Volume ElevenNumber Three

March 2009 Published Monthly

Feature Focus:

Executive compensation in

troubled timespage 32

Meet

Bill Parke Vice PresidentCorporate Compliance Rutherford Hopsitalpage 14

Unauthorized access to protected health

information: Educating the workforce

page 10HCCA is going green HCCA conference attendees will NOT automatically receive conference binders. If you would like to purchase conference binders, please choose that option on your conference registration form. Attendees will receive electronic access to course materials prior to the conference as well as a CD onsite with all the conference materials.

Earn CEU Creditwww.hcca-info.org/quiz, see page 13

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By Gerald M. Griffith, JD

Editor’s note: Gerald Griffith is a partner in the Chicago office of Jones Day where he practices as a member of the Health Care and Tax Practice Groups. He may be reached by telephone at 312/269-1507 or by email at ggriffith@jonesday.com.

For many nonprofit healthcare organizations, front page stories on executive compensation have become an annual event due to the information publicly available on Form 990. Recently,

the Internal Revenue Service (IRS) has increased the scrutiny of executive compensation among all nonprofits, including hospitals and academic medical centers, with three separate, detailed compliance checks sent to several hundred organizations in the past five years. In addition to educating the nonprofit sector, those compliance checks have sought to enforce the excess benefit sanctions that impose excise taxes of up to 225% on any insider compensation above reasonable amounts.

With healthcare and other sectors facing a difficult economic situation, including the highest rate of mass layoffs rates in more than ten years,1 compensation for health care executives is coming under increasing scrutiny. Executive compensation packages that may be viewed as rich in cash compensation by “Joe the Plumber” standards, or include hot button perquisites (e.g., first class travel), are drawing more intense media and government scrutiny. This article will explore how that added scrutiny has manifested itself, and what steps can be taken to minimize the negative publicity associated with executive compensa-tion, protect it against IRS sanctions, and demonstrate to policy makers, regulators, and charitable donors that nonprofit healthcare organizations can control executive compensation without additional regulation or investigations. Those proactive steps can be described as following best practices in the compensation approval process, obtain-ing appropriate comparability data, and adopting a compensation plan design that ties compensation to both financial and non-financial goals.

Effect of economic downturn on executive compensation

It is unusual now to hear news stories about prospective bailout pack-ages that do not also include calls for limits on executive compensa-tion. Just as the Sarbanes Oxley Act arguably started a transparency trend that has permeated healthcare governance thinking, so too may rules on executive compensation in Corporate America from the bailouts filter through to healthcare organizations facing their own financial challenges.

Economic pressuresMany health care organizations are feeling the pressure of the strug-gling economy, through reductions or delays in payment from govern-ment payment programs such as Medicaid, tougher negotiations with private payers, increased numbers of uninsured patients, mounting property tax exemption challenges, tighter credit, and plummeting investment returns. In what is not likely to be an anomaly, one highly regarded suburban hospital in a particularly hard-hit industrial state recently announced a voluntary turnaround plan to reduce a projected multi-million dollar loss in 2008, including a 10% pay cut for the CEO and other top executives and employed doctors, and a 4% pay cut for department managers as an alternative to lay offs. Sources esti-mated the pay cuts would save 225 jobs at the hospital.2 With rising unemployment rates, other health care organizations may feel the need to make similar reductions as part of an overall cost-cutting strategy.

