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New Excess Compensation Tax for Exempt Organizations Creates New Burdens for Nonprofit Health Systems with Highly-Compensated Physician Leaders

The Tax Cuts and Jobs Act added a new tax for exempt organizations in section 4960 of the Internal Revenue Code that will have implications for tax-exempt health systems, particularly with respect to their physician leaders. The entities subject to the tax include organizations that are tax-exempt under section 501(c)(3) of the Code.1 To the extent that its “covered employees” receive “remuneration” in excess of $1 million, a tax-exempt organization will pay a tax of twenty-one percent on that excess.2

Covered employees consist of the five employees with the highest compensation for the tax year, along with those who were covered employees in a prior year.3 Remuneration is generally defined in terms of wages,4 but there is a special definition for health care providers: “The term ‘remuneration’ shall not include the portion of any remuneration paid to a licensed medical professional (including a veterinarian) which is for the performance of medical or veterinary services by such professional.”5

Section 4960 contains a substantial number of ambiguities. For example, when is a medical professional being compensated “for the performance of medical . . . services?” In January, the IRS issued informal guidance under section 4960 in Notice 2019-09 (the “Notice”), which offers clarification of some of these ambiguities. Although not a formal regulation, the Notice provides guidance that organizations can rely upon now. The IRS will also potentially accept an interpretation of section 4960 that is at variance with the guidance provided by the Notice if it is based upon a reasonable, good faith interpretation of the statute.

A synopsis of some of the clarifications provided by the Notice follows, with a particular focus on the concerns of health care providers.

Remuneration for Health Care Services

Among the more obvious ambiguities in the statute is the standard for determining when a professional is rendering “medical or veterinary services” and when her compensation is being paid for those services. To the extent a doctor is compensated for performing procedures, that is an obvious case, but there are a variety of other functions in a medical practice.

The Notice recognizes this dichotomy, and draws a line between performance of medical services, recognizing that compensation received for providing services does not count towards the tax, while “remuneration paid to the professional for any other services, including administrative and management services associated with the performance of medical or veterinary services, is remuneration for purposes of calculating the excess remuneration (if any) subject to the excise tax.”6 While consistent with the statute, this standard is too vague to be of much utility in applying section 4960. Fortunately, the Notice does provide more precise guidance, which is summarized below.

Allocating Compensation

The Notice elaborates on the statutory language in two ways. First, it defines medical services as “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.”7 Based on this definition, the Notice then draws the line between medical services and management services in the following way:

For purposes of section 4960, documenting the care and condition of a patient is part of the direct performance of medical services, as is accompanying another licensed professional as a supervisor while that medical professional performs medical services. But managing an organization’s operations, including scheduling, staffing, appraisal, and other similar functions that may relate to a particular medical professional or professionals who perform medical services, is not the performance of medical services.8

Given that standard, it will now become incumbent upon tax-exempt providers to formulate a mechanism for allocating the compensation provided to medical professionals between compensation for providing medical services and compensation for management services. Specifically, the Notice calls for providers to “make a reasonable, good faith allocation between remuneration for medical services and other services.”9

The starting point will be any allocation made in the professional’s employment agreement, which will be considered binding unless the IRS concludes it is unreasonable or that the allocation was established to avoid the tax under section 4960. To the extent that an allocation is not established by an employment agreement, employers are to use other reasonable means to make the allocation: “For example, an employer may use a representative sample of records, such as patient, insurance, and Medicare/Medicaid billing records or internal time reporting mechanisms to determine the time spent providing medical services.”10

Observations for providers on the allocation process follow.

Considerations for Providers

First, the allocation of compensation needs to be documented, as it is reasonable to assume that audits under section 4960 will be a priority so that the IRS can identify compliance problems. As a corollary to this, the organization is going to need to capture statistical data on how its highly compensated professionals spend their time. Given that necessity, any inadequacies in existing record-keeping should be addressed. The provider should endeavor to develop a robust allocation mechanism as soon as possible, as changes in the methodology from one year to another may be viewed with suspicion.

