Intermediate sanctions for healthcare organizations: receiving generous compensation is desirable, but not if it exceeds the amount deemed appropriate by the IRS - U.S. Internal Revenue Service

Healthcare Financial Management, Sept, 2002 by David G. Samuels, Morris Shoretz

Senior executives of not-for-profit healthcare organizations should be well compensated for their services. Yet these individuals may face stiff penalties in the form of excise taxes if the IRS deems that they are receiving excessive compensation. Under "intermediate sanctions" legislation enacted by Congress as part of the 1996 Taxpayer Bill of Rights 2, the IRS has authority to impose an excise tax potentially amounting to tens of thousands of dollars, especially if the violation occurred over a period of several years.

In January 2002, the IRS issued final regulations with respect to the intermediate sanctions legislation. Because tax-exempt healthcare organizations are affected by the law and because of the potential severity of the penalties for noncompliance, accountants and other financial professionals working within these organizations should become familiar with the legislation and regulations, and alert the organizations' senior executives of the possible need to consult with counsel or take steps to avoid the potential penalties.

The Purpose of Intermediate Sanctions

The intermediate sanctions law provides the IRS with new, increasingly flexible sanctions to deal with excess-benefit transactions involving healthcare and other organizations exempt from taxation under Internal Revenue Code (IRC) Sections 501(c)(3) and (c)(4). Because a vast array of healthcare organizations, including hospitals, health clinics, and other Medicare-certified healthcare organizations, are 501(c)(3) organizations, the healthcare community is greatly affected by the statute.

The statute authorizes the imposition of excise taxes on certain insiders (typically senior officers or key employees) who are the recipients of the excess benefits defined in the statute as disqualified persons, and on organization managers. It is limited to highly compensated individuals, defined as persons with income over $85,000 per year. State hospitals and other government entities are not covered by the statute.

The statute does not provide any additional remedy with respect to not-for-profit organizations themselves, and it does not supersede or alter the existing remedy of revoking an organization's tax-exempt status in instances of "private inurement." Intermediate sanctions can be imposed either in lieu of, or in addition to, the revocation of an organization's tax-exempt status. The intermediate sanctions legislation applies to excess-benefit transactions occurring on or after September 14, 1995.

Calculation of the Excise Taxes

The excise taxes imposed on a disqualified person for a violation of the intermediate sanctions statute fall into two tiers. A first-tier tax of 25 percent of the excess benefit may be imposed with respect to each excess-benefit transaction. In any case in which the initial 25 percent tax is imposed and the excess benefit is not corrected within the taxable period, an additional second-tier excise tax equal to 200 percent of the excess benefit also may be imposed by the IRS, with both the first- and second-tier taxes to be paid by the beneficiary of the excess benefit.

In each instance, the amount of the excess benefit (reflecting both the amount that must be returned and the amount on which the excise tax is calculated) is the difference between the benefit actually received and the benefit that the IRS deems to be reasonable. Thus, if the IRS deems the reasonable salary and other benefits of an insider to be $100,000, and the individual receives $225,000, the excess benefit would be $125,000. If compensation or other benefits are scrutinized over a multiyear period, the total excess benefit could be much greater.

As under the existing law, the background, experience, qualifications, and special characteristics of an executive are relevant in determining whether compensation is reasonable. Thus, for example, the medical director of a healthcare organization who must-by the nature of his or her duties-be a trained physician, is entitled to greater compensation by virtue of the special training and experience. Highly compensated employees of not-for-profit healthcare organizations are not obligated to donate their time, and the compensation paid to their counterparts at for-profit competitors can properly be considered in assessing the reasonableness of their compensation and other benefits.

The IRS also has authority to "abate the excise tax penalty ... if it is established that the violation was due to reasonable cause and not due to willful neglect and the transaction at issue was corrected within the specified period."

In addition to the first- and second-tier excise taxes, the IRS is authorized to impose a 10 percent excise tax, up to a maximum of $10,000, on any organization manager (such as an officer, director, or trustee other than the recipient of the excess benefit) who has participated in an excess-benefit transaction "knowing that it is such a transaction, ... unless such participation is not willful and is due to reasonable cause."