With various sectors (e.g., financial, automotive) seeking federal bailouts, Congress has turned its attention once again to potential abuses in executive compensation. In a recent press release regarding the federal financial rescue program, the Senate Finance Committee strongly urged the Secretary of the Treasury to implement proposed limits on executive compensation for senior executives of institutions that receive federal bailout funds and ensure transparency in the bailout process.3 Those limits in Sections 162(m)(5) and 280G(e) of the Internal Revenue Code would limit deductibility to the first $500,000 of compensation and eliminate the exception allowing higher deductibility for performance-based compensation.4 In response

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to earlier concerns over corporate governance and transparency in the wake of the Enron scandal, Congress enacted other limits on executive compensation for public companies in the Sarbanes Oxley Act (SOX), including clawback provisions that would require repayment of certain compensation received by the CEO and CFO of any public company that issues a material restatement of its financials to comply with securities laws. Affected executives are required to repay (1) any bonus, incentive-based or equity compensation received within twelve months after release of the noncompliant financials; and (2) any profits realized from the sale of any securities of the employer during that same period.5

Congress also has a recent history of closely examining executive compensation in the nonprofit healthcare sector.6 Senator Grassley in particular has been very vocal about compensation levels in the nonprofit sector, noting that the “lack of transparency” in executive compensation and “the champagne lifestyles of certain non-profit executives” leave no room for doubt that the IRS needs to adopt clear guidelines on disclosure and acceptable compensation levels for nonprofits. In Senator Grassley’s view, “some individuals running charities view it as an opportunity to do well for themselves as opposed to doing good for those in need.”7 As pressure mounts on health care organizations to care for the uninsured and deal with declining reimbursement while stemming losses to keep programs afloat, execu-tive compensation levels and program design are likely to come under increased legislative scrutiny.

Moreover, a high ranking IRS official recently noted the current economic situation makes it even more important to ensure “proper stewardship of the tax subsidy” that nonprofits receive and to improve transparency in governance.8 In that regard, the IRS also remains highly interested in executive compensation at nonprofit organizations as reflected in the new Form 990 (described below). The same official noted that a pending report on the 2006 survey of nonprofit hospital executive compensation practices “will reveal high levels of executive compensation as well as extensive use by nonprofit hospitals of the rebuttable presumption of reasonableness.” He also implied that the IRS will look more closely at how well that process is being followed in upcoming audits, noting that the existing excess benefit rules of Sec-tion 4958 may not be adequate to challenge high compensation levels that may be defensible under the rebuttable presumption standard but may not satisfy the public and other interested parties. He also raised questions about the propriety of current law that allows a nonprofit to use compensation at for-profit companies as part of the comparable data in determining reasonable compensation at the nonprofit.9

Effects of increased transparencyMany local papers run annual stories listing top paid executives, including senior management of hospitals and other healthcare orga-nizations. For public companies, these figures are reported in securities filings and can be readily compared on public websites,10 or gleaned manually from reviewing SEC filings online.11 For nonprofits, this information is typically drawn from annual Forms 990 filed with the IRS, which are subject to public inspection after filing at the organiza-tion’s offices and, after a lag time, are available online.12

In recent years, the level of detail and number of executives included in the Form 990 compensation disclosures has expanded steadily. With the redesigned Form 990 for tax years beginning in 2008, that expansion will result in disclosure of base compensation, bonus and incentive compensation, other compensation reported on Forms W-2 or 1099-MISC (e.g., debt forgiveness, gross-up payments for taxes on cell phones), deferred compensation, and non-taxable benefits for all current and former (within the past five years) officers, directors, trustees, “key employees” and the top five highest paid other employ-ees.13 In addition, Parts I and III of Schedule J will require disclosure of a variety of hot button perquisites provided to executives, including first class or charter travel, spousal/companion travel, tax gross-up payments (e.g., to pay the executive’s tax liability on certain fringe benefits), discretionary spending accounts, housing, health club or social club dues and initiation fees, and various personal services (e.g., maid, chauffeur, chef ). Organizations are also required to disclose whether they follow the IRS-prescribed rebuttable presumption procedure (described below) for approving executive compensation,14 and whether they intend to rely on the initial contract exception for any compensation arrangements.15

