Executive Compensation T.J. Sullivan, Esq by lxm94617


									                               Executive Compensation
                                  T.J. Sullivan, Esq.


            With the resurfacing on Capitol Hill of charitable organization tax issues
     generally, and nonprofit hospital qualification for exemption in particular, it could only
     be expected that scrutiny and criticism of executive compensation practices would follow
     close behind. Critics, armed with data from now-public Forms 990, have leveled attacks
     on hospitals for charging high prices to the uninsured and having poor charity care
     records, but the frequent backdrop is that, all the while, charities lavish generous pay and
     perquisites on senior executives. In 2005, as then-Finance Committee Chairman Chuck
     Grassley was working with the Panel on the Nonprofit Sector to identify
     recommendations for reform, a high profile dispute over compensation between the
     American University Board and its President filled the pages of the Washington Post.
     The Staffs of the Senate Finance Committee and the Joint Committee on Taxation have
     openly questioned the process under which most charitable organizations establish the
     reasonableness of compensation - - a process carefully prescribed just thirteen years ago
     by Congress.

             For its part, the IRS, goaded by public criticism and Congressional pressure,
     conducted a nationwide examination during June 2005-06 focusing on compensation
     practices in Section 501(c)(3) organizations, and included compensation issues in its
     2006 hospital community benefit compliance initiative. The IRS is still learning how to
     apply its intermediate sanctions authority in the compensation context. It was handed a
     stunning defeat in a 5th Circuit appeal of its first intermediate sanctions case (a valuation
     issue), with an opinion that cited “a cascade of errors.” Nevertheless, IRS has stepped up
     its examination activity, especially around compensation issues, and now is armed with a
     greatly expanded revised Form 990 for use in tax years beginning in 2008 that will
     provide a road map of each reporting organization’s areas of exposure and a new Fast
     Track Appeals Program in which excess compensation and other issues may be resolved
     by the independent Appeals function.

            These developments are considered more fully below.

     A. Guiding Principle: Compensation Paid by a Tax-Exempt Organization Must Be
     Reasonable and a Tax-Exempt Organization Should Not Pay More than Fair
     Market Value for Goods and Services.

            1.      Definition of Reasonable Compensation

             A tax-exempt charitable organization is permitted to pay reasonable compensation
     to individuals who provide services to it. Whether compensation is reasonable is
     determined in light of all the facts and circumstances. As a general rule, “reasonable”
     compensation is the amount that a like organization in like circumstances would pay for
     like services.

             2.     Timing - - When Determination of Reasonableness is Made

                    a) Reasonable compensation is generally determined based                 on
                    circumstances existing at the date the contract for services is made.

                    b) Where reasonableness cannot be determined based on circumstances
                    existing at the date the contract is made, the determination is made based
                    on all facts and circumstances, up to and including the date of payment
                    (but not at the date when the contract is questioned).

                    c) A written, binding contract that is terminable or subject to cancellation
                    by the applicable tax-exempt organization without the disqualified
                    person’s consent is treated as a new contract as of the date that any such
                    termination or cancellation, if made, would be effective.

                    d) If a binding written contract is materially modified (e.g., extending the
                    term or increasing the compensation payable to the disqualified person), it
                    is treated as a new contract entered into as of the date of the material

             3.     Definition of Fair Market Value

              Fair market value is defined as the price at which property, or the right to use
      property, would change hands between a willing buyer and a willing seller, neither being
      under any compulsion to buy, sell, or transfer property or the right to use property and
      both having reasonable knowledge of relevant facts. Treas. Reg. § 53.4958-4(b)(1)(i).


              Nonprofit organizations are exempt from federal income tax as organizations
      described in Internal Revenue Code (“Code”) Section 501(c)(3) only if they are
      organized and operated exclusively for charitable purposes within the meaning of the
      statute. Treas. Reg. § 1.501(c)(3)-1(c)(2). They also are subject to the restrictions
      discussed below.

      A. Legal Restrictions - - Inurement And Private Benefit

             1.     The Code, the IRS, and many state attorneys general view tax-exempt
             organizations as charitable trusts for the benefit of the public. The regulatory
             scheme of § 501(c)(3) is designed to:

                    a) Ensure furtherance of public purposes, and

                    b) Prevent diversion of charitable assets into private hands.

             Accordingly, this body of law includes two important types of restrictions (or
      prohibited activities) on exempt organizations.

2.      The first is private inurement. For § 501(c)(3) exempt organizations, no
part of the net earnings may inure to the benefit of any private shareholder or
individual. This means an individual can’t pocket the organization’s funds,
except as reasonable payment for goods or services. IRS Exempt Organizations
Handbook § 381.1. There is no minimum threshold for inurement, and no de
minimis exception.

       a) The inurement proscription applies only to “private shareholders or
       individuals,” commonly referred to as “insiders” (i.e., those having a
       personal and private interest in or opportunity to influence the activities of
       the organization from the inside). Treas. Reg. § 1.501(a)-1(c).

