Nonprofit Hospital Executive Pay: Revisiting "Reasonable Compensation" in Light of the OIG 2014 Work Plan

Vol. 10 No. 8

AuthorThe Department of Health and Human Services’ Office of Inspector General (“OIG”) 2014 Work Plan has a new provision that has generated a fair amount of press lately: The proposal to review how executive pay falls within a hospital's operating costs.1  The review could result in the imposition of caps on the amount of executive compensation that can be included in the hospital's cost report.2   While caps have not been applied in the past, and the American Hospital Association has indicated its belief that the review is not intended to result in caps,3  there is still an existing requirement that in order to be included in the cost report, executive compensation must be reasonable.4  Given the new wave of attention on executive pay, now is a good time to review executive compensation packages and processes to ensure that compensation paid is reasonable.

Executive Compensation under Increased Scrutiny

Executive compensation, especially in the nonprofit hospital realm, has been a hot topic over the past few years.  With executive compensation of the top employees disclosed on the organization's annual Form 990 filed with the Internal Revenue Service (“IRS”), the contents of which must be publicly available on the company's website, nonprofit hospitals have been faced with the need to justify their compensation packages.  A few states have put compensation of nonprofit executives, including nonprofit hospital executives, under the microscope.  Massachusetts, for example, through its Office of the Attorney General, recently published a report on nonprofit chief executive officer (“CEO”) compensation.5 The report examined compensation not only of hospital CEOs, but also compensation of nonprofit insurers and universities. The New Hampshire Center for Public Policy Studies, a think tank for New Hampshire state policy needs, likewise conducted a review of nonprofit hospital executive compensation to review trends and compare New Hampshire's executive pay with other New England states.6  Now the OIG is conducting its own review as part of its 2014 Work Plan.

The OIG Work Plan indicates that this new priority item for fiscal year 2014 will entail a determination by the OIG as to "the potential impact on the Medicare Trust Fund if the amount of employee compensation that could be submitted to Medicare for reimbursement on future cost reports had limits."7 It goes on to state that the context is "employee compensation may be included in allowable provider costs only to the extent that it represents reasonable remuneration for managerial, administrative, professional, and other services related to the operation of the facility and furnished in connection with patient care."8  While the OIG does not indicate why this item is in the Work Plan now, one can speculate that it is the result of letters sent to several nonprofit hospitals in 2013 asking them for information on their highest paid executives dating back to 2008 and to which the American Hospital Association objected as not within the scope of the current Work Plan.9  The OIG is expected to issue its findings during fiscal year 2015.  

Determining Executive Compensation; Penalties

While it is premature to draw conclusions as to the results that the OIG will publish in 2015, the inclusion of executive compensation as an item on the 2014 OIG Work Plan serves as a good reminder that nonprofit hospitals must exercise due diligence in setting executive compensation packages.  These hospitals must exercise due diligence not only for the sake of public perception, but also to avoid penalties and possible revocation of tax exempt status under federal income tax laws and regulations.  Failure to pay reasonable compensation can expose a nonprofit hospital to penalties and possible loss of tax-exempt status under federal income tax laws that have been in effect for several years. 

From a federal income tax perspective, when designing executive compensation packages consideration must be given as to whether and to what extent the package could result in prohibited private inurement or expose the arrangement to intermediate sanctions under the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder.10  An organization faces loss of tax-exempt status if it engages in prohibited private inurement, which means that the earnings of the tax-exempt hospital inure to the benefit of private individuals.  A tax-exempt hospital may pay reasonable compensation for items and services.  If it pays more than reasonable compensation, the excess amount may be prohibited private inurement.  

While the Courts and the IRS have not found it necessary to provide a specific definition of inurement, they have provided guidance as to what constitutes "private". The existence of private inurement involves a facts and circumstances test, and only applies to private individuals, i.e., "insiders".11  Whether an individual is an insider involves an analysis as to whether he/she is an officer or director, or otherwise is in a position to exercise significant influence on the organization's decision-making process.12   Hospital executives would likely almost always meet this definition. 

