Hospital executives probably aren’t too stoked about the Internal Revenue Service’s recent notice on how the new excise tax on executive pay applies to their organizations.
The interim guidance clarifies how not-for-profit organizations should implement the 21% excise tax on executive compensation that exceeds $1 million, part of the Tax Cuts and Jobs Act of 2017. It says that payment for duties like teaching and performing research are indeed subject to the tax. Many health systems’ highest-paid employees are physician-executives, whose salaries cover both administrative duties and medical services. The tax applies to the former, but not the latter.
Some tax experts said the IRS’ definition of medical care is too narrow: “services for the diagnosis, cure, mitigation, treatment, or prevention of disease, including services for the purpose of affecting any structure or function of the body.” The definition “generally” excludes administrative, teaching and research services.
Consider teaching hospitals. It’s unclear whether a common task like grand rounds, when a physician faculty member treats patients in front of medical students, would be considered medical, said Tom Flannery, senior client partner with Korn Ferry. It’s also unclear how a physician treating patients as part of a clinical trial would be categorized.
To the extent there’s wiggle room, hospitals will take advantage of it, he said.
“My sense is that what healthcare providers are going to do is define medical services broadly and at some point there will be an IRS case about the definition of medical services,” Flannery said.
The guidance also clarified that the 501(c)(3) not-for-profit arms of governmental entities, such as the foundations that support state-sponsored medical schools, are subject to the excise tax. Similarly, public hospital districts or hospital authorities are not subject to the tax unless they have applied for 501(c)(3) status. Hospital districts often apply for tax-exempt status in order to use tax-sheltered annuities, said Doug Mancino, a partner with the firm Seyfarth Shaw.
If it’s any consolation, the new guidance reiterates the formal process for relinquishing 501(c)(3) not-for-profit status, Mancino said.
The 21% excise tax also applies to excess parachute payments, which the guidance defines as payments to a covered employee contingent on that employee’s involuntary separation that are equal to or in excess of three times the employee’s base pay.
The excise tax applies to an organization’s top five highest-paid employees, but an employee who makes the list must be tracked in each subsequent year of their employment with the company, which means the list will grow over time.
“This becomes an ongoing nightmare,” Flannery said.
Another point of confusion is how the tax will be applied following mergers, such as the pending deals between Catholic Health Initiatives and Dignity Health and between Baylor Scott & White Health and Memorial Hermann Health System. In those deals, Mancino said he’s not sure whether the individuals who were subject to the tax at the legacy health systems will still be subject to the tax once the systems are united.
People can submit comments on the interim guidance, which eventually will become a proposed regulation and, after a 90-day comment period and hearing, final regulations. There is no set timeline on when the proposed regulations will be released, and tax experts said the government shutdown will likely prolong the wait since a sizable portion of the IRS’ workforce was furloughed.
One thing experts agree on: The new excise tax will not prompt hospitals to lower executive compensation.
Travis Jackson, a partner with King & Spalding, said he thinks the new tax law penalizes not-for-profit hospitals and health systems more than other types of not-for-profit organizations.
“I think what it really was about was trying to address what is perceived to be excessive compensation in the hospital industry,” he said. “But the problem is these are really complex jobs that require significant skills, and this tax is not going to impact the amount that is paid to executives.”
Tax gurus say they’re now helping their clients avoid the excise tax as much as possible through strategies like split dollar loan arrangements.
“Tax evasion is illegal,” Flannery said. “Tax avoidance is a competitive sport.”