A Cautionary Case for Tax-Exempt Hospitals
© 2015 American Institute of CPAs - All Rights Reserved. Reprinted with permission from The Tax Adviser, September 2015.
A New Jersey case denying a hospital a property-tax exemption is a wake-up call for not-for-profit hospitals around the country.
By Stephen D. Kirkland, CPA, CMC, CFC, CFF
A recent property tax case from the Tax Court of New Jersey should serve as a warning to tax-exempt medical centers and their tax advisers throughout the country. Although this case was specific to New Jersey, similar facts and laws exist in many other jurisdictions.
The town of Morristown, N.J., challenged the property tax exemption of Morristown Memorial Hospital. The court issued a lengthy opinion that explains in detail the multiple issues, facts, analyses, and conclusions in the case (AHS Hospital Corp. v. Town of Morristown, No. 010900-2007 (N.J. Tax Ct. 6/25/15)). The 88-page opinion includes a review of the history of tax exemptions for charitable organizations generally and hospitals in particular under English common law, U.S. federal tax law, and New Jersey and other state laws.
The court went to great lengths to describe the ways that not-for-profit hospitals have changed over the years. When the state laws exempting not-for-profit hospitals from taxation were drafted decades ago, most not-for-profit hospitals were “charitable alms houses providing free basic medical treatment to the infirm poor” (slip op. at 3). Today, hospitals have become sophisticated medical centers, providing a variety of medical and related services.
The court acknowledged that the Morristown hospital had “a well-deserved reputation for excellence in medical care and education” (slip op. at 4). However, the court explained that tax-exempt status is not based on the quality of care and the court would “not succumb to emotion.” Rather, the court determined that it must rely “on the sufficiency of the evidence and sound legal reasoning” in deciding whether the hospital, under its current method of operation, satisfied the criteria for property tax exemption (id.).
The court concluded that the hospital had the burden of proving it was entitled to a tax exemption and had failed to meet that burden on several grounds. The statute in question (N.J. Stat. §54:4-3.6) required (1) the property’s owner be organized exclusively for an exempt purpose; (2) the property to be actually and exclusively used for the exempt purpose; and (3) the hospital’s operation and use of its property not to be conducted for profit (slip op. at 40–41, citations omitted). Most of the hospital’s real estate did not qualify for property tax exemption even though the property was owned and used by a tax-exempt entity.
The court closely examined what it meant for hospital activities to be conducted “for profit.” In this case, the hospital used its property to treat all patients regardless of their ability to pay. The court acknowledged that there is “no profit margin with respect to the treatment and care of Medicaid patients” (slip op. at 15). The court also acknowledged that the hospital operated programs that were “loss leaders.” For example, a pediatrician employed by a hospital may generate $100,000 in losses each year (slip op. at 16).
Although tax-exempt entities are not required to operate at a loss and are not prohibited from generating a profit, it is important to determine where the profit is going, the court said. A crucial factor was whether any of the profits could be traced “into someone’s personal pocket.” If so, the property would not be entitled to tax exemption (slip op. at 41).
In its defense, the hospital argued that the dominant motive for its activities was charitable. However, the court stated that an organization claiming exemption is permitted to have both exempt and nonexempt activities occurring on its property “so long as the two purposes can be separately stated and accounted for and so long as the non-exempt use is never subject to the property tax exemption” (slip op. at 45). Accordingly, for-profit activities carried out on tax-exempt property must be “conducted so as to be evident, readily ascertainable, and separately accountable for taxing purposes” (id.). On the other hand, exemption will be denied where there is significant and substantial “com[m]ingling of effort and entanglement of activities and operations” on the property, regardless of whether the for-profit entities are related or unrelated to the not-for-profit organization (slip op. at 46).
Many modern tax-exempt hospitals, including the hospital in this case, are “intertwined with both non-profit and for-profit subsidiaries and unaffiliated corporate entities” (slip op. at 4, emphasis in original).
The court attempted to discern where the hospital’s not-for-profit activity ended and its for-profit activity began. Otherwise, to permit a not-for-profit entity to claim a property tax exemption when it has become inseparably entangled with for-profit entities would allow indirect taxpayer subsidization of the for-profit activities. In other words, a competitive advantage would be conferred on those for-profit entities at the expense of the taxpaying public. The court was unable to distinguish between not-for-profit activities carried out on the hospital’s property and the for-profit activities carried out by private physicians.
Three categories of physicians treated patients on the hospital’s property: employed physicians, voluntary physicians, and exclusive-contract physicians. Employed physicians had employment contracts and were on the hospital’s payroll. Voluntary physicians and exclusive-contract physicians are private-practice doctors who were allowed to treat patients at the hospital. Those two types of doctors operate on a for-profit basis. “Accordingly, the court must be able to determine where these physicians practice on the Subject Property in order to identify the areas of the Hospital that are subject to taxation” (slip op. at 47). That delineation was not possible in this case because the activities of the for-profit physicians were not contained within any particular area of the hospital. They operated throughout the hospital and used the hospital’s property to generate private medical bills that they charged directly to the patients. All the money those physicians billed went directly to them.
The hospital argued that because those fees were generated and retained by the for-profit physicians, the hospital did not profit from the physicians’ use of hospital property. The court stated that the issue is not just “the profitability of the tax-exempt entity that owns the property” (slip op. at 51) but also the doctors’ for-profit activities conducted on the property. In other words, the court believed that it must consider not only the financial benefits flowing to the entity claiming exemption but also benefits going to related and unrelated for-profit entities, including physicians.
Even though the entity claiming exemption may not have violated the profit test itself, the court felt that the hospital failed the profit test because the operation and use of the property was conducted for the benefit of other for-profit entities.
The fact that the hospital maintained relationships with a number of affiliated and nonaffiliated for-profit entities was also problematic. This included physician practices the hospital owned (captive PCs), which the hospital loaned millions of dollars to and subsidized when they lost money.
Recruitment loans were made directly to private physicians transitioning into the local community. Those loans were subject to forgiveness after a certain period of time. The physician practices did not have their own accounting departments; their financial and billing operations were processed by the hospital.
The hospital was affiliated with other for-profit entities, and certain executives and board members had roles in both the not-for-profit and for-profit entities. The court believed that it was “impossible for an arms-length transaction to occur under such circumstances” (slip op. at 61). Therefore, the court considered whether transactions between the entities were conducted at arm’s-length, such as the hospital’s guarantee of a $10 million line of credit and loans to these other entities, where in some cases, no interest rate was indicated.
One of the relationships most scrutinized was the hospital’s relationship with a self-insurance trust fund in the Cayman Islands. The fund did not process any insurance claims but simply operated as a bank account.
Even if all of these related-party transactions had been properly “charged back,” the court nonetheless concluded that there would be no meaningful separation between the for-profit and not-for-profit subsidiaries. In short, the hospital “called all the shots.”
As a result, the court found that the operation and use of the hospital’s property was conducted for a for-profit purpose and advanced the activities of for-profit entities. By entangling and commingling its activities with for-profit entities, the hospital allowed its property to be used for forbidden for-profit activities.
The court also examined the salaries of hospital executives, which included rich benefits packages, and was not persuaded that the salaries were comparable to salaries paid for similar positions at similar institutions. Although the court acknowledged that not-for-profit entities were allowed to pay reasonable salaries for services actually performed, the hospital failed to meet its burden to establish the reasonableness of the compensation it paid.
New Jersey’s state law does not prescribe a method for determining comparable compensation, and the hospital had relied on federal law (Regs. Sec. 53.4958-6). The New Jersey court was not convinced that IRS regulations under federal income tax law should be relevant to New Jersey real property taxes, saying the hospital’s expert “provided no compelling reason why the court should employ the IRS standard other than it’s generally the only one out there” (slip op. at 70–71).
The hospital’s expert witness established a peer group of comparable hospital systems in the geographic area, but “he failed to show that the hospitals he chose for the peer group in fact did the same thing” by following a similar process (slip op. at 68). The court was not persuaded by the expert since he “offered no testimony or other evidence as to whether” the comparability “data was verified, accurate, reliable, or in fact, comparable” (id.). It was not known “whether the compensation committees of the peer group hospitals followed the same rigorous procedure” that the hospital’s expert had outlined. The court concluded that, if “the only consideration is what similar hospitals set as salaries, then the salaries would always be reasonable; a conclusion wholly self-serving to all non-profit hospitals” (slip op. at 69).