          (i)    The term “insider” does not appear in the Code or regulations,
          but is widely used in this context. See, e.g., Bruce R. Hopkins, The
          Law of Tax-Exempt Organizations § 20.3 (9th ed. 2007).

          (ii)     Historically, the IRS took the position that all physicians are
          insiders. See General Counsel Memorandum (“G.C.M.”) 39498 (Jan.
          28, 1986) (Medical staff physicians as employees or individuals with
          close professional working relationship are subject to the inurement
          restriction); G.C.M. 39670 (Jun. 17, 1987) (all employees as a class or
          persons performing services for an organization are subject to the
          inurement restriction).

          (iii) The intermediate sanctions provision, § 4958, added to the
          Code in 1996 and discussed below, uses the terms “excess benefits
          transaction” and “disqualified person.” It is not yet clear what effect
          these terms and concepts will have on inurement and the common law
          concept of an insider. Hopkins, supra, states that the terms “insider”
          and “disqualified person” are essentially synonymous.

          (iv)    The legislative history of § 4958 states that “[t]he Committee
          intends that physicians will be considered disqualified persons only if
          they are in a position to exercise substantial influence over the affairs
          of an organization.” H. R. Rep. No. 506, 104th Cong., 2d Sess. (1996).

       b) Paying excessive or greater than reasonable compensation to an
       insider, such as an officer or director, is a prime example of prohibited

3.      The second type of prohibited activity is private benefit. Section
501(c)(3) exempt organizations must be organized and operated to serve public
rather than private interests. Unlike the inurement prohibition, the private benefit
prohibition is not absolute. To be permissible, private benefit must be incidental
to (or a necessary concomitant of) accomplishment of the public benefits
involved. Treas. Reg. § 1.501(c)(3)-1(d)(1)(ii); see G.C.M. 37789 (Dec. 18,
1978) (meaning of incidental).

       a) Private benefit must be balanced against the public benefit. E.g.,
       Sonora Community Hosp. v. Comm’r, 46 T.C. 519 (1966), aff’d, 397 F.2d

              814 (9th Cir. 1968); G.C.M. 37789. The IRS updated the regulations in
              2008 by adding to Treas. Reg. § 1.501 (c)(3)-1 three examples illustrating
              the test for serving a public rather than a private interest. The private
              benefit prohibition is not limited to insiders.

              b) Some incidental private benefit is always present in hospital-physician
              relationships (i.e., private practice physicians use hospital facilities to treat
              paying patients).

       4.     Effect: Any private inurement or too much (i.e., other than incidental)
       private benefit could cause a hospital to lose its tax exemption. Until 1995,
       revocation of exemption was the only sanction available to the IRS, but see
       discussion of intermediate sanctions, below. It is generally the inurement
       prohibition (and the similar excess benefits restriction discussed below) that are
       most often at issue in the executive compensation context.

B. New Approach to Inurement - - Intermediate Sanctions

        Code Section 4958, enacted as part of the 1996 Taxpayer Bill of Rights II
(“TBOR II”), allows the IRS to impose penalty excise taxes on certain “excess benefits
transactions” between “disqualified persons,” and organizations described in Sections
501(c)(3) or 501(c)(4). Final regulations were issued in 2002, and recently the IRS has
been under serious congressional pressure to step-up enforcement. See 26 C.F.R. §
53.4958-1 – 53.4958-8.

       1.     Excess Benefit Transactions Include:

              a) A non-fair market value (“FMV”) transaction, in which a
              disqualified person pays less than FMV to the exempt organization or
              charges the exempt organization more than FMV, for a good or service
              (the preamble to the Temporary regulations made clear that embezzlement
              is included);

              b) An unreasonable compensation transaction, in which a disqualified
              person receives unreasonable compensation from the exempt organization;

              c) A prohibited revenue sharing transaction, in which a disqualified
              person receives payment based on the revenue of the exempt organization
              in an arrangement specified in final regulations under Section 4958 that
              violates the inurement prohibition under current law. [This portion of the
              regulations has been reserved for future rulemaking, so there presently is
              no special treatment under § 4958 for revenue sharing transactions, and
              all such transactions must be viewed under the existing § 4958 rules.]

              d) See discussion of “Automatic Excess Benefit Transactions,” and
              new excess benefits transactions added by the Pension Protection Act of
              2006, below.

