any total gain by the amount
paid, and the gain would be $15. This represents the excess of the fair market value of the stock
at the time of the transfer minus the amount paid.

The following table demonstrates the tremendous economic benefit an employee can realize
through such a program.
ADVANTAGES OF A STRAIGHTFORWARD STOCK BONUS PLAN
Value of shares granted $50,000
Years until restrictions lapse 3 5 10
Value (assume 10% growth
rate)
$66,125 $87,450 $175,894
Income tax due (assuming
30%)
–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 great
advantages to the employee.
Value of shares purchased $50,000
Years until exercised 3 5 10
Value (assume 10% growth
rate)
$66,125 $87,450 $175,894
Cost of shares = 75% 37,500 37,500 37,500
Taxable portion 28,625 49,950 138,394
Income tax due on
compensation (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 AN
EMPLOYEE?
Code § 83(b) allows a hospital employee who receives employer stock on a tax-deferred basis to
be taxed immediately in the year the stock is transferred, regardless of the presence of a
substantial risk of forfeiture. If the employee makes such an election, any subsequent
appreciation is not taxable as compensation. Once made, the IRS must approve any change you
may want to make. There are several reasons why a taxpayer might want to make such an
election.
First, absent a Section 83(b) election, any appreciation in the value of the stock that occurs after
transfer will then be subject to ordinary income taxation at the time of vesting for the full amount
by which the then-appreciated fair market value exceeds the amount paid, if any. If a Section
83(b) election is made, any post-transfer appreciation will not be taxed until the stock is sold and
will 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 to
hold 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-transfer
appreciation will escape income taxation entirely.
The main disadvantage of the Section 83(b) election is the triggering of current taxation for the
excess of fair market value (without regard to any restrictions or risk of forfeiture) over the
amount paid. In addition, the Code provides that, if a Section 83(b) election is made before the
lapse of the restrictions and such property is subsequently forfeited due to the failure to meet the
conditions, no deduction can be made.
Furthermore, if a Section 83(b) election is made and the property later declines in value; only a
capital loss is allowed. Finally, the employer receives no deduction for any later appreciation
before vesting, nor will the company be able to take a deduction in the case of transferred stock
on any dividends after the transfer that are paid to the employee. The following example shows
the benefit of electing Section 83(b) in certain circumstances.
Example: In 1995, Horizon Hospital Corp., a newly founded and highly promising hospital
network, grants restricted stock worth $10,000 to Anne, a senior executive, conditioned upon her
remaining 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 the
subsequent $90,000 of appreciation will be subject to the lower capital-gains rate only if and
when she sells the stock. If she does not elect to use Section 83(b), she would not recognize any
income 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 ANY
CURRENT CASH ACTIVITY?
To alleviate cash-flow problems of their employees, hospitals who want their employees to take
part in a discounted stock-purchase program may lend the money to the employees to pay any
taxes 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 is
secured by the stock on a non recourse basis, the transaction may be treated as if it were a grant
of 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 of
the debt, the employee will not pay the debt and walk away from the property, as he would an
option. Thus, until the note is paid, no transfer has occurred. This could negate the effect of a
Section 83(b) election.
The following example demonstrates how the use of employer loans, in connection with a
Section 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 the
income tax liability of the $10,000 grant at 30%, or $3,000. The employee gives the employer a
promissory note for $3,000, bearing interest at 8%. Thus, the employee acquires $100,000 worth
of employer stock ownership after five years with no out-of-pocket cost at the date of the grant
and 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 the
employee, as a bonus, sufficient cash to cover the tax liability. This is obviously more costly to
the 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 HOSPITAL
WITHOUT OWNING VOTING STOCK?
Many closely held hospitals or healthcare organizations may not wish to transfer actual shares of
stock 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 may
establish a so-called phantom stock or shadow stock plan. Under these arrangements the
employee 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. The
employer then issues “units” to the employee’s account. The number of units that the employee
receives under such a contractual arrangement is pegged to the price or value of the company’s
stock. Once the units have been credited to the employee, the equivalent of dividends on these
units are generally paid to the employee and are reinvested to purchase additional units or
deferred with interest. The plan normally provides for appropriate adjustment in the value of
units if changes are made in the capitalization of the stock with respect to which the units are
priced. Benefits under such a plan are usually deferred for a specific period of time or an event
such as death or retirement. When benefits are payable, they may be paid in cash, either in a
lump 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’s
stock, it may enable the employer to offer much of the practical benefit of stock ownership
without causing dilution of equity, securities law problems as to stock that would otherwise have
been 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. The
granting of the phantom stock units is not taxable to the employee. When the cash or stock is
distributed to the employee, it is taxed as ordinary income, equal to the amount of cash received
or the value of the stock. If the stock distributed is subject to a substantial risk of forfeiture, it
will 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-called
stock appreciation rights (SARs). This is a contractual arrangement that, when exercised, entitles
an employee to receive, in either stock, cash, or a combination of the two, an amount equal to the
appreciation in the employer’s stock subsequent to the date the SARs were granted (or related to
such appreciation, if the SARs are valued higher than the FMV of the stock when the SARs were
granted). The grant of SARs does not constitute the constructive receipt of income even though
the option is immediately exercisable, because the exercise of the option means that the grantee
will not get the benefit of additional appreciation of the stock on which the value of the SARs is
based.
Any declarable income with SARs occurs at the sale, not acquisition. Income received from the
exercise of SARs is ordinary, and is equal to the amount of cash received or the value of the
appreciated stock received. This amount will generally be reportable in the income of the
employee in the year of receipt; however, if the SARs are exercised for stock and the stock is
subject to a substantial risk of forfeiture, it will be subject to tax when the substantial risk of
forfeiture 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 employer
and employee. As a practical matter, if the individual is an employee at the time the tax is
determined, there will often be very little additional payroll taxes to pay because he or she will
already 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 10
years, to purchase stock of employer at a price of $10 a share. Thus, if the stock value increases
to $20 a share and the employee exercises the option he will pay $10 for an asset worth $20. On
the other hand, if the stock value decreases to $5 the employee simply does not exercise the
option and the option lapses. This arrangement allows the employee in effect to enjoy the risk
free 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 without
any immediate cash outlay. They can acquire stock at less than fair market value, and, under
certain conditions, obtain the economic benefit of the excess of the stock’s fair market value over
the option price without an immediate tax gain (which will be reported only on the subsequent
sale of the stock).
Options have simultaneous advantages to employers. First, they can provide incentives to
employees without a cash outlay. In fact, the employer receives cash when the employee
exercises 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 the
exercise 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 statutory
stock options. Statutory stock options include incentive stock options (ISO) and employee stock
purchase plans (ESPP). ESPPs are discussed below.
An ISO is similar in operation to other compensatory options. However, there are restrictions on
how the option may be structured and when the option may be transferred, and there is special
income-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 that
may be issued under options and the employees (or class of employees) eligible to
receive options, which is approved by the stockholders of the granting corporation within
12 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 the
plan 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 it
is 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 pursuant
to a will or the laws of descent and distribution) and is exercisable only by the employee
during his or her lifetime.
 The employee, at the time the option is granted, does not own more than 10% of the total
combined voting power of all classes of stock of the corporation, its parent, or its
subsidiary.
 The aggregate fair market value of the stock for which options may be granted to an
employee 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 applies
automatically to ISOs in the order of their grant dates. This does not mean the ISO must
be limited to $100,000; rather, to the extent the value of the stock exceeds $100,000 in
the 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 one
even though it satisfies all of the above requirements.