The court was not persuaded that the hospital’s compensation committee consisted of well-respected members of the board of directors, sophisticated business executives, and professionals, who understood the hospital, the health care industry, and the rules pertaining to executive compensation in the tax-exempt sector, because the record was “devoid of any evidence” of this expertise. The hospital expert’s claim that it had “to compete for talent with organizations in Manhattan, the rest of New York City, and its suburbs in New Jersey, New York and Connecticut” also did not persuade the court. Here again, the court said these conclusions were “unsupported by any evidence, testimony or reliable data for the court to evaluate” (slip op. at 69–70).
Compensation of employed physicians
Physicians employed directly by the hospital were paid a base salary plus an incentive. These amounts were based “very methodically on an assessment of the compensation for that specialty in the market area” (slip op. at 72). The incentive was paid based on qualitative factors, such as decreasing infections during a stay at the hospital, and quantitative factors such as the number of patient visits. The average incentive compensation amount paid to employed physicians was $32,000.
The hospital said it aimed to have base salaries for employed physicians at the 60th percentile of a peer group’s range as determined through national surveys. Once incentive compensation was added, total compensation was generally at about the 75th percentile of the range. Maximum total compensation was limited to the 90th percentile.
Although the compensation surveys had been obtained from reputable organizations, the court noted that there was no testimony about their credibility or reliability. In addition, the court noted that the hospital’s testimony claimed that it was common for hospitals to include incentive provisions in their physician employment contracts, but the hospital provided no evidence.
Incentive compensation was paid out of a portion of department revenues set aside for this purpose. The incentive pools were calculated in different ways among the departments, with many physicians receiving a percentage of their professional billings. Another format paid certain physicians a bonus from the net departmental revenues, with the remaining revenue going to the hospital.
In its analyses, the court acknowledged that not-for-profit organizations are permitted to pay salaries to their employees so long as the salaries “are not excessive, and they do not demonstrate a profit-making purpose” (slip op. at 75). However, the court believed there was a profit-making purpose in employment agreements “where revenues were divided between a hospital and its employed physicians” (id.). In this case, the revenue sharing showed that the employed physicians were given incentives that had been derived from departmental expenses. The profit was split between the hospital and the employed physicians, indicating that the operation was conducted for a profit-making purpose. Therefore, a portion of surplus revenues could be traced to “someone’s personal pocket” (slip op. at 76).
Hospitals often engage in contracts with third parties to provide certain services at the hospital. To satisfy the profit test, a hospital must prove that these contracts are not entered into with a “profit-making purpose.” The court examined the hospital’s management agreement with a private contractor that managed the visitors’ parking garage. Fixed fees paid were not excessive, and the garage operated at a loss. Therefore, the visitors’ parking garage was eligible for the property tax exemption.
The court then looked at another agreement the hospital had with a private contractor to provide food and nutrition services, laundry, transportation, and other services. This contract did not provide for a fixed management fee but instead split budgetary “savings.” This split was “profit-sharing disguised as cost-savings” (slip op. at 80), which showed a profit-making purpose typical of a “commercial activity or business venture” (slip op. at 81).
A gift shop within the hospital, run by the Women’s Auxiliary, did not qualify for the exemption. Although it generated a small profit, it did not qualify as a core hospital purpose since it did not provide “any medical service that a hospital patient may require pre-admission, during a hospital stay, or post-admission,” but was merely a convenience for hospital visitors that competed with “commercially owned facilities” (slip op. at 84).
The court concluded that a not-for-profit organization that generates revenue in excess of expenses does not demonstrate, in itself, a profit-making purpose. However, “[i]f it is true that all non-profit hospitals operate like the Hospital in this case, as was the testimony here, then for purposes of the property tax exemption, modern non-profit hospitals are essentially legal fictions. . . . Accordingly, if the property tax exemption for modern non-profit hospitals is to exist at all in New Jersey going forward, then it is a function of the Legislature and not the courts to promulgate what the terms and conditions will be” (slip op. at 87–88).
As modern not-for-profit hospitals compete more and more with for-profit hospitals, and states and municipalities are hungry for revenue, hospitals and other not-for-profits will find their exemptions under attack. The New Jersey court looked to the state legislature to solve this problem by enacting laws to exempt these modern hospitals from property tax going forward if “a property tax exemption for modern non-profit hospitals is to exist at all” (slip op. at 88).
Stephen D. Kirkland serves as an expert witness in U.S. Tax Court cases involving (un)reasonable compensation issues.
Tax Treatment of Loans from Hospitals to Newly Recruited Physicians
So these loans are not considered compensation, hospitals should be sure they observe all the requirements for bona fide debt.:
By Stephen D. Kirkland, CPA/CFF
This article was originally published by the AICPA on TheTaxAdviser.com on August 16, 2017.
To help attract physicians in a competitive environment, hospitals and other health care providers may extend loans to newly recruited doctors. The cash can help physicians and their families in many ways, including offsetting the inconveniences and costs of a job change or relocation.
However, if not handled carefully, these loans may be recharacterized as compensation, which can trigger unexpected income and payroll taxes for the doctor. In addition, the recharacterized debt could cause a total pay package to be considered unreasonable compensation that is in excess of fair market value (FMV).
The Tax Court recently examined the tax treatment of a loan extended by a health care provider to a newly recruited physician (Salloum, T.C. Memo. 2017-127). In this case, Centerpoint Medical Center of Independence, LLC (the hospital) transferred $146,500 to Dr. Ellis Salloum when he joined the hospital's medical practice. At the time, both parties agreed that the transfer of cash was a loan.
In 2009, Salloum agreed that he would join the hospital's medical practice in Missouri for at least 36 months. He was to engage in private practice as a vascular surgeon within the geographic area served by the hospital and be treated by the hospital as an independent contractor. He signed a physician recruiting agreement, a compensation guarantee with forgiveness agreement, and a promissory note. These documents stated that:
- The hospital would loan the physician $146,500, and that amount was to be advanced in monthly installments over the first six months (the guarantee period);
- Interest would begin to accrue at the end of the six months at the lower of the prime rate reported in the Wall Street Journal plus 1% or the maximum rate permitted by law;
- As security for the payment of principal and interest on the loan, the physician granted the hospital a security interest in the accounts receivable of his private practice;
- To encourage prompt payment, the hospital would forgive interest on any amounts repaid within six months after the sixth monthly installment had been made to Salloum;
- To encourage the doctor to remain in the geographic area, the hospital agreed to forgive and cancel one thirtieth (1/30th) of the loan amount for each calendar month after the end of the first six months that he remained in the full-time practice of medicine in the community, maintained privileges in good standing at the hospital, and remained available for emergency room coverage at the hospital; and
- Salloum's income from any forgiveness of debt on the loan would be reported as nonemployee compensation on Form 1099-MISC, Miscellaneous Income.
The compensation guarantee with forgiveness agreement explained that the hospital would treat the loan as an advance of compensation. The guarantee amount was limited to the compensation paid to him. The parties agreed and verified that the guarantee amount represented no more than FMV for the doctor's specialty in that community.
In accordance with the agreements, the hospital reported a small amount of nonemployee compensation to Salloum on a Form 1099-MISC for 2009, but did not include the $146,500. Likewise, Salloum did not include the $146,500 in his taxable income in 2009. During 2010, the hospital again paid nonemployee compensation and reported it on Form 1099-MISC.
In February 2011, Salloum terminated his relationship with the hospital. As required under the agreements, during 2012 he transferred $46,884 to the hospital to repay the remaining balance that the hospital had loaned to him in 2009.
In its opinion, the court remarked that the determination of whether a transfer of funds constitutes a loan is a question of fact. For a cash transfer to be a loan for tax purposes, two important conditions must exist when the funds are transferred. First, the transferee must be unconditionally obligated (i.e., the obligation is not subject to a condition precedent) on the transferee's part to repay the funds. Second, the transferor must unconditionally intend to secure repayment of the funds.
Whether these two conditions exist is inferred from the following factors:
- The existence of a debt instrument;
- The existence of a written loan agreement;
- Collateral securing the purported loan;
- The treatment of the transferred funds as a loan by the purported lender and borrower;
- A demand for repayment of the funds; and
- The repayment of the transferred funds.
Various factors surrounding the 2009 transfer to Salloum indicated that it was indeed a loan. This included the fact that he had executed a promissory note in which he agreed to repay all amounts that the hospital transferred to him and that the compensation guarantee with forgiveness agreement referred to the "Loan Repayment Amount."