2.   Disqualified Persons

     a) Section 4958 deems certain people to be disqualified persons:
     (a) voting members of an organization’s governing board; (b) persons who
     have or share ultimate responsibility for implementing the decisions of the
     governing body or for supervising management, administration, or
     operation of the organization (such as presidents, CEOs, COOs, treasurers
     and CFOs unless demonstrated otherwise); and (c) persons with a material
     financial interest in a provider-sponsored organization. The final
     regulations clarify that this category can include organizations such as
     management companies.

     b) Others are deemed not to be disqualified persons: (a) all organizations
     described in § 501(c)(3)(note: The Pension Protection Act of 2006 appears
     to have created on exception for supporting organizations); (b) with
     respect to § 501(c)(4) organizations, other 501(c)(4) organizations, and (c)
     full-time or part-time employees receiving total direct and indirect
     economic benefits in an amount less than the amount of compensation
     necessary to be highly compensated, as defined in § 414(q)(1)(B)(i)
     ($110,000 in 2009), who are not substantial contributors within the
     meaning of § 507(d)(2) (taking into account certain adjustments) or
     otherwise within the definition of “disqualified person.”

     c) In all other cases, a “disqualified person” is: (i) any person who was, at
     any time during the previous five years, in a position to exercise
     substantial influence over the affairs of the organization; (ii) certain family
     members (lineal descendants, brothers and sisters, whether by whole or
     half-blood, and spouses of any of them); or (iii) an entity 35% or more of
     which is controlled by such persons.

     d) The legislative history recognizes that a non-employee, such as a
     management company or the employee of a subsidiary, even a taxable
     subsidiary, could be in a position to exercise substantial influence. The
     regulations provide that, in the case of multiple organizations affiliated by
     common control or governing documents, the determination of whether a
     person does or does not have substantial influence is made separately for
     each applicable tax-exempt organization.

     e) PPA Note: The Pension Protection Act of 2006, Section 1242(a), adds
     several new classifications of disqualified persons. Any disqualified
     person with respect to a Section 509(a)(3) supporting organization is a
     disqualified person with respect to the supported organization. Any
     substantial contributor to a donor advised fund is a disqualified person
     with respect to the donor advised fund. Any investment advisor to an
     organization sponsoring a donor advised fund is a disqualified person with
     respect to the sponsoring organization. The legislative history suggests
     that, despite the IRS position in the Section 4958 regulations that Section

      501(c)(3) organizations are not disqualified persons, supporting
      organizations can be disqualified persons.

3.    The Initial Contract Rule

      a) The regulations establish an “initial contract rule” to protect from
      intermediate sanctions liability certain “fixed” payments for the provision
      of services or property made under a binding written contract to persons
      who were not disqualified immediately before entering into the contract.

         (i)     “Fixed payments” are defined to include an amount of cash or
         other property that is either specified in the contract or determined
         using a “fixed formula” specified in the contract.

         (ii)    Payments that include a variable component (such as achieving
         certain levels of revenue or business activity) may qualify as a fixed
         payment so long as the components are calculated pursuant to a pre-
         established, objective formula.

4.    Penalty Excise Taxes

      a) A disqualified person is liable for an initial 25% tax on the amount of
      the excess benefit and an additional tax of 200% on the amount of the
      excess benefit if the transaction is not timely corrected.

      b) An organization manager who knowingly, willfully, and without
      reasonable cause participates in an excess benefit transaction is personally
      liable for a 10% tax (to a maximum of $20,000) on the amount of the
      excess benefit. (Note: The Pension Protection Act of 2006 doubled the
      maximum organization manager penalty to $20,000.)

      c) Note that no penalties are assessed on the organization itself, though
      revocation remains an option in extreme cases (see discussion of new
      regulations below). The real punishment for the organization is having to
      publicly disclose on its IRS Form 990 that it engaged in an excess benefit

5.     Rebuttable Presumption That Compensation Arrangement Is Not An
Excess Benefit Transaction

      a) The legislative history underlying Section 4958 of Code sets forth
      guidelines for raising a "rebuttable presumption" of the reasonableness of
      compensation or fair market value of payments made to disqualified
      persons. The Treasury Regulations implement these guidelines by
      providing that payments under a compensation arrangement are presumed
      to be reasonable and the transfer of property (or the right to use property)
      is presumed to be at fair market value, if the following three conditions are

b) A rebuttable presumption of reasonableness applies to a compensation
arrangement or transaction between an exempt organization and a
disqualified person if:

  (i)    The arrangement was approved by the organization’s governing
  body or a committee of the governing body composed entirely of
  individuals who do not have a conflict of interest with respect to the

  (ii)   The governing body or committee obtained and relied on
  appropriate data as to comparability (internally or externally
  developed); and

  (iii) The governing body or committee adequately documented the
  basis for its determination by the later of the next meeting of the
  authorized body or 60 days after final approval by the authorized body.

c) Condition One: Approval Process. The approval process requires that
the specific compensation arrangement or specific terms of a property
transfer is approved in advance by an "authorized body" of the
organization composed entirely of individuals who do not have a conflict
of interest with respect to the transaction. An authorized body includes
the governing body (i.e., the board of directors, board of trustees, or
equivalent controlling body) or an appropriately qualified committee
thereof. Such committee may be composed of any individuals permitted
under state law to serve on such committee, to the extent that the
committee is permitted by state law to act on behalf of the governing
body. To the extent permitted under state law, other parties (such as
senior managers) may also constitute an "authorized body" if authorized
by the board of directors to act on its behalf by following specific
procedures and guidelines established by the board.

