Issue: Tax exempt 501(c)3 charitable organization could lose their tax exempt status or be severely penalized for paying executive management or physicians beyond fair market value. Below is a hypothetical analysis of a situation where your hospitals CEO is requesting a compensation increase and offers anecdotal data to support the raise. What should you do and how should you approach a proper compensation analysis to avoid penalties.
Rule: 26 USC § 4958 sets forth “intermediate sanctions” in the form of excise taxes imposed on the “disqualified person” (25% of the benefit and possibly as much as 200% of the benefit) as well as organization management (10% of the benefit, jointly and severally applied, unless the involvement was not knowingly done and was not willful and was due to reasonable cause) for all excess benefit transactions.
Analysis: The fundamental principle for all charitable organizations under 501(c)(3) is to ensure that each transaction is transparent and in furtherance of the charitable purpose and mission. An important secondary reason is to protect the organizations tax-exempt status. Providing an excess transaction benefit could jeopardize tax-exempt status. The IRS has determined that the best way for any charitable organization to insure transparency and accountability is to first ensure the organization has a clearly articulated purpose that describes its mission, together with a knowledgeable and committed governing body and management team, together operating within sounds management practices.1 Therefore, the organizations by-laws and written policies should contain sufficient direction on how executive compensation is determined and under what circumstances said determination should be made together with a clearly defined process. Any organization, charitable or otherwise, has a strong desire to find and retain competent executive management. To do this the organization must offer a compensation package that is marketable and appealing to the qualified applicants it seeks. That said, each director has a duty of loyalty. “The duty of loyalty requires a director to act in the interest of the charity rather than in the personal interest of the director or some other person or organization.2” The best practice to ensure transparency and exemplify the duty of loyalty is to create a completely independent compensation review team that satisfies the IRS’s rebuttable presumption test outlined in section 4958. Failure to satisfy the rules under section 4958 may result in the imposition of an excise tax against the disqualified person (25%), the management (10%), and disgorgement of the excess benefit in the form of a 200% excess tax on the disqualified person3, unless the excess benefit is repaid to the organization within the taxing period. Repayment means to restore the organization to a financial position that equals or exceeds its position prior to the excess benefit payment.
1) Excess benefit transaction –”The term ‘excess benefit transaction’ means any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration received for the benefit.”4
2) Disqualified person – Disqualified person means “any person who was, at any time during the 5-year period ending on the date of such transaction, in a position to exercise substantial influence over the affairs of the organization.”5 The following persons are presumed disqualified: president, CEO, CFO, treasurer, etc.
3) Rebuttable presumption test – “Under this test, compensation payments are presumed to be reasonable if the compensation arrangement is approved in advance by an authorized body composed entirely of individuals who do not have a conflict of interest with respect to the arrangement, the authorized body obtained and relied upon appropriate data as to the comparability prior to making its determination, and the authorized body adequately documented the basis for its determination concurrently with making the determination.”6
B. CEO data and request to participate
The initial data suggested by the CEO may be used to formulate an initial impression of whether or not an increase in compensation is warranted but it should not be used in formulating the opinion. The initial data suggested by the CEO is tainted in several ways. First and foremost is the fact the CEO is the one who obtained the information and implicitly selected the information he/she wants the board to use to determine his/her compensation. This is clearly not transparent and has several elements making the very transaction susceptible to a claim of conflict of interest. Secondly, the CEO cannot be part of the discussion. “Certain individuals within an organization are specifically labeled as disqualified persons. These include any individual who serves as a voting member of the governing body of the organization; any individual who has the power or responsibilities of the president, chief executive officer (CEO), or chief operating officer of an organization; and any individual who has the power or responsibilities of treasurer or chief financial officer of an organization.”7
C. Compensation committee
The compensation committee must be made up of independent directors that do not have a stake in the outcome. The committee members must be of sufficient integrity that allows them to act independently and receive and review data without the pressure of the CEO or other person(s) that are looking to increase the compensation behind fair market value. The directors should make sure the team is made up of an array of people with sufficient expertise in evaluating the data. The duty of loyalty requires directors to avoid even the appearance of impropriety. To ensure against conflicts of interest, the IRS encourages boards to implement and enforce a written conflict policy. Part of the policy should require all decision makers to disclose if they have a financial, business or other interest in the considered transaction(s). Any directors assigned to the compensation committee should disclose in writing that they do not have a family, business or financial interest in the CEO and would not benefit directly or indirectly in the compensation decision. If the board does not currently have such a policy I would encourage the board to draft one, disseminate to all appropriate personnel, include it in their training modules/work rules, and follow it. “Organizations that file Form 990 will find that part VI, Section B, Line 15 asks whether the process used to determine the compensation of an organization’s top management official and other officers and key employees included a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision.”8 In order to qualify for the rebuttable presumption of section 4958 the IRS will look to determine if the governing body committee making the compensation decision was composed entirely of individuals who do not have a conflict of interest with respect to the transaction. Qualifying under the presumption is critical to safeguarding against an adverse ruling and the imposition of the excess tax. The independent approval prong is one of three prongs reviewed by the IRS. Each member of the compensation committee, whether a director or not, becomes an “organization manager” for the purposes of section 4958.