In addition, there was a loan agreement that comprised the recruiting agreement, the compensation guarantee with forgiveness agreement, and the promissory note. The physician agreed to pay interest at the rate specified in that note; he had granted the hospital a security interest in the accounts receivable of his private practice; the borrower had the ability to repay the loan; he in fact repaid the $146,500; and both parties treated the cash transfer as a loan in that the hospital did not report it on Form 1099-MISC and the physician did not include it in his 2009 gross income.
Despite these factors, by 2012, Salloum took the position that the $146,500 that he received from the hospital should be considered an advance payment of his salary, not a loan. This was inconsistent with the way he had originally treated the transfer, because he had not reported the amounts in income in 2009 and treated the money as a loan. Since he now had decided that the original transfer was an advance of compensation, he thought his repayment should be a deductible expense. Therefore, he deducted the $46,884 repayment to the hospital as an expense on his Schedule C, Profit or Loss From Business.
When the IRS challenged his deduction, he contended that he was not unconditionally obligated to repay the amount that had been extended to him. He claimed that any repayments of the $146,500 would become due only if he materially breached the physician recruiting agreement and that his obligation to repay was subject to a condition precedent, and consequently his obligation to repay the hospital was not unconditional.
According to the physician, when he terminated his employment with the hospital, any unearned advanced amounts became due to the hospital.
In support of his position, the physician pointed to this language in the compensation guarantee with forgiveness agreement:
Any failure by Physician to comply with the terms of Paragraph E of this Addendum shall be considered a material breach of this Addendum and the Recruiting Agreement by Physician and shall authorize Hospital, at its option, to pursue the remedies described in the Material Breach Section of the Recruiting Agreement.
The Tax Court said that his reliance on the above paragraph ignored other important provisions in the agreements. For example, the compensation guarantee with forgiveness agreement also contained the following provisions:
A. Hospital hereby agrees to loan Physician [the physician] certain amounts of money which Hospital shall advance as a guarantee of compensation for Physician totaling a maximum of $146,500.00 (hereinafter the "Guarantee Amount"). . . .
E. Physician agrees to actively engage in the full-time practice of medicine in the Community and geographic area served by Hospital, to bill all patients and third-party payors promptly for all services rendered, and to use his/her best efforts to collect all patient accounts. Hospital shall have the right to review and audit Physician's books and records for whatever period of time is necessary to assure compliance with the Recruiting Agreement and any Addenda thereto.
F. At the end of the Guarantee Period, the sum of all Guarantee Payments made by Hospital to Physician during the Guarantee Period, not otherwise repaid or recouped pursuant to any other provision in this Addendum shall be calculated. This amount represents the "Loan Repayment Amount" which shall be due and payable by Physician as evidenced by the attached Promissory Note (Exhibit "A") executed by Physician. Interest on the Loan Repayment Amount will begin to accrue at the end of the Guarantee Period. However, in an effort to encourage prompt payment, interest will be forgiven on any amounts repaid within six months of the end of the Guarantee Period. Amounts so forgiven, if any, (as well as any imputed income as required by law) will be reported on Form 1099.
Despite the doctor's argument, the court decided that he had an unconditional obligation to repay the $146,500 that the hospital had transferred to him, even though that obligation was subject to a condition subsequent in that the loan would be forgiven if the doctor continued to practice in the area and met the requirements summarized above.
Therefore, the Tax Court ruled that Salloum did not fulfill his burden of proving that the $146,500 was not a loan.
Salloum did not dispute that, if it was a loan, he would not be entitled to deduct the 2012 repayment.
Hospitals and their recruits need to be careful how these loans are structured and be consistent in their documentation. Also, tax advisers should remind borrowers that forgiveness of a loan creates taxable income, even if there is no cash transfer or withholding related to it in that same year.
Stephen D. Kirkland is a compensation consultant with Atlantic Executive Consulting, LLC (www.ReasonableCompensation.expert).
Compensation Paid by Healthcare Providers
Physician compensation continues to be an especially important issue due to extensive integration of medical practices into larger healthcare systems and the severe penalties for non-compliance. Healthcare providers should carefully consider the following three important sets of rules when preparing compensation plans:
1. Federal Income Tax
Hospitals and other healthcare providers need to ensure that they pay only “reasonable compensation” in order to comply with the Internal Revenue Code and IRS regulations, regardless of whether the payer is for-profit or tax exempt. (Other whitepapers on this website provide further details of these income tax regulations and offer broad recommendations for avoiding penalties and assessments.)
2. State and Local Tax
Healthcare providers operating as tax-exempt entities need to be careful to comply with state and local laws in order to maintain their exempt status. (Their exemption from local property taxes and sales taxes may be completely independent of their exemption from federal income tax).
If they pay more than reasonable compensation to physicians, for example, the benefit of the organization’s resources may be considered to have inured to the benefit of those physicians. This could result in loss of exempt status for purposes of property taxes and/or sales taxes, if local law provides that no benefits may inure to an individual.
Local laws may also state that the financial resources of an exempt organization must be used exclusively for exempt purposes.
State and local requirements vary across the country, so please check with a local attorney. But state and local regulations should not be overlooked. If an organization becomes subject to local property taxes on its real property and equipment, the amount of tax that has to be paid annually may be substantial.
In addition, healthcare providers need to ensure that the compensation they pay to physicians is “fair market value” and “commercially reasonable.” Federal rules for this purpose vary from the federal income tax regulations.
Some important guidelines for determining what is fair market value and what is commercially reasonable have been derived from case law. Perhaps the most publicized litigation in this area has been that of Tuomey Healthcare System. However, “fair market value” is found in the Stark statute at 42 U.S.C. § 1395nn (h)(3):
“The term "fair market value" means the value in arms length transactions, consistent with the general market value, and, with respect to rentals or leases, the value of rental property for general commercial purposes (not taking into account its intended use) and, in the case of a lease of space, not adjusted to reflect the additional value the prospective lessee or lessor would attribute to the proximity or convenience to the lessor where the lessor is a potential source of patient referrals to the lessee.”
Severance Agreements for CEOs of Tax-Exempt Hospitals
By Stephen D. Kirkland, CPA, CMC, CFC, CFF
Tax-exempt hospitals often offer severance agreements to protect their Chief Executive Officers if they are ever terminated through no fault of their own. Although these agreements are common, they should be handled carefully to avoid creating excess benefit transactions under Internal Revenue Code section 4958.
Hospitals offer severance plans for CEOs and other key executives in order to attract and retain the best possible talent, provide a secure work environment, remain competitive, avoid potential litigation and facilitate succession planning.
Hospital Boards hope these agreements will increase stability and reduce costly turnover by providing appropriate incentives to the executives. Simply put, these agreements are a form of golden handcuffs.
In return for a promise to pay severance, hospitals usually require the executives to sign general releases that reduce the likelihood of future lawsuits. Obtaining the release is important in an environment in which terminated employees often file lawsuits for various reasons. Without an offer of severance pay, there may be no incentive for an executive to sign a release.
Since severance payment amounts can be substantial, hospitals should carefully consider whether any such payment would be in line with the value received and whether it supports their charitable missions.
How They Work
A severance agreement usually obligates the hospital to continue an executive’s salary and certain benefits for a number of months following termination of his or her employment. The severance benefits may operate on a single trigger, meaning that the severance pay and benefits would be provided if the executive’s employment was terminated for any reason other than “for cause.” Or they may use a double-trigger, which applies only if there is a change of control and the executive is subsequently terminated.
A severance plan may determine the amount of severance pay based on a combination of factors including the executive’s years of service, position, total pay level and job performance. The amount of severance pay may also be significantly influenced by the contractual agreements offered in exchange. For example, in addition to the general release, a severance agreement may include a non-disparagement clause, a confidentiality clause and/or a limited non-compete clause. Each of these provisions can provide considerable value to the hospital, thus helping to ensure that the payment terms do not exceed fair market value.
In addition to cash payments, severance packages may include extended benefits, such as health insurance and other welfare benefits. Some include outplacement assistance to help executives transition to new positions, although the type and level of benefits vary widely. (At for-profit entities, severance plans often include accelerated vesting of stock options under certain circumstances. The IRS has said that practices at both for-profit and nonprofit entities could be used for benchmarking.)...
Change of Control Severance Agreements for Hospital Employees
During this age of integration, severance agreements are being used by hospitals to keep key employees in place during transitions. The agreements are most common for executives who may no longer be needed after the transitions have been completed.