  (i)     A board or committee member does not have a conflict of
  interest (i.e., is a "disinterested" director or member) with respect to a
  compensation arrangement or other transaction if he or she:

              (a)    Is not the subject of and is not related to any
              disqualified person participating in the subject transaction;

              (b)     Is not employed by or under the employment
              direction of the subject disqualified person;

              (c)    Is not receiving compensation or other payments
              under the approval of the subject disqualified person;

              (d)     Has no material financial interest affected by the
              subject transaction; and

              (e)     Is not approving a transaction providing economic
              benefits to a disqualified person when the subject

                             disqualified person will be called upon to approve (or has
                             already approved) a transaction providing benefits to the

              d) Condition Two: Comparability Data. In making its determination as to
              the reasonableness of compensation or fair market value of a property
              transfer, the board or a committee thereof must obtain and rely upon
              appropriate data as to comparability. An authorized body has appropriate
              data as to comparability if, given the knowledge and expertise of its
              members, it has information sufficient to determine whether the
              compensation or property transfer is at fair market value.

              (i) DBR comment: The IRS has recently exhibited a willingness to
       challenge peer groups and comparability data on examination.

              e) Condition Three: Documentation. The authorized body making the
              decision with respect to a transaction or arrangement must adequately
              document the basis for its determination of reasonableness concurrently
              with making that determination. The Regulations provide that "adequate
              documentation" means board or committee records that note:

                 (i)    The terms of the compensation or arrangement that was
                 approved and the date it was approved;

                 (ii)    Board or committee members present during the debate on the
                 transaction or arrangement that was approved and those who voted on

                 (iii) The comparability data obtained and relied upon by the board or
                 committee and how the data was obtained; and

                 (iv)    Any actions taken with respect to consideration of the
                 transaction or arrangements by anyone who was otherwise a member of
                 the authorized body but who had a conflict of interest with respect to
                 the transaction or arrangement.

        In the event that the authorized body decides that the appropriate compensation
for a specific arrangement, or fair market value for a specific transaction, is higher or
lower than the comparability data obtained, the board or committee must record the basis
for that determination.      To satisfy this condition, the documentation must be
"concurrent." "Concurrent documentation" of a decision means that records must be
prepared by the later of the next meeting of the authorized body or 60 days after final
action of the authorized body is taken. Such records must be reviewed and approved by
the board or committee as reasonable, accurate, and complete within a reasonable period

              f) Best Practice Note: We generally recommend that minutes reflect an
              intent to qualify for the presumption and that compensation approvals and
              documentation be approached on an individual by individual basis.

              g) The presumption may then be rebutted by the IRS if it shows sufficient
              contrary evidence that the compensation was not reasonable.

              h) No negative inference is to be drawn from failure to take advantage of
              the rebuttable presumption. Nevertheless, organizations should do so
              whenever possible.

              i) Certifications: The approving body is protected in relying on a
              consultant’s written reasoned analysis, if the consultant certifies that it:

                  (i)     Holds itself out to public as compensation consultant,

                  (ii)    Performs these compensation analysis regularly, and

                  (iii)   Is qualified to perform compensation analysis valuations.

                  These certifications should be in every compensation consultant’s

              j) Note: Finance Committee Ranking Minority Member Grassley,
              reflecting the sentiments of Committee minority staff and the staff of the
              Joint Committee on Taxation, has called for modifying or doing away with
              the rebuttable presumption in the belief that it has encouraged
              compensation growth and compromised the IRS’s ability to enforce tax-
              exempt organization law.

       6.     Compensation for Section 4958 Purposes

        Compensation includes: salary, fees, bonuses, and severance payments; deferred
compensation that is earned and vested, whether or not funded (but if deferred
compensation for services performed in multiple prior years vests in a later year, the
compensation is attributed to the years in which the services were performed); premiums
for liability or other insurance and payment or reimbursement for charges, expenses, fees,
or taxes not ultimately covered by the insurance coverage; all other benefits, whether or
not included in income for tax purposes, including payments to welfare benefit plans
(e.g., medical, dental, life insurance, severance, disability), and taxable and nontaxable
fringe benefits (other than working condition fringe benefits described in Section 132(d)
and de minimis fringe benefits described in Section 132(c)), including expense
allowances or reimbursements or foregone interest on loans.

