Tax Reform Redefines ‘Reasonable’ Compensation For Nonprofit Execs

Excise tax on salaries above $1 million could make competing for top talent even more expensive for nonprofit healthcare organizations.

One provision in the GOP’s tax reform bill—which is headed to President Donald Trump’s desk for a signature after the House passed the final version Wednesday morning in a 224-201 vote—will penalize nonprofit healthcare organizations that pay executives seven-figure salaries.

The measure, which imposes a 21% excise tax on compensation above $1 million for each of the five highest-paid employees of a nonprofit organization, promises to overhaul the way large hospitals and health systems compete for top talent. Compensation paid to licensed medical professionals for the performance of medical services is exempt.

Related: How 4 Healthcare Measures Weathered Tax Bill Reconciliation

It’s relatively common for the top executives of large healthcare nonprofits to make more than $1 million in a given tax year, as a HealthLeaders Media review of recent Form 990 filings with the Internal Revenue Service confirms. Moving forward, those organizations will have to recalibrate their financial priorities.

“It’s going to be a mess to begin with because I suspect most of those executives have employment contracts, and the organization is bound by contract to pay them,” says Gregory B. Lam, JD, managing partner of Copilevitz & Canter’s Kansas City office.

Beyond the hurdles related to existing contracts, affected organizations will likely do one of two things, Lam tells HealthLeaders Media. Either they will pay less and risk losing highly qualified executives to for-profit competitors who can pay more, he says, or they will continue to pay top dollar and incorporate the excise tax into their budgets.

“Or they’ll do a combination of those sorts of things so they try to create a balance yet at the same time not lose talent to the for-profit sector,” Lam adds.

Earlier this month, the National Council of Nonprofits published analysis of the proposed excise tax, which appeared in both the House and Senate version of the bill, suggesting that the change would “bring nonprofit pay rules in line with the for-profit cap on compensation.”

Nonprofit Quarterly’s Michael Wyland echoed that sentiment after the conference committee’s report.

“This change would bring nonprofit salary taxation in line with longstanding tax policy governing for-profit corporations,” Wyland wrote.

What’s ‘Reasonable’?

This excise tax is significant not only because it adds an expense to nonprofit payrolls but also because it renovates the structures that have guarded against excessive compensation for the past two decades.

“It obviously doesn’t preclude payment of that level of compensation, but it changes the historical rules for compensating principles of an exempt organization,” Lam says. “Those rules were always couched in terms of ‘reasonable’ compensation.”

In 1996, Congress enacted the intermediate sanction rules of IRS Code Section 4958. When someone in a key position related to a tax-exempt entity receives what is deemed an “excess benefit,” Section 4958 imposes an excise tax on that person, as Dennis Walsh, CPA, wrote in a primer for the Planned Giving Design Center. (The new excise tax, by contrast, is imposed on the organization rather than the individual.)

“The reasonable value of services is the amount that would ordinarily be paid for like services by like enterprises (whether taxable or tax-exempt) under like circumstances,” Walsh wrote.

In order to guard itself preemptively against accusations of overcompensating its employees, a nonprofit organization can follow a three-step procedure under Section 4958 to establish a “rebuttable presumption” of reasonableness, as Walsh outlined:

1. An authorized body of the organization, such as a board of directors, must approve the compensation agreement.
2. The authorized body must gather comparability data and rely upon that data in making its decision.
3. The authorized body must document the rationale for its decision in a timely and adequate fashion.

The tax reform bill doesn’t remove this process of establishing a rebuttable presumption of reasonableness; it suggests, however, that anything above $1 million is unreasonable insofar as it should be subject to the excise tax.

Multiple healthcare nonprofits that employ top executives who earn more than $1 million annually, according to their IRS filings, declined to comment for this story.

The 21% excise tax is expected to generate $100 million in revenue for the federal budget in 2018 and $1.8 billion over the coming decade, according to an estimate released with the House and Senate conference report.