These agreements are not perks for key employees, but retention tools to help ensure a smooth transition, if and when a change of control occurs. The possibility of such change creates risks and uncertainty, which could otherwise lead to the distraction or departure of the employees to the detriment of the hospitals and their patients.
Change of control severance agreements have a double-trigger, meaning that severance benefits are payable only if a change of control occurs and the employee’s employment is involuntarily terminated by the hospital or its successor.
Change of control severance agreements are designed to prevent the employees from having personal interests that conflict with the hospitals’ interests, thus ensuring the best future for the hospitals’ patients.
The Boards try to get key employees to remain at the hospitals and to cooperate fully with changes of control, even though the employees may lose their jobs afterwards.
Regardless of whether it is contractually required, hospitals sometimes pay some form of severance when they terminate loyal employees without cause. It is worth noting that, if a hospital needs to replace one of its key employees, it may have to offer severance plans to candidates in order to attract qualified replacements.
It is also worth considering that severance agreements may help keep employees at the hospital even if there is no change of control.
Hospitals often provide severance pay for a year or more to former employees. Some add a lump-sum amount in place of incentive compensation that the employee could have earned. In addition, they may add cash payments for benefits that would have been provided. Severance is traditionally paid over time, but is sometimes paid in lump sums when termination follows a change of control. Hospital severance plans with double-trigger features may pay severance even if an employee is offered a similar job in the new organization.
Severance agreements usually require the covered employees to sign a general release of all claims, which protect the hospitals from expensive litigation. The releases can have significant value to the hospital, especially for any worker who is in a protected class of employees. Therefore, the terms do not provide a private benefit to any employee without also providing important benefits to the hospital.
Before finalizing any severance agreement, the Boards must determine that the proposed severance terms are in the best interests of the patients, the community and their charitable mission.
Hospital Boards often ask compensation consultants to help determine terms that will be fair market value. The consultants may then issue opinion letters that can help protect against excise taxes under Internal Revenue Code section 4958.
The issuer of an opinion letter will analyze the terms of the severance agreements to determine whether they are reasonable based on all of the facts and circumstances. In this process, they will consider the employee’s key roles, tenure, job performance, current cash compensation and benefits. They will also consider compensation comparability data, the potential costs to the hospital, the potential benefits to the hospital, and severance pay plan practices of other healthcare providers.
The methodology that severance agreements use to determine payout amounts varies among employers in the health care industry.
The resulting cash compensation and benefits for each covered employee, taken as a whole, should not exceed fair market value and reasonable compensation for their services. Carefully consider each employee’s overall value to the hospital and its patients. Also consider the costs and disruption that could be incurred if the employee voluntarily left during a major transition such as a change of control, or if they brought legal action against the hospital following a termination.
The issuer of an opinion letter may state that he or she is assuming that the employees will continue to perform their duties satisfactorily for the remainder of their employment.
Severance agreements can help hospitals terminate employees following a change of control without treating them unfairly. To warrant offering such a plan, the Boards must believe that the employees’ continued service would be needed if and when a major change occurs. Carefully consider the employee’s experience and knowledge of the hospital and the local community. Any severance pay (with or without a change of control) should support the tax-exempt organizations charitable mission.
Legal counsel should draft the agreements and the compensation professional will want to be sure he or she understands the terms before issuing an opinion letter. Separately, qualified professionals should address the financial statement treatment and the tax treatment.
Ways to Improve Your Partner Compensation Plan
By Stephen D. Kirkland, CPA, CMC, CFC, CFF
Reprinted with permission from the January/February 2017 issue of The Value Examiner
One key difference between successful and unsuccessful financial service firms is the way that partner compensation amounts are determined. Successful firms have strong compensation plans that help retain their top performers and motivate all partners to do their best. Other firms have plans that encourage average or below-average performers to stay, and send the best looking for greener pastures.
The partner compensation plan serves many purposes and risk mitigation may be the most important. Business valuators understand that all professional service firms face many risks, and the defection of a top performer can be one of the most difficult risks to manage.
One of the worst ways to compensate partners (or other owners) may be to share pay equally regardless of individual results. This type of plan is not a motivator and does not give everyone enough incentive to go the extra mile. In today’s highly-competitive environment, each owner needs to be fully incentivized. Although there are exceptions, firms paying all owners equally usually do not achieve the long-term stability, growth or profitability that the owners desire. Even for those who are not motivated primarily by money, being paid equally can be a powerful de-motivator.
"When performance is irrelevant to compensation, the organization gets less than it pays for," says compensation expert E. James Brennan.
A better approach may be to keep base salaries (aka show-up pay) to no more than about 70% of total expected pay. This allows for sizeable bonuses, which are powerful motivators.
Incentive bonuses are effective not only because of the financial reward, but also because everyone appreciates having their hard work recognized and rewarded. For both of these reasons, well-designed incentive bonuses can bring out the best in everyone.
Ala Weiss, an advisor to consultants, warns against trying to manage (lower) the amount paid to a partner. Instead, he suggests trying to manage (raise) the partner’s value.
Weiss also reminds firms to design their plans for the future, not for the past.
“You want to foster an environment where everyone believes that one partner’s success is best for the firm rather than detrimental to another partner,” says James “Jim” George CPA, CVA, JD.
One of the first questions to answer is: who will design and update the partner compensation plan? Larger firms often have an executive committee or a compensation committee which is charged with that responsibility. For smaller firms, it may be most appropriate for the managing partner to make these decisions. Regardless of who handles this important task, the following reminders may be helpful...
Upholding the IRS’s denial of a tax exemption, the Tax Court found the organization at issue, created to provide gaming activities in a “sober” environment, was not operated exclusively for charitable purposes.
By Stephen D. Kirkland, CPA, CMC, CFC, CFF
The U.S. Tax Court recently issued an opinion focusing on the requirements for an organization to qualify for a tax exemption under Sec. 501(c)(3), emphasizing that an organization must strictly comply with those requirements.
In GameHearts, T.C. Memo. 2015-218, the Tax Court held in a declaratory judgment proceeding that the IRS was justified in denying the nonprofit organization GameHearts a tax exemption. The organization claimed in its bylaws that it would promote “adult sobriety and the general welfare of the citizens of the State of Montana.”
In its Form 1023, Application for Recognition of Exemption Under Section 501(c)(3), GameHearts said it was committed to “providing alternative forms of entertainment” including “free and low cost tabletop gaming activities in a supervised non-alcoholic, sober environment …” GameHearts also stated that it was working toward the betterment of the region by attracting participants to its activities “during evening hours, as opposed to frequenting bars and casinos in the area, as well as to inspire decision making and problem solving abilities by teaching and promoting educational and strategic games and activities ...” On its Form 1023, GameHearts also said it depended on donations from the gaming community and was largely a “mobile tutorial program.”
To encourage adult sobriety, GameHearts offered tutorials on how to play card games and miniature games and offered “organized play.” Many of the games were similar to those offered in nearby for-profit casinos. GameHearts claimed that another purpose for its programs was to teach participants how to develop relationships with retailers and game manufacturers and teach important life skills and work ethics.
Its stated purpose for providing free services was to appeal to the poor, distressed citizens in the community. However, GameHearts also claimed that it would help “boost the overall market shares of the industry by introducing new and motivated players into the environment.”
The IRS concluded that GameHearts was not organized or operated exclusively for exempt purposes because (1) GameHearts failed to establish that it benefited a charitable class; (2) GameHearts’ nonexempt activities were more substantial than its exempt activities; and (3) GameHearts did not meet the exempt purpose requirements of Regs. Sec. 1.501(c)(3)-1(d) since it did not limit its activities to addicts with low incomes.
The requirements for exempt status
In its opinion, the court included two important reminders. First, the organization bears the burden of proving that it meets the requirements under Sec. 501(c)(3). Second, a statute creating an exemption “must be strictly construed.”
The exemption under Sec. 501(c)(3) is available to the following organizations:
Corporations … organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition …, or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual …
Although an organization must be both organized and operated exclusively for tax-exempt purposes, the court focused primarily on whether GameHearts was operated for charitable purposes.