       7.   A Payment Is Not Compensation Unless Intent to Treat it as
       Compensation Is Clearly Indicated

              a) Section 4958(c)(l)(A) provides, in relevant part, that “an economic
              benefit shall not be treated as consideration for the performance of
              services unless such organization clearly indicated its intent to so treat
              such benefit.”

              b) Benefits not clearly indicated as intended compensation may be excess
              benefits or prohibited inurement or more than insubstantial private benefit,
              even if they would have constituted reasonable compensation if so treated.
     c) To be clearly indicated as intended compensation, there should be
     substantiation contemporaneous with the transfer. The Regulations
     provide that if the organization or a disqualified person reports the benefit
     (e.g., Forms W-2/1099, 990 and 1040), or if the failure to report is due to
     reasonable cause, there is contemporaneous written substantiation of

8.   “Automatic” Excess Benefit Transactions

     a) In a FY2004 Continuing Professional Education Text (CPE) article,
     the IRS warned exempt organizations that unreported compensation to a
     disqualified person will be treated as an automatic excess benefit
     transaction. Under this approach, exempt organizations must properly
     report any payments or fringe benefits they provide to their executives as
     compensation to avoid having these amounts automatically treated as
     excess benefits subject to penalties under Section 4958. An exempt
     organization providing compensation and fringe benefits is required to
     report them on Forms 990, 1099, or W-2, and the individuals receiving the
     payments or fringe benefits as compensation must report them on their
     Federal tax return (Form 1040). If neither the organization nor the
     employee reports a payment as compensation, it will be treated as an
     “automatic” excess benefit to which penalty excise taxes may apply, even
     if the payment would have been reasonable in relation to the services
     provided had it been reported.                See www.irs.gov/pub/irs-

     b) Example: Employer Provided Cell Phones. Many employers provide
     cell phones to executives and employees for business use, but the phones
     are also useable for personal calls. Cell phones are "listed property" under
     Section 280F, so they are not deductible or excludable as a fringe benefit
     unless the strict substantiation rules of Section 274(d) are complied with.
     If a tax-exempt organization provides a cell phone to a disqualified person
     without prohibiting personal use or satisfying the strict substantiation rules
     (and without taxing the executive on the value of all cell phone use), the
     IRS could take the position that the value of the cell phone and its use is
     an automatic excess benefit. The interaction of these rules in the
     intermediate sanctions context seems unduly harsh (it is) and unrealistic,
     but the IRS has begun highlighting this issue in fringe benefit publications.
     See, e.g., Taxable Fringe Benefit Guide (January 2007)
     http://www.irs.gov/pub/irs-tege/fringe_benefit_fslg.pdf. See also TAM
     2004-35019 (Aug. 27, 2004), wherein the IRS found an automatic excess
     benefit resulting from employer provided cell phone use where the Section
     274(d) substantiation rules were not met.

     c) PPA Note: The Pension Protection Act of 2006 created a new class of
     statutory automatic excess benefits transactions for supporting
     organizations and donor advised funds the rules for which may vary
     somewhat from the general Section 4958 scheme.

        (i)     If a supporting organization makes a grant, loan, payment of
        compensation, or similar payment (including an expense
        reimbursement) to a substantial contributor or a related person, the
        substantial contributor is treated as a disqualified person and the entire
        amount of the payment is treated as an excess benefit. Note the
        variation from the usual Section 4958 treatment of only the excess over
        fair market value as an excess benefit. Section 4958(c)(3).

        (ii)   Loans by any supporting organization to any disqualified person
        are automatic excess benefits transactions in the full amount of the
        loan. Note that the statute and legislative history indicate that another
        supporting organization or a private foundation can be a disqualified
        person for this purpose. Section 4958(c)(3).

        (iii) If a donor advised fund makes a grant, loan, payment of
        compensation, or similar payment to a donor or donor-advisor with
        respect to the fund or a related person, the donor or donor-advisor is
        treated as a disqualified person with respect to the fund and the entire
        amount of the payment is treated as an excess benefit. Section

9.   Intermediate Sanctions Litigation

     a) The IRS lost on appeal its first court case challenging imposition of
     intermediate sanctions excise taxes. In Caracci v. Commissioner, 118
     T.C. 379 (2002), rev’d, No. 02-60912 (5th Cir., 2006), also known as the
     “Sta-Home” case after the tax-exempt home health agencies involved, the
     Tax Court initially upheld imposition of substantial penalty excise taxes
     stemming from an alleged transfer of charitable assets for less than fair
     market value. The Tax Court decision was best described as a split
     decision in that the IRS’s attempt to revoke the tax exemption of the home
     health agencies was overturned and the court refused to accept in their
     entirety either the Caracci’s expert’s valuation or the IRS’s expert’s
     valuation. Still, the Tax Court found a $5.1 million excess benefit and the
     nearly $70 million in excise taxes initially upheld were significant.

     b) Facts: The case stemmed from a 1995 conversion transaction through
     which members of the Caracci family caused three tax-exempt home
     health agencies controlled by them to transfer all their assets to new S
     corporations owned by the family members. In exchange for the assets,
     the S corporations assumed all outstanding liabilities. Based on two
     appraisals, the Caraccis determined that the liabilities assumed exceeded
     the fair market value of the assets transferred. Accordingly, neither the
     Caraccis nor the newly-formed entities made any cash payment to the tax-
     exempt entities in connection with the conversion. On audit, the IRS
     sought to impose Section 4958 excise taxes on the transferee corporations
     and on the Caraccis as organization managers and proposed retroactive
     revocation for the home health agencies involved.