The IRS is also becoming more attuned to process issues in audits and compliance checks. For example, the executive compensation por-tion of the Hospital Project Compliance Check Questionnaire (May 2006) asked: n Whether officer, director, trustee and key employee compensa-

tion was approved in advance by disinterested individuals (The Instructions to the new Form 990, Core Form, Part VII define “key employees” as the twenty highest paid employees paid more than $150,000 for the year by the organization and all related organiza-tions, and who have responsibilities, power or influence over the organization as a whole, manage a discrete segment or activity of the organization accounting for more than 10% of the organiza-tion’s activities, assets, income or expenses, or have sole or shared

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authority or control over determinations of 10% or more of the organization’s capital expenditures, operating budget or employee compensation);

n Who exactly approves the compensation, n What comparability data is relied on in the process, n Whether the compensation was within the range of that data, and n Whether the comparables included compensation levels at other

tax-exempt hospitals.16

The IRS has also instructed agents to focus on the effectiveness of internal financial controls when auditing exempt organizations to help shape the course and scope of the audit – consistent with the IRS view (and a theme of the new Form 990) that organizations following good governance practices are more likely to be in compliance with the tax laws.17 As part of the opening document requests in hospital audits, IRS agents are now asking for compensation committee minutes as well as internal audit reports.

Fiduciary dutiesSetting appropriate parameters for executive compensation is not only likely to be viewed by the public as the right thing to do in tough economic times, it is also good business and in the best interest of the organization. In that regard, directors and officers of nonprofit corporations owe fiduciary duties of care, loyalty, and obedience to the corporation. Those fiduciary duties require directors and officers to act in good faith and in a manner they believe to be in the best interests of the corporation as opposed to their own personal interests.18 In fulfilling those duties in the area of executive compensation, directors and officers may rely on:

“information, opinions, reports, or statements, including financial statements and other financial data, if prepared or presented by … legal counsel, public accountants or other persons as to matters the director reasonably believes are within the person’s professional or expert competence.”19

When the process breaks down, directors and officers are at risk for state attorneys general seeking to recoup excessive payments, including bonuses and other insider deals.20

Although fiduciary duties for nonprofits arise under state law, they also can lead to federal tax compliance concerns including imposition of excise taxes at rates up to 225% for excess benefits under Section 4958 if executive compensation exceeds fair market value. In the redesigned Form 990, the IRS will be asking a number of new and

expanded questions regarding board independence, conflicts of interest procedures, disclosure of financial statements, governance policies, and compensation review procedures. These questions are consistent with the IRS’s view that a well governed exempt organization is also a compliant one. Now the IRS intends to prove that theory.

In its FY2009 work plan released in late November, the IRS Exempt Organizations Division (EO) announced a new three-part initiative aimed at nonprofit governance issues. EO will continue its work in the nonprofit governance area by focusing on three areas:

First, EO will develop a checklist to be used by agents in examina-tions of exempt organizations to determine whether the organization’s governance practices impacted the tax compliance issues identified in the examination and to educate organizations about possible gover-nance considerations.

Second, EO will commence a training program to educate its employ-ees about nonprofit governance implications in the determinations, rulings and agreements, and education and outreach areas.

Third, EO will begin identifying Form 990 governance questions that could be used in conjunction with other Form 990 information in possible compliance initiatives, such as those involving executive compensation, transactions with interested persons, solicitations of noncash contributions, or diversion or misuse of exempt assets.21

Given the emphasis on compensation matters in recent IRS compli-ance initiatives, it is likely that these new governance initiatives also will include close scrutiny of executive compensation processes. Failure to provide proper oversight of the executive compensation process, including an appropriate conflict of interest policy and ensuring that compensation levels and plan design are reasonable, also may lead to state law allegations of a breach of fiduciary duty. Compensation deci-sions, however, are more than a pure numbers game, whether for state law or federal tax purposes. Simply limiting total compensation does not necessarily better serve the organization, if it is done at the expense of recruiting and retaining qualified executives or compromising job performance (by providing little or no incentive for improving the organization’s performance in financial and non-financial areas).