The court explained that the term “charitable” is used in Sec. 501(c)(3) in its generally accepted legal sense. According to Regs. Sec. 501(c)(3)-1(d)(2), the term includes, but is not limited to:
[r]elief of the poor and distressed or of the underprivileged; … lessening of the burdens of Government; and promotion of social welfare by organizations designed to accomplish any of the above purposes, or (i) to lessen neighborhood tensions; … or (iv) to combat community deterioration and juvenile delinquency.
The Tax Court had previously held that the term “charitable” could include “any benevolent or philanthropic objective not prohibited by law or public policy which tends to advance the well-doing and well-being of man” (Hutchinson Baseball Enters., Inc., 73 T.C. 144, 152 (1979), aff’d, 696 F.2d 757 (10th Cir. 1982) (quoting Peters, 21 T.C. 55, 59 (1953))).
Operating exclusively for charitable purposes
According to Regs. Sec. 501(c)(3)-1(c)(1), an organization will be regarded as operated exclusively for one or more exempt purposes only if it engages primarily in activities that accomplish one or more of the exempt purposes specified in Sec. 501(c)(3).
The IRS’s primary issue with GameHearts was that it was not operated exclusively for charitable purposes because of the way it promoted sobriety and the general welfare of the people of Montana. A single, substantial nonexempt purpose will disqualify an organization despite the importance of its exempt purpose. Also, if an organization serves private rather than public interests, it will not qualify.
GameHearts claimed that it was in fact operating for charitable purposes because it provided relief for the poor, distressed, or underprivileged and promoted general welfare by encouraging community-minded sobriety. The IRS argued that more than an insubstantial part of GameHearts’ activities furthered “nonexempt social and recreational interests” because GameHearts offered gaming to anyone who was over 18 years old and sober.
The IRS’s positions were that (1) gaming is recreational, and (2) GameHearts did not limit its services to a charitable class. GameHearts countered, and the court agreed, that the specific type or nature of recreation is not relevant.
GameHearts also argued that it served a charitable class because its programs did not compete with the for-profit gaming industry.
The court focused on how an organization that offers a recreational activity to achieve a charitable purpose can qualify as a charitable organization. A single activity can have more than one purpose. The purpose of the activity, not the nature of it, is determinative. Therefore, the Court focused on whether GameHearts’ primary purpose for engaging in its sole activity (gaming) was an exempt purpose or whether there was another substantial nonexempt purpose (recreation).
Prior case law
In its analysis, the court considered earlier cases on this point.
B.S.W. Group, Inc., 70 T.C. 352 (1978), involved an organization that provided consulting services to not-for-profit, limited-resource organizations that were engaged in various rural-related activities. The court did not find that B.S.W. Group was not exempt because its activities might be a trade or business, but it did conclude that its activities were commercial rather than charitable. The organization failed to show that it did not compete with commercial consulting businesses. Also, B.S.W. Group charged fees for its services, which produced a net profit, and also did not get any public support besides the fees. B.S.W. Group also failed to limit its clientele to other organizations that were exempt under Sec. 501(c)(3). As a result, B.S.W. Group did not qualify for exemption because the primary purpose for its sole activity (consulting) was commercial rather than educational, scientific, or charitable.
In Schoger Foundation, 76 T.C. 380 (1981), a religious retreat facility in Colorado was not operated primarily for an exempt religious purpose. Although wholesome family recreation and contemplating nature might provide a religious or uplifting experience, Schoger Foundation failed to show how its religious retreat experience differed from experiences available at any other quiet inn or lodge in Colorado.
Hutchinson Baseball Enters., Inc.,73 T.C. 144 (1979), involved an organization that primarily promoted baseball in the surrounding community by maintaining a baseball field for the public, providing coaches and instruction for children, and sponsoring a baseball camp. As a result, the organization was operating for an exempt purpose.
However, in Wayne Baseball, Inc., T.C. Memo. 1999-304, the organization’s nonexempt social and recreational activities were substantial in comparison to the organization’s promotion of baseball in the community. The sole activity sponsored by the organization was the operation of an adult amateur baseball team, and the primary beneficiaries were the individual team participants. Allowing spectators to watch the baseball games without charge was incidental to the purpose of providing enjoyment, recreation, and social interaction for the team participants.
In Peters, 21 T.C. 55 (1953), a foundation qualified for exempt status since it was organized to promote social welfare by furnishing public swimming facilities to all residents of a school district, especially those who did not have access to private facilities.
In Columbia Park & Recreation Ass’n, 88 T.C. 1 (1987), aff’d, 838 F.2d 465 (4th Cir. 1988), the association, which was organized to provide recreational facilities for residents of a planned community, did not qualify for exemption because it benefited only residents of the planned community, limited access to them, and obtained funding only from those residents rather than by voluntary contributions from the public. The key difference between Peters and Columbia Park & Recreation was not whether the activities themselves were charitable, but whether the organizations were organized for charitable purposes.
The GameHearts court recognized that recreational therapy could be a way to achieve a charitable purpose. Nonetheless, GameHearts did not show that it was “operated exclusively” for one or more exempt purposes. The organization was denied tax-exempt status because there was a single, substantial nonexempt purpose, despite the importance of the exempt purpose. Although promoting sober recreation may benefit the community, the form of recreation GameHearts offered was also offered by for-profit entities. Even though GameHearts did not profit from the recreation that it offered and it could not offer recreational gaming that competed with for-profit casinos, tax-exempt status was denied. Recreation was found to be a significant purpose, in addition to the therapy provided, because of the inherently commercial nature of the recreation and the ties to the for-profit gaming industry.
As a final note, the court mentioned that the IRS had encouraged GameHearts to apply for exemption as a social welfare organization under Sec. 501(c)(4) instead of trying to qualify as a charity under Sec. 501(c)(3), but GameHearts had declined.
Designing Effective Compensation Plans
Your employees are one of your most valuable assets. In fact, they may be the backbone of your business. That is why management consultants say that hiring and keeping good employees should be a high priority for every manager or business owner. But attracting and retaining qualified, loyal employees are also among the most difficult challenges for any business today. To meet this challenge, businesses must compensate each employee in ways that rewards them fairly and motives them to improve.
Years ago, employers commonly paid their workers through weekly salaries or hourly wages. The amounts were based primarily on experience, title, and length of service to the company. In effect, they based pay levels on seniority. Then they noticed that more seniority does not always result in more productivity. So, in recent years, employers have been moving to new compensation methods, basing pay more on performance.
This shifts the focus to results achieved (output) and away from experience and qualifications (input). And it allows the employer to see compensation as an investment that provides a return, rather than seeing it as just a major on-going expense.
Does Your Company Offer this Great Benefit?
One of the best benefits any company can offer to its employees is financial education. At relatively modest costs, instructors can be brought in to teach the basics of household budgeting, debt management, income tax planning, saving for college, and retirement readiness.
Sad to say, but much of the American workforce is woefully unprepared to deal with these critical day-to-day financial challenges. Many workers grew up in homes where the parents set poor examples of how to manage money. The schools did not teach financial management basics, and we cannot rely on the government to teach it. So, to a great extent, it is up to the employers.
And employers have a self-serving reason to offer this type of education. When employees get into financial trouble, the employers are impacted. This is because the employees’ financial issues often lead to increased absenteeism, distractions while on the job or employee theft.
If your company does not offer this type of benefit, let me encourage you to seriously think about it. Consider covering topics such as government benefits including Social Security and Medicare, (i.e. what to expect, how to apply, what does and does not affect the amount of benefits).
Other good topics to address are the retirement and welfare benefits offered by the employer. How many workers really understand the retirement plan and insurance options that are offered to them? Another great topic is the financial aspects of parent care (how many workers understand the differences between disability insurance and long-term care insurance?)
Brief classes can be offered in the mornings, during lunch or after hours. Instructors who offer education (and not sales pitches) are probably available nearby and would be glad to speak for a nominal payment. Simple rewards in the form of recognition can be offered to employees who participate. And the employer should get a good return on its investment.
What is an Employee Worth?
It is well established that the most difficult part of running a business is attracting and retaining the best available workers. This is also one of the most important aspects of running a successful business. In fact, one business consultant has said that recruiting and keeping good employees should ultimately be the only priority for a business owner.
Although unemployment and under-employment rates are high, the market for reliable, talented, devoted employees is still tight. Competition for these top performers has been referred to as a “talent war.”
Consequently, some pay levels have moved higher in recent years, and you may be reluctant to match what the market is paying. But if you pay too little, you risk losing a good employee, and losing all that goes with him or her, including relationships and company knowledge. In addition, recruiting and training a replacement will be expensive, especially if you have to pay a recruiting agency, relocation costs and a signing bonus to replace unvested benefits your new employee is leaving behind at the former employer.
