Temp. Reg. § 53-4958-3T(e)(2)(iii)—Revenue-Based Compensation
The temporary regulations’ definition of "disqualified person" includes as a factor tending to show substantial influence the fact that a "person’s compensation is primarily based on revenues derived from activities of the organization that the person controls." Temp. Reg. § 53.4958-3T(e)(2)(iii). The corresponding section of the proposed regulations contained the same factor without the word "primarily."
The addition of "primarily" was a significant improvement. Nonetheless, this factor is still overly broad. It is increasingly common for tax-exempt organizations to use contingent compensation arrangements that include productivity as a factor (and sometimes a very important factor) in determining the participant’s eligibility for a level of contingent compensation. Many who participate in such contingent compensation plans do not have substantial influence over the organization. This is especially true for health care organizations where operating losses and other factors are influencing a trend toward making productivity incentives a larger and larger part of professional compensation.
An example is a health care system that has a primary care physician network, including a remote office staffed by one pediatrician. As the only physician at the site, the pediatrician controls all the revenue generated at the site. If that pediatrician’s compensation consists of a $50,000 base salary and incentive compensation of up to an additional $100,000 based on meeting personal productivity measures, that pediatrician may be a disqualified person even though the pediatrician never sets foot in the system’s administrative offices.
To characterize the pediatrician in this example as a disqualified person is an overly broad application of the disqualified person definition. Moreover, to base a person’s status as a disqualified person solely on revenue-based compensation that the person controls seems inconsistent with the decision to reserve the section 53.4958-5 of the 1998 proposed regulations for further study. For the same reasons that it is prudent to devote further study to, and to reserve judgment on, the extent to which revenue-sharing ventures should be characterized as per se excess benefit transactions, it also would be prudent to reserve judgment on whether basing a person’s compensation on revenues that the person controls is by itself a basis for disqualified person status.
The expansive reach of this factor discourages organizations from legitimate uses of incentive compensation to require, as well as reward, employee productivity. In the more than 30 years since Rev. Rul. 69-383, 1969-2 C.B. 113, was issued, revenue-based compensation has become increasingly accepted and widely used. Merely because an employee’s compensation is weighted heavily with incentives does not mean that the employee has substantial influence over the organization. As organizations place greater emphasis on productivity, expense control, and other incentives, this factor will become more problematic.
If it is decided to retain this factor in Temp. Reg. § 53.4958-3T(e)(2), the revenues controlled by the person should at least be substantial in relation to the organization’s total revenues. This "substantiality" standard permeates the definition of disqualified person. If compensation based primarily on revenues controlled by a person is to be a factor by itself, without more, the revenues controlled by the person should be a substantial part of the organization’s revenues.
To add a substantiality test, we suggest inserting the following clause at the end of Temp. Reg. § 53.4958-3T(e)(2)(iii): ", provided that such revenues controlled by the person represent a substantial part of the organization’s total revenues." In addition, Example 10 in Temp. Reg. § 53.4958-3T(g) should be amended to reflect the fact that the revenues controlled by X are not a substantial part of the hospital’s revenues.