Under special stock ownership attribution rules, for purposes of the percentage limitations, the
employee will be considered as owning the stock owned, directly or indirectly, by or for his or
her brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal
descendants. Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or
trust shall be considered as being owned proportionately by or for its shareholders, partners, or
beneficiaries.
Under an ISO, no gain is recognized when the option is granted; nor is any income recognized
when 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 is
taxed at long-term capital-gains rates. The gain may be taxed as ordinary income if the holding
period requirement is not met. The employer is not entitled to any deduction at any time. The
difference between the option price and the fair market value of the stock at the exercise date is a
tax 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’s
stock at a price equal to the fair market value of the stock at the date of grant. The economic
benefit is shown in the following table.
FMV of stock when option granted $50,000
Years until option exercised 2 4 9
Value when exercised $57,500 $76,044 $152,951
Cost of exercising option –50,000 –50,000 –50,000
Remaining value of option $ 7,500 $26,044 $102,951
Years until stock sold 3 5 10
Value when sold (assumed) $66,125 $87,450 $175,894
Capital gain on sale 16,125 37,450 125,894
Income tax due on capital gain (18-
month hold) –3,225 –7,490 –25,197
Economic 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 does
not dispose of the shares within two years of the date of the grant of the option, or within one
year 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 the
day of the granting of the option until three months before the option is exercised. Termination
of 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 was
granted, or less than 12 months after the option is exercised and the stock is received, any gain
must be reported as ordinary income.
In such a case, however, the employer may be able to claim a deduction equal to the amount of
ordinary income reported, whereas ordinarily the employer would be able to claim no deduction
at all.
If an individual who has acquired stock through an ISO disposes of it at a loss (i.e., a price less
than the exercise price) within two years from the date of the granting of the option, or one year
from the date of the exercise of the option, the amount includable in the gross income of the
individual, 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 an
ISO or options not granted under a qualified employee stock-purchase plan. Most hospital
employee 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 a
readily discernable FMV, the employee must include it as income for the year received. Almost
all employee options are nontransferable and therefore they are not considered to have a readily
ascertainable value. Upon exercise of the option the employee will usually recognize income to
the 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 of
forfeiture, no gain is recognized until the risk lapses. Any future appreciation realized on the
stock will be taxed as capital gain at the time the stock is sold. The hospital receives a tax
deduction 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 stock
at a price equal to the fair market value of the stock at the date of grant. The economic benefit of
the NQSO is shown in the following table.
Value when exercised (assume a 10%
increase per annum) $66,125 $87,450 $175,894
Cost of shares –50,000 –50,000 –50,000