              c) In a surprise turnabout, the U.S. Court of Appeals for the Fifth Circuit
              on July 11, 2006, reversed the Tax Court’s decision and decided – without
              remand – for the Caraccis because the Commissioner did not, and based
              on the record, could not in the Court’s view meet his burden of proof. The
              case turned chiefly on the legal standards for business valuations, not
              Section 4958 tax law per se, but the somewhat mean-spirited tone of the
              decision, referencing a “cascade of errors” by the IRS and the Tax Court,
              will likely lead to more careful and less hurried case preparation in the
              next IRS case.

              d) DBR Comment: Caracci provided EOs a glimpse of the IRS’
              willingness to name an exhaustive list of disqualified persons (including
              controlled corporations) and organization managers, to assert first and
              second tier penalties simultaneously, to challenge valuations, and to
              propose revocation in addition to imposing the maximum possible
              intermediate sanctions taxes. It also illustrates a court’s willingness to
              take an activist approach to respond to perceived overreaching by the
              Commissioner (for example, by initially failing to give valuation credit for
              the liabilities assumed). The IRS no doubt will bring other Section 4958
              cases, mindful that it loses often on valuation issues. As a practical
              matter, it highlights for EOs the benefit of shifting the burden of proof to
              the IRS whenever possible.

              e) Areas of likely continued scrutiny include executive compensation and
              benefits; deferred compensation, physician incentive compensation; sales
              and conversions of charitable providers; transactions with Board members
              and other insiders; and similar arrangements.

       10.    New Regulations Clarify Interplay Between 4958 and Revocation

        In 2008, the IRS finalized regulations governing the relationship between excess
benefits excise taxes under Section 4958 and revocation of exemption under Section
501(c)(3). (See Treas. Reg. §1.501(c)(3)-1). The regulations make clear that the IRS can
seek revocation in addition to imposing excise taxes in certain situations. The regulation
includes a list of facts and circumstances the IRS will consider in determining when
excess benefit transactions jeopardize exemption. These factors include but are not
limited to the following:

              a) The size and scope of the organization’s regular and ongoing activities
              that further exempt purposes before and after the excess benefit
              transaction or transactions occurred;

              b) The size and scope of the excess benefit transaction or transactions
              (collectively, if more than one) in relation to the size and scope of the
              organization’s regular and ongoing activities that further exempt purposes;

              c) Whether the organization has been involved in repeated excess benefit

             d) Whether the organization has implemented safeguards that are
             reasonably calculated to prevent future violations; and

             e) Whether the excess benefit transaction has been corrected or the
             organization has made good faith efforts to seek correction from the
             disqualified persons who benefited from it.

      See Treas. Reg. § 1.501(c)(3)-1(f)(2).

C. Corporate Responsibility/Best Practices

      1.     In 2002, Congress enacted new corporate oversight legislation (the
      Sarbanes-Oxley Act). The new law was conceived as a set of legal reforms in
      response to:

             a) the corporate accounting controversies of 2002,

             b) the need to protect the interests of investors, and

             c) the need to provide stability to financial markets. The Act establishes
             a new oversight mechanism for the public accounting profession, creates
             new rules for the auditor/client relationship, and institutes new criminal
             penalties for corporate finance-related crimes. It also establishes corporate
             responsibility procedures for executive and board conduct, assigns new
             ethical obligations to corporate counsel, and provides new protections for
             investors. Presently, the Act only applies to publicly-traded companies.
             However, it is foreseeable that many of the corporate responsibility
             themes will be extended to nonprofit, Section 501(c)(3) organizations by
             state attorneys general, courts, the IRS, and evolving “best practices”.

      2.      As a result of the Sarbanes-Oxley Act and evolving corporate governance
      best practices, nonprofits and their boards should be constantly evaluating their
      governance, compliance, compensation, and reporting practices to ensure that
      they are up to date and appropriate.

      3.      The Senate Finance Committee Staff has floated ideas for exempt
      organization governance and compensation setting processes. Most of those ideas
      were not endorsed by the Independent Sector-sponsored Panel on the Nonprofit
      Sector, so the likelihood that they will be proposed in legislative form is unclear,
      but bears careful monitoring.

      4.      As a result of these developments, we generally recommend that large
      charitable and other exempt organizations

             a) establish a dedicated Compensation Committee of the board made up
             of all independent directors (or other members), and subject to a board-
             approved written charter;

             b) this Committee should develop a written compensation philosophy for
             board approval to govern its processes and substantive decisions;

                     c) while the Committee should be empowered to approve compensation
                     for Section 4958 purposes, the Panel on the Nonprofit Sector has
                     recommended that CEO compensation be finally approved by the full


       A. Executive Compensation Compliance Project

                The IRS announced in 2004 a “soft-contact” correspondence examination
       initiative to contact 2000 charitable organizations and ask for a complete description of
       how they establish and report executive compensation. Many hospitals and health
       systems received letters in March-June 2005, asking for information regarding
       compensation for the 2002 return year.