The data reviewed to make the determination is the second of three prongs reviewed by the IRS to determine if the organization qualifies under the presumption. Note: qualifying under the presumption is critical, but it is only a presumption in favor of validity. “Once that test is met, the IRS may rebut the presumption that an amount of compensation is reasonable only if it develops sufficient contrary evidence to rebut the probative value of the comparability data relied upon by the authorized governing body.”9 Therefore, the data used to support the compensation package is essential. Additionally, compensation is viewed in the aggregate and includes base salary, bonuses, fringe benefits, travel allowances, etc. Compensation is also measured against compensation paid to similar CEOs in the same or similar market. This is one of many reasons why the CEO’s suggested data would not be acceptable, it was “anecdotal data he obtained and averaged from talking with various (some similar, some larger, some smaller) hospitals in various larger and smaller cities.”10 The best practice would be to retain the services of a qualified compensation consultant and instruct the person to ensure the data relied upon was from “similarly situated” organizations taking into account the size of the organization, the function, the market served, the complexity of the work performed, the training, experience, educational qualifications, and prior experience required. In reviewing the transaction the IRS will take into consideration the independence of the study, the quality of the study, and the type/similarity/quality of the data obtained.11 The importance of data collection and analysis cannot be overstated. The personnel in charge (consultant preferable) of the collection and analysis must be independent and their methodology, data and results must be documented and transparent. The directors reviewing the data must also be independent and thoroughly document their conclusions and recommendation to the entire board.
E. Adequate documentation
The third and final prong of the three part presumption is proper documentation. It goes without saying if the organization seeks to avail itself of this valuable presumption in favor of validity then the process, data, methodology etc. must be readily available to the IRS for review purposes. It is very difficult to allege the decision was properly made when the organization cannot support the decision with proper documentation of the process and data reviewed. Form 990, as discussed previously, requires the board to verify that the compensation decision included a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision. The key here is the “contemporaneous substantiation of the deliberation and decision.” One of the ways to accomplish this is to require the consultant to prepare a detailed report of their findings including the methodology, raw data, interpretations, assumptions, and conclusions. The committee should then keep detailed minutes of all meetings, questions and additional data. The final decision should be put to the committee and then to the board in writing with attachments of supporting data.
F. Suggested checklist to answer the question, “Has the health care provider explained the amounts and bases by which it compensates its officers, highly compensated employees, and physicians?12
a) Is there an employment contract?
b) Were the compensation arrangements approved by an independent board of directors or compensation committee subject to a conflict of interest policy?13
c) Was an independent consult or other person or entity used that was free of any conflict of interest? Was an independent analysis of substantially similar organizations performed? Is the methodology used, data collected, assumptions, and conclusions clearly articulated and beyond reproach?
d) Does the compensation analysis include the base salary, bonuses, fringe benefits, travel, and anything of value given to the CEO or highly compensated person?
e) Did the directors use their independent judgment, free from any conflict of interest, to analyze and review the data and make a reasonable decision based on appropriate supporting data?
f) In light of the charitable mission, is the compensation fair, reasonable, and in furtherance of the charities purpose?
This hypothetical situation could happen to you. Your failure to properly analyze all necessary factors could lead to serious penalties for your organization. If you have questions please do not hesitate to call Ron Chapman at Chapman Law Group.
Chapman Law Group is a professional health care law litigation firm, with offices in Michigan and Florida. For over 25 years Chapman Law Group has defended the rights of health care professionals, providers and corporations involved in the delivery of health care at all levels. We believe the dedicated men and women who provide health care deserve an exceptional defense when their integrity and actions are called into question.
Ronald W. Chapman is the founder and shareholder of Chapman Law Group. For 30 years Ron has focused his practice in the defense of health care providers of all levels including correctional law, civil rights law, medical malpractice defense, and health care administrative law at the state and federal level in Michigan and Florida.
1. Governance and related Topics – 501(c ) (3) Organizations p1
2. Governance and related Topics – 501(c ) (3) Organizations p4
3. 29 USC § 4958 (a) – (f)
4. 29 USC § 4958 (c)(1)(A)
5. 29 USC § 4958 (f)(1)(A)
6. Governance and Related Topics – 501(c ) (3) Organizations p4
7. “Intermediate Sanctions” by Jeffrey S. Tenenbaum Esq., Venable LLP, June 2002
8. Governance and Related Topics – 501(c ) (3) Organizations p 5
9. Governance and Related Topics – 501(c ) (3) Organizations p 4
10. Class written assignment instructions
11. “There is a special relief provision for organizations with annual gross receipts of less than $1 million. An organization will be automatically treated as satisfying the data requirement if it has data on compensation paid by five comparable organizations in similar communities for similar services.” “Intermediate Sanctions” by Jeffrey S. Tenenbaum Esq., Venable LLP, June 2002
12. Department of the Treasury Internal Revenue Service Memorandum for managers, EO determinations , control # TEGE-07-0806-04, p3
13. Department of the Treasury Internal Revenue Service Memorandum for managers, EO determinations , control # TEGE-07-0806-04, p3