Compensation element $16,125 $37,450 $125,894
Income tax due on compensation* –4,838 –11,235 –37768
Economic benefit remaining** $11,287 $26,215 $ 88,126
* 30% marginal tax bracket **Value when exercised – Cost of shares – Income tax due on
compensation
Greater flexibility in the pricing, permissible time of exercise, employment status, and other
matters is possible with an NQSO than with an ISO or an option granted under a qualified
employee stock-purchase plan.
For example, an NQSO could be offered that would permit the grantee to purchase stock at a
price of $5 per share even though the stock was worth $10 a share at the date of the grant of the
option. The option could be granted to a consultant who was not an employee, and the option
could be exercisable for a period in excess of 10 years. None of these terms would be possible
with an ISO.
Some companies will grant a “discounted stock option,” under which the exercise price is
intended to be substantially below the value of the stock at the time of grant. When used, this
form 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’s
stock was selling at $100 per share. At the beginning of the year, the director might be offered
the choice of the customary $10,000 directors’ fee, or an option to purchase 100 shares of
company stock at $5 per share. The advantage to the director of the option is that, assuming no
constructive receipt, there will be a deferral of recognition of income until the option is
exercised.
IS A HOSPITAL ISO MORE ADVANTAGEOUS THAN AN NQSO?
The difference in tax treatment between an ISO and an NQSO can be crucial in determining
which stock option is more advantageous to an employee.
For a designated amount of shares, an ISO is usually more beneficial to a hospital employee than
an NQSO. The employee can defer recognition of all gain until he or she sells the shares and can
report all his or her gains at long-term capital-gains rates. The following table shows how an ISO
usually provides a greater advantage than an NQSO to an employee exercising the option.
Economic benefit remaining*
ISO (see Example, Planning Issue 17) $12,900 $29,960 $ 100,697
NQSO (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 the
date of grant.
If the employer is willing to set the option price substantially below the fair market value at the
date 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 may
be to the employee’s advantage:
Cost of exercising option –25,000 –25,000 –25,000
Compensation element $32,500 $51,044 $127,951
Income tax due on compensation –10,075 –15,824 –39,665
Economic benefit remaining $22,425 $35,220 $ 88,286
Because corporate tax rates are presently higher in general than individual tax rates, there may be
a net tax advantage to the corporation and the employee to using an NQSO over an ISO. Because
an employer gets no tax deduction for the ISO, the employer may be willing to grant NQSOs
consisting 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 buy
1,000 shares of Healthorama stock at $10 per share. A year later, the stock rises to $20 per share
and both Alex and Beth exercise their options in full, receiving $20,000 of stock (not subject to a
risk 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). Thus
there 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 costs
and the additional tax cost to Alex of the bonus), Healthorama would have a total net tax savings
of $4,711 (34% of 3,857 = 1,311, 3400 +1,311 = 4,711). Alex would have no net loss (except for
the issuance of the stock), and he would pay no net taxes. In contrast, Beth will not recognize
any income at the time of exercise, and Healthorama will have no deduction. Subsequent
appreciation in Healthorama’s stock will be treated as a capital gain to either Alex or Beth on
disposition of the stock, assuming that Beth holds the stock at least a full additional year and
meets the other requirements for an ISO.