Emphasis on process

Real estate experts are fond of saying that the value of property is all about location, location, location. For executive compensation, at least

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Executive compensation in troubled times – Part 1 ...continued from page 35

as far as the federal tax-exemption rules are concerned, it is all about process, process, process.

Rebuttable presumptionDespite recent criticism of the rebuttable presumption process as potentially protecting compensation levels that the public would not be satisfied with, the law remains clear. If an organization successfully establishes a rebuttable presumption of reasonableness, the burden shifts to the IRS to prove that compensation of disqualified persons (including many senior executives) is unreasonable. As noted above, by the admission of a senior IRS official, that is often a difficult task. In addition, establishing the presumption ordinarily protects organiza-tion managers against imposition of the 10% excise tax that applies to anyone approving an excess benefit transaction.22 Given the increased scrutiny of executive compensation decisions in nonprofit health care, it is more important than ever for hospitals to take steps to establish a rebuttable presumption of reasonableness for executive compensation packages.

To establish a rebuttable presumption, the compensation package must be reviewed and approved in advance by an independent board or committee as being consistent with fair market value based on appropriate market data for comparable compensation arrangements. The decision also must be documented on a timely basis (within 60 days or prior to the next meeting) in the board or committee records (e.g., minutes), and the minutes or other records of the board or committee must note the terms of the compensation package that was approved, the members who were present for the debate and voted on the arrangement, the comparability data relied on and how it was obtained, and any actions taken with regard to the arrangement by any member with a conflict of interest in relation to the transaction.23

The presumption is available for all fixed compensation (i.e., specific dollar amounts, fixed formulas that are not subject to discretion such as certain percentage formulas or payments conditioned on achieving specific goals, or approval of a maximum payment as reasonable).24 To avoid disagreements over whether a particular compensation method-ology is a “fixed formula,” organizations may wish to include a cap on total compensation at a reasonable level.

If the board or committee approves compensation that exceeds the range of comparable data reviewed, the rebuttable presumption can still be established if the reasons for exceeding the range are recorded in the minutes.25 Acceptable reasons for exceeding the range may include some combination of a prior history of below-market compen-sation, specific increased duties or time commitment, truly exceptional

performance that far exceeds expectations (which may be easier to demonstrate with reasonable performance goals clearly defined in advance), bona fide competing offers from unrelated entities, and demonstrated difficulty in recruiting or retaining executives.26 Failure to follow the rebuttable presumption procedure does not necessarily mean that compensation is excessive,27 but the IRS reports on the Executive Compensation Initiative and the Hospital Project suggest that following this procedure is a best practice.

Conflicts of interestIn recent years the IRS also has shown an increasing interest in good governance practices in general, issuing and revising both a model conflicts of interest policy (available in the Instructions to Form 1023) and good governance guidelines.28 The model conflict of interest policy is a starting point for many health care organizations in developing their own conflict of interest policy, which can be helpful in minimiz-ing the excess benefit, inurement, and tax risks of executive compensa-tion and other insider transactions. The IRS also included specific safe harbors in the regulations to determine when a board or committee will be sufficiently independent to be able to meet the requirements for establishing the rebuttable presumption of reasonableness.

Specifically, a member of the reviewing body will be deemed to be independent for that purpose if he or she: n Is not a disqualified person (insider) or family member of a

disqualified person who participates in or benefits economically from the transaction (For this purpose, “family members” include spouses, ancestors, brothers and sisters (whether whole or half blood), children (whether natural or adopted), grandchildren, great grandchildren, and spouses of brothers, sisters, children, grandchil-dren, and great grandchildren);

n Is not an employee of or supervised by a disqualified person who participates in or benefits economically from the transaction;

n Does not receive compensation or other payments subject to approval by a disqualified person who participates in or benefits economically from the transaction;

n Has no material financial interest affected by the transaction; and n Does not engage in vote swapping (i.e., trading his/her vote

for approval of another transaction that benefits the member economically).29

Board independence is also relevant for disclosure purposes on Form 990, and the degree of independence of the board may affect how the IRS, the media and the public perceive an organization and its com-pensation practices. The Instructions for the new Form 990 define