              In preparing client responses, we noted the following issues in a number of

              1.     Unreported items of W-2 compensation such as spousal travel, country
              club dues, housing and moving expenses, use of automobiles, cell phones, or
              other employer property without recordkeeping, etc.

              2.     Unreported (or improperly reported) items of Form 990 compensation
              such as annual accruals to supplemental executive retirement programs (SERPs).

              3.     Inadequate documentation of qualification for the rebuttable presumption,
              such as insufficiently detailed minutes or unclear delegations of authority for

       B. IRS Report on Executive Compensation Compliance Project

              The IRS released March 1, 2007 a report summarizing its findings and
              conclusions from the Executive Compensation Compliance Project.

                     The report found

                     (i) Significant reporting issues. Over 30% of organizations receiving
                         compliance checks had to amend their 990’s.

                     (ii) No evidence of widespread concerns other than reporting.

                     (iii) Enough problems with loans to justify a follow up project.

                     (iv) Problems, mostly in private foundations, at 25 organizations resulting
                          in $21 million of proposed excise taxes on 40 disqualified persons or
                          organization managers.

                     (v) Many incorrect or incomplete responses to question 89(b) in the Form

              The report is found at www.irs.ustreas.gov/pub/irs-tege/exec._comp._final.pdf

C. Hospital Community Benefit Questionnaire

       1.       In 2006, the IRS sent out over 400 Forms 13790 Compliance Check
       Questionnaire for Tax-Exempt Hospitals. The IRS maintains that compliance
       checks are not examinations as they do not relate to the determination of tax
       liabilities for a particular period.

       2.     While the majority of the Questionnaire covered how the hospital meets
       the community benefit standard of Rev. Rul. 69-545, Part III included nine
       questions about how the hospital sets compensation for disqualified person
       employees. The questions addressed in particular

               a) whether approving individuals had a conflict of interest,

               b) sources of comparability data and comparability factors, and

               c) outside business relationships with officers, directors, trustees, or key

       3.      The IRS issued its final report on Hospitals in February 2009 in which it
       analyzed responding hospitals’ executive compensation practices by size and type
       of facility and reported on a follow-up examination of 20 hospitals whose
       compensation had appeared high. Even in these selected cases, compensation was
       found to be reasonable on all the facts and circumstances. Nearly all the
       responding hospitals had followed the procedures to establish the rebuttable
       presumption or reasonableness. In general, the amount of compensation to the top
       officer increased with hospitals’ revenue size. The report is available at

D. Other Developments

       1.      Grassley Letter Raises Travel Reimbursement Concerns

         On May 25, 2005, Then-Senate Finance Committee Chairman Grassley sent a
letter to ten hospital systems asking for voluminous information about (1) charity care
and community benefits, (2) joint ventures with for-profit entities, (3) research and
teaching activities, (4) compensation arrangements with physicians and other
professionals, (5) payments, charges, and debt collection services (especially with respect
to the uninsured), (6) use of Type I and Type II supporting organizations, and of interest
here, (7) a detailed breakdown of travel expenses for the top five salaried employees.
The Finance Committee has not yet reported the results of that effort.

       2.      Grassley Letter Urges Stepped Up Enforcement

        On June 1, 2006, then-Chairman Grassley sent two letters to the IRS urging it to
step-up enforcement in the exempt organizations area and respond to a series of issues
arising from problems in this area. One issue Grassley focused on was director and
trustee compensation. Another issue was the tax-exempt health care sector. Sen.
Grassley advised the IRS to look specifically at the definition of charity care, the
requisite level of charity care, the definition and level of community benefit, the
definition of joint ventures, joint ventures involving non-profit hospitals, the payment of
      excessive compensation, and the use of tax-exempt bond proceeds. Grassley also noted
      that he agreed with former Commissioner Everson that it is often times difficult to
      distinguish the activities of a tax-exempt hospital from those of a for-profit hospital. See
      Grassley Solicits IRS Comment, Urges Enforcement on Series of Problems in the Tax-
      Exempt Arena, 2006 TNT 106-16, www.tax.org.

             3.      Fast Track Settlement Program

             In late 2008, the IRS announced establishment of a Fast Track Settlement
      Program for TE/GE taxpayers. Under the approach set forth in Announcement 2008-105,
      2008-48 I.R.B 1219, TE/GE and the taxpayer can agree to a 60 day consideration of
      issues in a TE/GE exam during which a Fast Track Appeals Officer specializing in
      TE/GE cases will consider the issue and help the parties achieve a settlement. However,
      the Appeals Agents in this program are helping the parties achieve settlement and not
      acting as an independent decision maker as in traditional IRS Appeals. This program
      affords a quick, potentially additional bite at the apple for taxpayers, but appears likely to
      generate proposed settlement terms more in the nature of mediation than traditional IRS
      Appeals. IRS examinations officials have been encouraging taxpayers under examination
      to consider this route, but the program is too new to have yielded many results.