Intermediate sanctions involve a tax penalty and correction of the excess benefit.13  If a disqualified person (one who is in a position to exercise substantial influence over the hospital) receives a benefit that is in excess of the benefit received by the hospital, then there would likely be an excess benefit.  An evaluation of the facts and circumstances to determine whether or not the executive meets the definition of a disqualified person (similar to the exercise under the evaluation of private inurement) would be the first step.14 If the executive meets the definition of a "disqualified person,” then the next step would be to determine if there is an excess benefit transaction.15  If there is an excess benefit transaction, then the organization will want to examine whether it can meet the rebuttable presumption test which would indicate that the compensation was reasonable, i.e., the compensation was approved in advance by an authorized body that relied on appropriate data for comparability, and the entire process was adequately documented.16 If there is an excess benefit transaction, the taxes can be steep – from 25 percent to over 200 percent of the amount of the excess benefit.17  There are correction methods which might be available to mitigate the tax and limit the penalty to a total of 25 percent as long as the insider returns the excess benefit to the hospital within the statutorily prescribed timeframe.18  If the compensation is not returned, then an additional 200 percent tax of the amount of the excess benefit may be imposed.19   

Implications for Hospitals

To date, the policing of executive compensation has been conducted primarily by the IRS.  With the addition of executive compensation as a new item in the OIG 2014 Work Plan, and uncertainty as to what this might mean for nonprofit hospitals, nonprofit hospitals should ensure that a process is in place, preferably through a compensation committee with no conflicts of interest, to conduct an analysis of any proposed compensation arrangement with hospital executives.  While not an absolute shield from liability, taking steps to ensure that a nonprofit hospital's compensation package for an executive is reasonable can serve to ensure that an organization would be less likely to have issues from a revocation of tax-exempt status perspective as well as an excise tax perspective.  In the event the review outlined in the OIG 2014 Work Plan results in the implementation of parameters for executive compensation for cost reporting purposes, the nonprofit hospital which has taken steps to ensure it pays reasonable compensation would likely be in a good position.    If the OIG ends up imposing caps, and those caps are enforceable, then nonprofit hospitals may need to adjust their executive compensation packages; however, it is premature at this stage to make material changes to existing compensation packages for executives.  Rather, the inclusion of executive compensation in the 2014 OIG Work Plan should serve as a reminder to a nonprofit hospital that it must ensure that it pays reasonable compensation to remain in compliance with existing federal tax laws and regulations and also to ensure it attracts and retains the right talent mix during this transformative period in the healthcare delivery system.

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1

U.S. Department of Health and Human Services, Office of Inspector General Work Plan for Fiscal Year 2014, p.2 .

2

Id.

3

American Hospital Association News Now February 12, 2014, www.ahanews.com.

4

OIG Work Plan at 2.

5

Massachusetts Public Charities CEO Compensation Review, December 2013, http://www.mass.gov/ago/doing-business-in-massachusetts/public-charities-or-not-for-profits/ma-pc-ceo-comp-review.html.  

6

New Hampshire Center for Public Policy Studies, Executive Compensation at New Hampshire's Non-Profit Hospitals, June 2012. http://www.nhpolicy.org/report/executive-compensation-at-nhamp39s-non-profit-hospitals.

7

OIG Work Plan at 2.

8

Id.

9

Letter from American Hospital Association to Inspector General Daniel Levinson, December 11, 2013, http://app6.vocusgr.com/Tracking.aspx?Data=HHL%3d90%3c8%3e%26JDG%3c98%3c!OHL%3d8%2b62&RE=IN&RI=18695155&Preview=False&DistributionActionID=22135&Action=Follow+Link.

10

I.R.C. Section 4958; Treas. Reg. 1.501(c)(3)-1(c)(2).

11

See, e.g., People of God Community v. Commissioner, 75 T.C. 127 (1980); G.C.M. 39498 (January 28, 1986); Rev. Rul. 73-313, 1973-2 C.B. 174.

12

Id.

13

I.R.C. Section 4958; Treas. Regs. 53.4958 et. seq.

14

Treas. Regs. 53.4958-3(d).

15

Treas. Regs. 53.4958-1(e).

16

Treas. Regs. 53.4958-6.

17

Treas. Regs. 53.4958-1.

18Id.
19Id.

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