However, Alex’s basis will be $20,000 (the $10,000 paid and the $10,000 recognized as ordinary
income when the option was exercised), and Beth’s will be $10,000 (the $10,000 paid). Thus, if
the stock acquired through exercise of NQSO is sold at $20,000, no further gain will be
recognized.
HOW ARE EXERCISES OF HOPSITAL STOCK OPTIONS FUNDED?
The holder of a stock option may encounter financial difficulty in exercising the option and
holding the stock. Unless the exercise price is nominal, the employee will need funds to purchase
the stock, and, if the option is an NQSO, there will be a need for cash to pay the tax on the
taxable 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 exercise
of an option and sells the underlying shares on the same day. By using the optionee’s exercise
notice as collateral, a brokerage firm can finance the exercise of the option, plus any applicable
withholding taxes. As an alternative, the optionee may sell only the number of shares required to
cover 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 from
the employer’s viewpoint, since the employer wants the employee to continue to have the equity
interest. Instead, the company might permit the employee to pay the option exercise price with
stock already owned, but then grant the employee additional options equal to the number of
shares 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 to
purchase 500 more shares at $10 per share. When the price is $30 per share, the employee
exercises the option. The exercise price is paid by transferring 334 shares to the employer. The
employer issues the 500 shares resulting from the option and grants an additional 334 shares to
the 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 the
same equity interest as before. However, it also reduces the potential for the employee to gain on
the stock, since the employee will end up with fewer shares than if he or she had used cash to
exercise the option.
If an optionee does not have other employer stock available to use in exercising the option, an
employer could simply allow the employee to surrender a portion of the option grant as
consideration for exercising the remaining shares. This option reduces the potential gains on the
stock 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 tandem
with options.
SARs can be granted in connection with stock options. If the SARs are granted in connection
with a stock option, cash received on the exercise of the SARs will help the employee pay for the
stock when he or she exercises the options.

For example, a key hospital employee might be granted an NQSO to buy 1,000 shares of stock
and SARs on another 1,000. The SARs would entitle the employee to be paid by the company
the 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 that
amount in shares of company stock. Thus, if the stock option and SARs both were granted when
the stock is $10 per share, and the NQSO is exercised when the fair market value is $25 per
share, the key employee will have to provide $10,000 to purchase the stock and then must pay
tax 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 problems
caused by purchase of the stock and the payment of taxes and will, therefore, be more likely to
hold the stock.
Sometimes when a stock option and SARs are issued together, the exercise of the SARs is
automatic on the exercise of the stock option, and vice versa. The SARs and the stock option
may be issued in tandem so that the exercise of the SARs for cash reduces the amount of stock
options that may be exercised. For example, if SARs for 1,000 units were issued, and the
recipient exercised 750, that recipient could purchase only 250 shares of stock through the stock
option. In this case, the SARs can be written to be exercisable in stock, in cash, or in a
combination of the two.
The SARs can be issued in conjunction with an ISO (as well as an NQSO) as long as the ISO is
not 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 underlying
shares 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 and
any income-tax withholding requirements. It is important to reiterate that the debt must be full
recourse and must bear interest.
Finally, a hospital employer can simply give enough cash to the optionee as a bonus to cover the
costs 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 hold
the stock following the exercise, or is going to sell the stock immediately. If the employee
intends to sell the stock, then he or she should try to time the exercise so that the stock is at its
highest value. If the employee is going to hold the acquired stock for future investment, then he
or she should exercise the option as late as possible. The employee thus enjoys all upside
potential 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 cover
the financing cost, or is at least equal to other investment returns, then exercise of the options
makes sense.

HOW DIVIDENDS CAN AFFECT DECISIONS ABOUT EXERCISING STOCK OPTIONS
NQSO ISO
Value of stock $87,450 $87,450
Cost of option 50,000 50,000
Income tax due on exercise 11,610 0
Total cash cost of exercise $61,610 $50,000
Annual cost of borrowing at 8% $4,929 $4,000
Dividend rate necessary to exceed costs of
borrowing
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 Tax
without
Exercise
AMT: Exercise
1,000 Shares
in Year 7
AMT: Exercise
500 Shares in
Year 7
AMT: Exercise
500 Shares in
Year 8
Adjusted gross income $175,000 $175,000 $175,000 $175,000
Itemized deductions –28,000 –23,000 –23,000 –23,000
Exemptions (4) –10,000 n/a n/a n/a
Tax preference* n/a 65,653 32,827 41,500
AMT exemption amount n/a –28,087 –36,293 –34,125
Taxable amount $137,000 $189,566 $148,533 $159,376
Tax $41,324 $49,579 $38,089 $41,125
AMT due n/a 8,255 none none
Total 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 HOW
DO THEY BENEFIT EMPLOYEES AND THEIR HOSPITAL EMPLOYERS?
An employee stock-purchase plan qualified under Code § 423 allows eligible employees to
purchase stock of an employer under special tax rules and favorable prices.
An employee stock-purchase plan is intended to benefit virtually all employees, not just
exceptional ones or limited groups. Because the granting of options to purchase employer stock
under an employee stock-purchase plan cannot discriminate in favor of key employees, usually
the plan will appeal only to an employer who simply wants to provide, as a general benefit of
employment, the right to buy employer stock, or believes that owning employer stock will act as
an incentive to employees to perform well. A hospital employee stock-purchase plan must meet

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