So how much should you pay?
Salary surveys and databases are available to show compensation levels paid by others in the same industry for similar positions, and that may be a good place to start. This market-based information is known as comparability data and the process of comparing one employee to such market data is known as benchmarking. But an employee might handle multiple tasks, which can make it difficult to find comparability data and put specific numbers on that person’s value. In other words, finding comparability data is not the end of the process, instead it may be the beginning of the hardest part. Since every employee is unique, many factors must be considered in determining whether a specific person is worth more or less than what the comparability data shows. One helpful step might be to ask the employee to complete an informal evaluation on himself or herself, listing recent accomplishments and short-term goals. Then prepare your own lists of the employee’s strengths and weaknesses. Review their job description and determine whether their actual duties are the same as what is on the written job description. This helps make benchmarking more reliable.
Remember to focus on output (results) more than input (i.e. hours worked, experience, education). Results are what you are paying for. Carefully consider intangibles such as relationships with other employees, regulators, customers, and referral sources. These relationships, along with loyalty, a good attitude and dependability, are hard to measure and value. Ask yourself: what would I lose if this employee walked out the door and joined a competitor? What costs would I incur to get a comparable replacement?
Then ask yourself: what am I providing to this employee in addition to cash compensation? A pleasant work environment? Advancement opportunities? Flexible work schedule? Health insurance? Assistance with child care? Paid vacation time (and flexibility to use that time)? These are highly-valued benefits and should be considered to be part of the employee’s compensation package. In other words, if these benefits are provided, they could significantly reduce the cash compensation required to keep and motivate an employee.
This process can help you decide whether your employee should be paid more or less than the amounts shown in the comparability data.
Remember also that the least expensive reward is the one that is most appreciated – simple recognition. Hand-written thank you notes are powerful because they are so rare in this electronic age. Another powerful reward is a spot bonus. This is a one-time, unexpected cash bonus used to recognize a special accomplishment or extra effort.
Regardless of how valuable an employee is, be cautious about giving a large pay increase when times are good since higher base salaries might force you to lay off people when business slows down. Try giving cash bonuses instead, so base wages don’t have to be cut so much when business drops off.
For more articles on determining reasonable compensation amounts, please see our website:
Ways to Improve an Incentive Bonus Plan
Here are some potential ways to improve an employee bonus plan.
Reduce base salary and increase variable pay. Make the potential bonus large enough that the employee is truly motivated to work for it.
Simplify the bonus plan. People have a tendency to be skeptical of anything they do not fully understand.
Use the bonus plan to unify, not divide, your workers. If everyone gets a bonus when the company meets budget, the employees will pull together rather than competing with each other and finger-pointing.
Include some flexibility and subjectivity so you can adjust the amount upward or downward for hard-to-measure attributes like attitude. You do not want to be contractually committed to paying a year-end bonus to someone who was just fired for embezzling.
Consider spot bonuses. You can recognize someone’s unexpected, extraordinary performance by awarding an on-the-spot bonus. These bonuses are intended to show immediate appreciation for an exceptional accomplishment. These bonuses are completely subjective and are usually small (it’s the thought that counts) and should be given soon after the time of achievement.
Personalize it. Rather than simply having the net amount electronically deposited in the employee’s bank account, consider hand-delivering a paper check. Look the employee in the eyes, shake their hand, and say “Thank you!” while handing them the check. Or, send a hand-written note to their home address. We live in an electronic age but the old-time personal touch is still powerful.
Pay bonuses more often. Once a year may be a golden handcuff, keeping employees on board until the annual bonus is finally paid. But in today’s want-it-now society, a year can be a long time. Perhaps more motivation can be derived from two six-month bonuses rather than one annual bonus. Also, pay the bonus as soon as practical after the amount has been determined. Attitudes tend to sour when people have to wait longer than they think they should.
Be careful with non-qualified deferred compensation. This is simply an unfunded promise to pay some amount at a future date if certain conditions are met. Strict requirements must be met to avoid tax problems and care must be taken to record the contingent obligation correctly on the books.
Be sure to get legal counsel on any obligation you make to your employees and carefully address the income tax and payroll tax consequences of any payment.
Are Tax Assessments for Unreasonable Compensation Subject to the 20% Penalty Under Section 6662?
Yes, a company may be liable for the section 6662(a) and (b)(1) and (2) accuracy-related penalty when the IRS determines that a portion of its tax underpayment was due to either a substantial understatement of income tax or negligence.
There is a "substantial understatement" of income tax for any tax year where, in the case of corporations (other than S corporations or personal holding companies), the amount of the understatement exceeds the greater of (1) 10% of the tax required to be shown on the return for the tax year or (2) $10,000. See Sec. 6662(d)(1)(B).
Section 6662(a) and (b)(1) also impose a penalty for negligence or disregard of rules or regulations. Under section 6662(c), "negligence" includes “any failure to make a reasonable attempt to comply with the provisions of this title."
Under case law, negligence is "a lack of due care or the failure to do what a reasonable and ordinarily prudent person would do under the circumstances." See Freytag v. Commissioner, 89 T.C. 849, 887 (1987) (quotingMarcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967), affirming on this issue 43 T.C. 168 (1964) and T.C. Memo. 1964-299), affirmed, 904 F.2d 1011 (5th Cir. 1990), affirmed, 501 U.S. 868 (1991).
There is an exception to the section 6662(a) penalty when a company can demonstrate (1) reasonable cause for the underpayment and (2) that the company acted in good faith with respect to the underpayment. See Sec. 6664(c)(1). Regulations under section 6664(c) provide that the determination of reasonable cause and good faith "is made on a case-by-case basis, taking into account all pertinent facts and circumstances." See Sec. 1.6664-4(b)(1).
Reliance on the advice of a professional may, but does not necessarily, establish reasonable cause and good faith for the purpose of avoiding a section 6662(a) penalty. See United States v. Boyle, 469 U.S. 241, 251 (1985).
Case law sets forth the following three requirements for a company to use reliance on a professional adviser to avoid liability for a section 6662(a) penalty:
(1) The adviser must be a competent professional who had sufficient expertise to justify reliance,
(2) the taxpayer provided necessary and accurate information to the adviser, and
(3) the taxpayer actually relied in good faith on the adviser's judgment.
See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), affirmed, 299 F.3d 221 (3d Cir. 2002); see also Charlotte's Office Boutique, Inc. v. Commissioner, 425 F.3d 1203, 1212 n.8 (9th Cir. 2005) (quoting with approval the above three-prong test), affirming 121 T.C. 89 (2003).
Since executive compensation is a complex subject, and usually involves large amounts, some companies rely on the three requirements above for protection against non-deductible penalties.
Compensation Paid By Non-Profits
Complying with IRS Regulations
Executive compensation is one of the most controversial issues in America today. The media is focused on this complex issue. The public, the Internal Revenue Service and the Securities and Exchange Commission are debating the value of executives’ services. At non-profit organizations, the employees, donors, and patients are following the debate. Everyone has an opinion, and most people are anxious to express their opinions.
The Internal Revenue Service (IRS) has always watched charities to ensure that their tax-exempt status is not abused. One of the primary factors the IRS now examines is the amounts of compensation and benefits provided by charities, foundations and social welfare organizations to their key employees, contractors, directors and trustees.
The IRS believes that some of these key employees may be taking advantage of their influential positions by setting their own compensation packages at above-market levels.
Results of IRS “Colleges and Universities Compliance Project”
The Internal Revenue Service believed that many colleges and universities were not complying with IRS regulations concerning how executive compensation should be set at tax-exempt organizations. So the IRS launched its “Colleges and Universities Compliance Project” to find out just how wide-spread this problem was.
In May 2013, the IRS published its report on this Compliance Project and that report shows they found wide-spread noncompliance in the area of executive compensation.
According to Code Sec. 4958, tax-exempt organizations cannot pay more than reasonable compensation to disqualified persons (their officers, directors, trustees and other key employees).
Section 4958 applies to private colleges and universities and imposes a 25% excise tax on disqualified persons who receive unreasonable compensation and another 10% excise tax on those persons who approve payment of the unreasonable compensation.
What constitutes reasonable compensation is open to debate. But the exempt organization has the burden of proving that it did not pay unreasonable compensation and that it complied with IRS regulations when determining the amounts to pay.