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independence for board members in this context using a three-part test, and all three parts must be met: 1. No compensation to the member as an officer or employee of any

related entity; 2. Total of all other payments to the member for the tax year from

any related entity do not exceed $10,000 (reasonable directors’ fees for board service and reimbursement of expenses under a plan requiring documentation of amounts and business purpose do not count toward the $10,000); and

3. Neither the member nor his/her family were directly or indirectly involved in a transaction with any related entity that must be reported on Schedule L (or would be reportable on Schedule L if the related entity were a 501(c)(3) organization).30

IRS compliance checksThe IRS, however, is doing more than just talk about the compensa-tion process – it is also examining developing trends among non-profits and building a database for more effective, focused audits. For example, the report on the IRS Executive Compensation Initiative noted among other things that: n Over 30% of the organizations surveyed did not report compensa-

tion correctly on Form 990;n Form 990 reporting requirements for executive compensation

needed clarification (which the IRS has since addressed); n The IRS should revisit (i.e., expand) the circumstances under which

it assesses penalties for filing an incomplete Form 990;n Following the rebuttable presumption procedure to establish execu-

tive compensation levels is a common practice, though only 51% of organizations surveyed addressed all three requirements for the presumption and many organizations may have difficulty in under-standing, applying or meeting all of the requirements;

n Future compliance initiatives should focus on the correlation between meeting the rebuttable presumption requirements and rea-sonableness of compensation (including 5% of organizations where the affected person did not leave the meeting prior to a vote on his or her own compensation); and

n Loans to insiders present a high potential for abuse (followed by excessive compensation and personal use of exempt organization as-sets – likely a reference in part to employer-provided cell phones).31

A report on the executive compensation phase of the Hospital Project that started in May 2006 is expected to be released in early 2009. Another compensation review project involving approximately 400 colleges and universities, including some academic medical centers, is currently in progress, following an extension of the due date for initial

responses (to February 6, 2009). With the substantial increase in disclosure requirements for executive compensation in the new Form 990 (described above), it is also likely that the IRS will continue to use similar compliance checks to find potentially abusive or excessive compensation arrangements among nonprofits nationally, including in health care. Those compliance efforts at the IRS likely will be aided to some extent by whistleblowers, who are able to recover a bounty of up to 30% of the taxes and penalties collected by the IRS in cases over $2 million, or 15% in smaller cases.32 n

Part 2 of this article will appear in the April issue of Compliance Today and will address comparability data and compensation plan design.

1 See J. Carlson, “Healthcare Nears 10-year Record for Mass Layoffs,” ModernHealthcare.com (Nov. 21, 2008) (mass layoffs are more than 50 employees from a single employer).

2 See J. Greene, “Beaumont Hospitals to lay off employees, cut millions from 2009 budget,” Crain’s Detroit Busi-ness (Nov. 17, 2008).

3 The November 19, 2008 news release is available on the Committee’s website at http://finance.senate.gov/press/Bpress/2008press/prb111908e.pdf.

4 See Notice 2008-94, 2008-44 I.R.B. 10.5 15 U.S.C. § 7243.6 G. Griffith and J. King: “The dollars and sense of executive compensation,” Compliance Today p. 20 (HCCA,

April 2007).7 Press Release, “IRS report on non-profits’ executive compensation” (March 1, 2007), available online at http://

finance.senate.gov/press/Gpress/2007/prg030107.pdf.8 Remarks of Steven T. Miller, Commissioner TEGE (IRS), Western Conference on Tax-exempt Organizations

(Nov. 20, 2008), available online at http://www.irs.gov/pub/irs-tege/stm_loyolagovernance_112008.pdf.9 F. Stokeld, “IRS Interest in EO Executive Compensation Strong, Official Says,” Tax Notes Today, 2008 TNT