      A. Physician Compensation Letter

             In IRS Information Letter 2002-0021 (Jan. 9, 2002), TE/GE responded to an
      information request regarding participation by Section 501(c)(3) hospitals in a
      demonstration program (the “Program”) designed to provide more cost-efficient
      cardiovascular and orthopedic services to Medicare beneficiaries under which hospitals
      are permitted to make incentive payments to physicians. The IRS stated that “there is no
      prohibition or per se rule that prevents health care organizations from making incentive
      payments to physicians.”         In analyzing any physician incentive compensation
      arrangement to determine whether it permits private inurement or confers impermissible
      private benefit, the Service stated that it has generally considered various factors in
      determining whether the arrangement violates the proscriptions against private inurement
      and impermissible private benefit. These factors are outlined and discussed in a helpful
      manner in the information letter.

      B. Executive Compensation Audit Guide

              A new IRS audit guide discusses the treatment of club membership, corporate
      credit cards, spousal life insurance, spousal travel, and vehicles provided to executives.
      Fringe Benefits Audit Techniques Guide (02-2005) available on the IRS website at:

      C. GAO Study of Hospital Compensation Policies

             1.     The United States Government Accountability Office issued a report to
             former Ways and Means Committee Chairman Thomas on June 30, 2006, entitled
             “Nonprofit Hospital Systems: Survey on Executive Compensation Policies and
             Practices.” The report is available at http://www.gao.gov

           2.      GAO reported that nearly all of the respondent hospital systems (65 of 100
           to whom surveys were sent) have an executive committee or compensation
           committee that sets top executive pay based on comparability data obtained from
           a compensation consultant. All 65 had a conflict of interest policy covering the
           compensation body. Practices with respect to perquisites, entertainment, and
           travel expenses varied.

           3.     In response, then-Finance Committee Chairman Grassley issued a
           statement calling it “disappointing” that 35% of those surveyed failed to respond.
           He also called for scrutiny of supplemental executive retirement plans (SERPS)
           and reforms to the Section 4958 rebuttable presumption process. See Grassley
           Disappointed with Findings of GAO Survey, 2006 TNT 146-74.


     A.     The IRS issued final regulations in 1999 subjecting tax-exempt organizations to
     new requirements regarding disclosure of their Application for Exemption (Forms 1023
     or 1024) and their three most recent annual information returns (Forms 990). 64 Fed.
     Reg. 17279 (Apr. 9, 1999). Generally, organizations must provide copies of these
     documents to anyone who requests them, in person or by mail.

           1.    Forms 990 and information gleaned from the forms, including
           compensation data, is now routinely made available to the public for free at

     B.      The IRS released a new Form 990 and instructions for 2005 making a number of
     changes to required executive compensation disclosure for officers, directors, key
     employees as well as the top compensated employees and independent contractors. The
     result of the new questions was to close certain loopholes that allowed arrangements to
     escape disclosure and to require more information about compensation involving former
     executives and related individuals and organizations.

     C.      The IRS revised the Form 990 and instructions again for 2006, this time
     concentrating on relationships between entities, between executives and governing board
     members, and between and among board members and organizations they own or
     control. This suggests an IRS intention to concentrate on governance, conflicts of
     interest, and possible excess benefit transactions.

                   (i)   Practitioners were concerned that the 2006 revision was overly
                         burdensome. The IRS provided clarifications and limited relief in
                         the form of Q’s and A’s posted on its website (www.irs.gov) on
                         April 26, 2007.

     D.     The IRS has dramatically revised Form 990 and the instructions for tax years
     beginning in 2008 and thereafter. The new form includes an 11 page core form that
     delves heavily into governance (Part VI) and executive compensation (Part VII), and 15
     schedules, including Schedule J, requiring detailed reporting of compensation of current
     and former officers, directors, and key employees. New Schedule J asks questions about
     spousal travel, first class and charter travel, club dues, and tax gross ups, inquires about

       the process used to approve compensation, and is substantially more directive about
       which compensation amounts must be reported in which of five columns.

       E.     IRS posted Form 990 Filing Tips concerning executive compensation on its Tax
       Information    for     Charities     website    on  May      1,  2009.          See

       F.     IRS was given greater authority to share otherwise confidential taxpayer
       information with state charity regulators under the Pension Protection Act of 2006, Pub.
       L. No. 109-280.

                                      *       *      *       *      *

The author gratefully acknowledges the assistance of Karen Brown McAfee, Esq., formerly of
Drinker Biddle & Reath LLP, Washington, in preparing this outline.


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