An organization may shift the burden of proving unreasonable compensation to the Internal Revenue Service by: using an independent consultant to review and determine compensation amounts; relying on appropriate comparability data; and contemporaneously documenting the compensation-setting process. (Please see IRS Reg. § 53.4958-6(a) for more details.) By meeting these strict requirements, an organization can create a “rebuttable presumption” that the compensation it is paying is reasonable.
Most of the 34 private colleges and universities that were examined by IRS in this project had attempted to meet the rebuttable presumption standard. However, about 20% of them failed to do so because of problems with their comparability data, including:
Selecting institutions that were not similarly situated, based on: location, endowment size, revenues, total net assets, number of students, and/or selectivity;
- Failing to document selection criteria for the schools included or to explain why they were deemed comparable; and
- Using compensation surveys that did not specify whether amounts they reported included only salary or also other forms of compensation
The IRS also examined employment tax returns for some of the colleges and universities, and all of the exams resulted in adjustments to wages. This led to assessment of tax and, in some cases, penalties. Wage adjustments totaled $36 million, while taxes and penalties were over $7 million.
As a result, through education and examination, the Internal Revenue Service says they plan to ensure that tax-exempt organizations are aware of the importance of using appropriate comparability data when setting compensation.
Planning for Golden Parachute Payments
“Golden parachute” arrangements typically provide for large cash payments to a corporation’s top executives if those individuals are terminated due to a change in the control of the company.
Years ago, these payments were fully tax deductible by the employer if they were “ordinary and necessary” business expenses under Internal Revenue Code § 162. Due to controversy over large executive pay packages, the Tax Reform Act of 1984 added § 280G to the Code.
Board of Directors Compensation
Executive compensation is a complex and controversial personal subject. But the controversy does not stop with the top employees. I often hear people questioning the compensation packages offered to members of the Boards of Directors of companies, hospitals and foundations. This controversy seems to arise from the various understandings, or lack of understanding, that people have about the duties of a director.
Prior to the Enron debacle, many people viewed the Board of Directors as a country club setting. The perception was that directors came together for a good time and a round of golf every three months or so. Now, however, more people realize the significant responsibilities and the risks that come with having a seat at the Board of Directors.
The compensation typically paid to directors varies significantly depending on the type and the size of the organizations, and the expectations of the directors.
For example, many small charitable organizations expect the directors to serve as volunteers. These organizations may not even reimburse travel costs or other out-of-pocket expenses. Not only do these directors serve without compensation, but they may be expected to donate a certain amount to the organization annually as long as they serve on the Board.
Foundations often compensate their board members, who may be referred to as trustees rather than directors. The foundations may compensate their trustees because of the significant duties expected of those trustees. For example, many foundations have no employees and the trustees devote significant amounts of time to reviewing grant applications, visiting the sites of charities that have been funded, participating in public education events, and assisting with management of the foundations’ investments, financial records and compliance issues.
For-profit companies typically pay individuals who serve on their Boards. For startup companies, the compensation may be in the form of stock awards or nonqualified deferred compensation. Established companies usually pay annual director fees, meeting fees, travel reimbursement and/or stock awards.
Determining appropriate director fees usually begins with taking a close look to see what is expected of the directors. For many, being a director is a significant commitment. It often takes them away from their other professional activities and their families. It requires significant amounts of study to keep up with current developments in their industries, especially for companies operating in industries that are changing rapidly or that are highly regulated. This includes technology companies, financial institutions and hospitals, among others.
The next consideration in determining director fees is their qualifications. Most often, individuals are asked to serve as directors because they are highly-educated, experienced, mature, and well-respected. Based on these qualifications, their time and input is valuable. In today’s environment, risks must also be considered. Anyone who serves on a Board of Directors is exposing himself or herself to at least some levels of risk.
The next step may be to do some benchmarking. In this step, we look to see what similar companies are paying to their directors. In effect, we look at market rates of pay. This helps ensure that only reasonable compensation is paid.
There are differences between compensating directors and compensating executives. For example, executives may have their performance and accomplishments evaluated at least annually. However, members of the Board may not go through an evaluation process. Therefore, Board members may be compensated equally, with a few exceptions. One exception is the meeting fees which are paid for each meeting but paid only to those who attend. Another exception may be the chairperson, who receives additional compensation for handling the chairperson’s responsibilities. Also, full-time employees of a company who serve on the Board usually do not receive director fees since they are already being compensated for full-time duties by the company. But again, there are exceptions.
All of these factors should be considered when determining how much compensation directors should receive. Then, considerable judgement must be applied, since every situation is unique. The result needs to be positive for both the directors and the other stakeholders of the organization.
A phantom stock plan is a type of incentive compensation plan which a company can use to reward management for increasing the value of the company. Although this type of plan often uses the changing value of the company as a basis for determining the amount of a bonus, the actual payment is made in cash.
The covered employees are offered an annual bonus based on a percentage of the increase in the company’s value.
For example, the sole shareholder of ABC Company offers a senior executive a cash bonus equal to 20% of the increase in the company's value during a particular year. The company's value would need to be determined at the beginning of the year and again at the end of the year. Let's assume that the company's value increases by $1,000,000 during that year. The executive would be paid a cash bonus following the close of the year in the amount of $200,000 (20% of $1,000,000).
Opinion Letters on Compensation Paid by Charities
The Internal Revenue Service now keeps a close eye on charities and social welfare organizations to ensure that their tax-exempt status is not abused. One of the primary factors the IRS examines is the amounts of compensation and benefits provided by these tax-exempt organizations to their key employees.
The IRS believes that some officers and other employees may be taking advantage of their influential positions by setting their own compensation at above-market levels. The IRS has begun a wide-spread initiative to find those overpaid individuals.
The IRS is primarily using Internal Revenue Code section 4958, which allows them to impose excise taxes on the excessive portion of compensation paid to a charity’s employee. These excise taxes are referred to as “intermediate sanctions” since they are less severe than having the IRS revoke the charity’s tax-exempt status.
These excise taxes are aimed at unreasonable compensation paid to a “disqualified person.” A disqualified person is anyone who was “in a position to exercise substantial influence over the affairs” of the tax-exempt organization at any time during the five-year period prior to the transaction, and the family members of any such person. Note that it is not necessary that the person actually exercised substantial influence, only that he or she was in a position to do so.
Over-paid independent contractors may be subject to the excise tax also. This could include CPAs and attorneys if they meet the definition of disqualified person.
The Code refers to the unreasonable portion of compensation as an “excess benefit transaction” because the individual is getting a benefit (compensation) in excess of the value of the services he or she provides for that compensation.
Expect the IRS to look closely at compensation amounts paid to: officers who also sit on the charity’s Board of Trustees, relatives of major donors, long-term employees who have reduced their duties or work hours, employees who receive performance bonuses, and anyone who has a hand in setting his or her own compensation level. Certain industries are of special interest to the IRS. For example, hospitals are being examined because market conditions have pushed their compensation amounts to higher levels in recent years.
Under Code section 4958(a)(1), the IRS can impose a 25% excise tax on the unreasonable portion of an individual’s compensation. (This excise tax is in addition to federal and state income taxes, and FICA tax the employee has to pay on that compensation.) If the unreasonable portion is not repaid promptly after the 25% tax is imposed, section 4958(b) provides for an excise tax equal to 200% of the unreasonable portion.
In addition, Code section 4958(a)(2) allows the IRS to impose an excise tax on an “organization manager” (officer, director or trustee) who participated in permitting the unreasonable compensation, unless such participation was not willful and was due to reasonable cause. This tax is 10% of the unreasonable portion of the compensation. It was limited to $10,000 per excess benefit transaction until the Pension Protection Act of 2006 raised that limit to $20,000. Those organization managers who knowingly allow the excessive compensation are jointly and severally liable for this excise tax. Of course, the last thing any volunteer board member wants is to be personally exposed to a tax.
Note that both the 25% and the 10% excise taxes are imposed upon the individuals, not the charity.
To let everyone know that they are serious about this, the IRS announced that it was proposing over $21 million in section 4958 excise taxes on forty disqualified persons and organization managers at twenty-five charities.
In addition to the monetary impact, publicity resulting from these penalties can be disastrous for a charity.