226-3 (Nov. 21, 2008).10 Two such websites are http://www.vault.com and http://swz.salary.com/.11 SEC filings are available on the EDGAR system at http://www.sec.gov/edgar.shtml.12 Forms 990 can be accessed free of charge for three years on www.guidestar.org, or for all available years with a

paid subscription.13 Form 990 (2008), Schedule J, Part II, available at www.irs.gov/charities/article/0,,id=185561,00.html. 14 Form 990 (2008), Part VI, Line 15a & b, Schedule J, Part I, Line 3 and Schedule L, Part II, Column (f ).15 Form 990 (2008), Schedule J, Part I, Line 8; see also 26 C.F.R. § 53.4958-4(a)(3).16 Copies of the questionnaire and IRS report are available online at http://www.irs.gov/charities/charitable/

article/0,,id=172267,00.html.17 See F. Stokeld, “IRS to Ask About Internal Controls During EO Exams,” Tax Notes Today, 2008 TNT 226-3

(Nov. 21, 2008).18 See Griffith & King, supra; Revised Model Nonprofit Corporation Act, § 8.30(a)(1) (1987) (the “Model Act”).19 Model Act, § 8.30(b).20 See, e.g., J. Glater & V. Bajaj, “Coumo Seeks Recovery of Bonuses at A.I.G.,” N.Y. Times (Oct. 16, 2008) (de-

mand for repayment of multimillion dollar bonuses citing “unwarranted and outrageous expenditures” including “a lavish golf outing and an overseas hunting trip that cost nearly $100,000”); State v. Anclote Manor Hospital, 566 So. 2d 296 (Fla. Dist. Ct. App. 1990), rev. den., 576 So. 2d 296 (Fla. 1991) (suit to require directors of a nonprofit to disgorge the profits from a self-dealing transaction); 2008 Fla. Stat. § 617.2003; E. Brody, “A Taxing Time for the Bishop Estate: What Is the I.R.S. Role in Charity Governance?”

21 University of Hawaii Law Review 537 (Winter 1999) (removal and repayment of excessive compensation allegedly paid to trustees of nonprofit school).

21 IRS Exempt Organizations Division Work Plan (FY2009), p. 20, available online at www.irs.gov/pub/irs-tege/finalannualrptworkplan11_25_08.pdf.

22 26 C.F.R. § 53.4958-1(c)(4)(iv).23 26 C.F.R. § 53.4958-6(c)(3)(i) & (ii).24 26 C.F.R. § 53.4958-4(a)(3)(ii) & -6(d).25 26 C.F.R. § 53.4958-6(c)(3)(ii).26 See, e.g., Choate Construction Co. v. Commissioner, 74 T.C.M. (CCH) 1092 (1992); Medina v. Commissioner,

46 T.C.M. (CCH) 76 (1983); 26 C.F.R. § 53.4958-6(c)(2)(i). In one exempt organization case where such arguments were made they were rejected for lack of substantiation. See Northern Illinois College of Optometry v. Commissioner, 2 T.C.M. (CCH) 664 (1943).

27 26 C.F.R. § 53.4958-6(e).28 The revised good governance guidelines are available on the IRS website at http://www.irs.gov/pub/irs-tege/

governance_practices.pdf. For a summary of the good governance guidelines and other considerations for good governance please see the Commentary at http://www.jonesday.com/pubs/pubs_detail.aspx?pubID=S4013.

29 26 C.F.R. § 53.4958-6(c)(1)(iii) and 26 C.F.R. § 53.4958-3(b)(1).30 Form 990, Instructions for Core Form, Part VI, Line 1.31 The full report is available online at http://www.irs.gov/pub/irs-tege/exec._comp._final.pdf.32 26 U.S.C. § 7623; 26 C.F.R. § 301.7623-1(c).