For all these reasons, charities need to be very careful about how much they pay and how the amounts are determined. But, setting levels of compensation for key employees is difficult for charitable Boards of Trustees since most board members are not familiar with the complexities of compensation analysis. And, determining appropriate cash compensation levels for key employees at a charity may be more challenging than doing so at for-profit companies since charities do not offer stock options, profit-sharing plans and some of the other incentives rewarded to executives at for-profit entities.
Yet pay levels and benefits at charitable organizations must keep up with the market to prevent turnover, since turnover among key employees is costly, disruptive, and damaging to donor relations.
Many charitable boards need guidance on pay levels due to the subjective nature of determining reasonable compensation, complex facts and the desire to avoid IRS scrutiny. An opinion letter from an independent party can give board members reassurance that pay levels are in line with the market, reduce turnover, and help avoid the excise taxes by creating a rebuttable presumption that the compensation is reasonable.
If the compensation is presumed to be reasonable under the excess benefit rules, section 4958 excise taxes can then be imposed only if the IRS develops sufficient contrary evidence to rebut the charity’s evidence. In other words, the burden shifts to the IRS to prove that the compensation was unreasonable.
The charity’s board must meet three requirements to create a rebuttable presumption that compensation is reasonable:
1. The compensation must be approved in advance by an independent board or board committee without the disqualified person participating,
2. Appropriate comparability data that documents the arms’ length nature of the transaction, such as compensation surveys, must be relied upon, and
3. The basis for approval must be documented in writing, such as through board minutes.
A qualified compensation consultant can help the board meet these requirements by providing comparability data and documenting it in an opinion letter. In preparing opinion letters, the compensation professional should take into consideration all relevant facts and circumstances including, but not limited to:
1. Compensation levels paid by similar organizations, both taxable and tax-exempt, for comparable positions;
2. The availability of similar employees in the geographic area;
3. Current compensation surveys compiled by independent firms; and
4. Any written offers from similar employers competing for the services of the disqualified person.
Other relevant factors usually include the size of the organization, the geographic area it serves, and the qualifications and duties of the employee.
The opinion letters serve another important purpose. Reg. 53.4958(d)(4)(iii) provides protection for the organization managers against the 10% excise tax even if the compensation is determined to be unreasonable. To get this protection, the managers must obtain an opinion letter stating that the compensation consultant believes that if the compensation amount is challenged by the IRS, it would “more likely than not” be upheld in court. Other requirements must be met as well. Although this does not guarantee that the compensation will not be found to be unreasonable, obtaining and using such an opinion letter can protect the officers and board members from personal exposure to the 10% excise tax.
The opinion letter should also include a statement of independence from the compensation professional.
* * * * * *
This article provides only a brief overview of the complex rules governing compensation paid by charities. With emphasis on corporate governance now at an all-time high, advisors and board members should become familiar with these rules and carefully monitor the compensation and benefits of key employees and contractors. The steps taken by a charity to avoid the excess benefit transaction excise taxes can also be useful in an audit by a state regulatory agency, and in responding to inquiries from potential donors.
Addressing Reasonable Compensation
Executives tend to be well paid in corporate America. In response, the media is debating whether these executives are really worth the amounts they are taking home. And, since the answer to that question has dramatic tax consequences, the Internal Revenue Service (IRS) and state tax authorities are paying close attention to this debate.
Pursuant to Internal Revenue Code section 162, the IRS allows corporations to deduct “ordinary and necessary” expenses incurred in carrying on their businesses. This includes compensation for services performed by stockholders and their family members, but only if the amounts paid are “reasonable” for the services performed.
C corporations pay income tax on their earnings and then may distribute some of the after-tax earnings to shareholders as non-deductible dividends. The shareholders must pay income tax on the dividends they receive, so corporate earnings are effectively taxed twice, once at the corporate level and once at the shareholder level.
A closely-held C corporation paying excessive compensation to a shareholder-employee is required to treat the excess portion as a dividend (provided there are adequate earnings and profits) rather than as compensation. This has unfavorable tax consequences for the company, since a dividend is not deductible. Therefore, funds withdrawn from a C corporation as dividends are effectively taxed twice – to the corporation and the shareholder-employee. Compensation is taxed only once – to the employee.
Whether compensation is reasonable depends on all the facts and circumstances. The analysis can be complex and requires judgment. But compensation may be considered to be reasonable if the same amount was paid for comparable services provided by someone other than a stockholder. A true comparable, however, is rarely available.
Be sure to consider how much an employee would be paid if the business was owned by an unrelated investor. After payment of all compensation, are there enough earnings left in the company to satisfy this hypothetical investor? If so, that may be one factor which suggests that the compensation was reasonable.
To determine a reasonable level of pay for an employee, we must consider many additional factors. For example, look at the employee’s input – long hours, special skills, relationships, years of experience and education brought to the job.
We must also look at the employee’s output, or the results he or she achieved. After all, pay for key employees should be performance-based. Consider new clients and contracts brought to the company, increases in profitability, and similar accomplishments. Measuring one person’s accomplishments can be difficult and time-consuming, however, since most accomplishments come from the efforts of several people working together.
Also consider the size of the company, the complexity of the industry, economic conditions, the geographic location and other factors.
An executive’s compensation for a particular year may include an amount for services he or she performed in an earlier year. Business owners often receive reduced pay in the early years of a business, even though that may be when they work the hardest. They also may not be adequately paid during periods of rapid growth, when cash flow is tight. If so, they may be entitled to catch-up pay later. If an employee will be underpaid until a new business becomes profitable, and will receive proportionately larger pay later, consider stating that in board minutes or an employment agreement.
In addition to an employee's salary, employer-provided benefits should be considered in determining whether an employee's compensation is reasonable. This includes pension and welfare benefits, as well as fringe benefits such as personal use of a company car. An otherwise high salary might be reasonable if the employee’s benefits are less than those usually provided to a comparable employee.
Due to the potentially adverse tax consequences, you should advise shareholder-employees to carefully document the reasonableness of their compensation and explain how the amount was determined. Documentation should describe the unique and valuable nature of the individual’s skills and of the services provided.
If a year-end bonus is to be awarded, the terms should be written out in advance. The bonus may be equal to some percentage of the increase in pretax profits over the prior year, for example. If awarded, a resolution should explain how and when the bonus was earned and computed.
S corporations, on the other hand, are inclined to keep the compensation of shareholder-employees low. This is because their compensation is subject to payroll taxes, but distributions to stockholders are not. (Either way, S corporation earnings are subject to income tax only once.)
Federal and state tax authorities are aggressively reviewing S corporations to ensure they pay enough payroll taxes on funds turned over to stockholders.
On the other hand, an S corporation must be careful not to over-compensate any shareholder. If the IRS determines that one shareholder was overpaid, the excess compensation will be treated as a distribution to that one shareholder. This could create a disproportionate distribution to that shareholder. Since the IRS can terminate a company’s S status for making a disproportionate distribution to one shareholder, the S status could be terminated as the date of the over-payment the company would be treated a C corporation thereafter. Therefore, subsequent distributions would be subject to two levels of tax.
As with C corporations, records should be kept to show what services were provided and how compensation levels were determined.
The Internal Revenue Service also keeps a close eye on tax-exempt organizations to ensure that their exempt status is not abused. Under Internal Revenue Code section 4958, the IRS can impose a 25% excise tax on the unreasonable portion of compensation received by a key employee.
The IRS can also impose a 10% excise tax on officers or directors who permitted the excessive payment. Both of these excise taxes are imposed on the individuals, not on the charity.
The Code refers to this unreasonable compensation as an “excess benefit transaction” because the executive is getting a benefit (compensation) which exceeds the value of services he or she provides in exchange.
Financial Accounting Standards Board issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”) says that preparers of financial statements must recognize and measure uncertain tax positions taken by the company. Among other things, disclosure of the potential impact of these positions is required. This includes estimating and disclosing the amount of the company’s potential tax assessments. One of the issues covered by FIN 48 is a potential tax assessment due to the payment of unreasonable compensation.
Who else is asking?
IRS agents are not the only ones concerned with compensation amounts that may be excessive. Many parties have a vested interest in this issue. Directors, shareholders, creditors, bankruptcy trustees, and others are looking closely at executive compensation packages. And they all have their own opinions as to what an employee’s services are worth. But not everyone understands the complex factors which come into play. So, the reasonableness of executive compensation packages may continue to be one of the most debated issues in the business world for years to come.
Our income tax laws change often. Please advise your clients to work closely with you or a tax advisor in structuring compensation plans.
* * * * *
Stephen Kirkland can be reached at (803) 724-1414