Second, existing employment agreements should be examined. To the extent that they do allocate compensation, it may still be prudent to test the allocation against billing records to determine whether the allocation is a reasonable one. In drafting new employment agreements it makes sense to incorporate an allocation, but only if it has a reasonable basis in identifiable data; the Notice indicates that the IRS will not apply an unreasonable allocation of compensation. In an extreme case, it might impose penalties.

Providers may also want to consider whether the value ascribed to different categories of services is equal. In doing so, however, care should be used, as the Notice shows a predisposition to simply allocate compensation on the basis of hours expended, as it suggests that providers “allocate remuneration to medical services in the proportion such time bears to the total hours the covered employee worked for the employer for purposes of making a reasonable allocation of remuneration.”11 The Notice does, however, suggest that salaries of other employees could offer a basis for an allocation, offering the example of a hospital administrator and a physician.12 Consequently, an allocation of compensation that treated medical services as more valuable than administrative services might be appropriate, but the data supporting it should be carefully documented given the apparent view of the IRS that compensation should be allocated solely on the basis of hours expended.

Exempt organizations that are part of a related group face additional complications, as described below.

Compensation from Related Entities

In assessing whether they are subject to tax, providers who form part of a group of related entities must consider all compensation paid by the group, not just the amounts that they pay: “Remuneration of a covered employee by an applicable tax-exempt organization shall include any remuneration paid with respect to employment of such employee by any related person or governmental entity.”13

The determination whether entities are related will be made under a control test, which applies a majority in interest standard.14 The term “related” is construed broadly, and it would include a for-profit entity under common control with an exempt organization. Health care providers will need to form judgments about the extent to which compensation a professional receives from a related organization is being provided in return for medical services, in which case it would not count towards the individual’s compensation for purposes of the tax.

Where multiple related organizations pay compensation, they will be jointly liable on a proportionate basis for the tax on excess compensation.15 The Notice establishes a “limited services exception,” however, which provides that an employee is not a “covered employee” of any organization that does not pay at least ten percent of his compensation.16

Related Issues

Tax-exempt entities were already subject to an excise tax regime designed to curb compensation abuses, the tax on excess benefit transactions under section 4958. An excess benefit transaction occurs when an exempt organization provides an economic benefit that is excessive in relation to what it will receive in return in a transaction with a “disqualified person.”17 Because the term “disqualified person” is defined to include individuals “in a position to exercise substantial influence over the affairs of the organization,”18 there is likely to be overlap between the covered employees under section 4960 and the disqualified persons under section 4958, making both taxes potentially applicable. The Notice addresses this in a straight-forward manner, indicating that the imposition of the excise tax on excess compensation under section 4960 does not create an inference that the compensation is unreasonable under section 4958; the Notice also indicates that the fact that no tax is imposed under section 4960 does not create a presumption that the compensation paid is reasonable.19

Similarly, the Notice indicates that the mere fact that compensation paid to a disqualified person associated with a private foundation is subject to tax under section 4960 does not establish that the compensation will be treated as self-dealing for purposes of the excise tax under section 4941.20

One issue that the Notice does not address is whether payment of the section 4960 tax will have any effect on the continued qualification of a tax-exempt organization. Under current law, excess benefit transactions can potentially trigger the loss of tax exempt status under a multi-factor test that considers (among other things) the size and number of transactions, the charitable programs of the entity, and corrective actions taken by it.21 At present, it is not clear whether an organization that pays tax under section 4960 is at risk of losing its exempt status. Hopefully, that will be addressed in the formal regulations issued under section 4960.


Section 4960 will come with compliance costs. Health care providers will face complications that other exempt organizations will not because of the need to determine the portion of compensation that is tied to providing medical services. It is important that providers act on the basis of the guidance provided to develop defensible positions on allocation of compensation for purposes of section 4960.

Disclaimer: This E-Flash does not offer specific legal advice, nor does it create an attorney-client relationship. You should not reach any legal conclusions based on the information contained in this post without first seeking the advice of counsel.

1 See I.R.C. § 4960(c)(1)(A).

2 I.R.C. § 4960(a)(1). The tax will also apply to an excess parachute payment to a covered employee. I.R.C. § 4960(a)(2).

3 I.R.C. § 4960(c)(2). Only tax years commencing after December 31, 2016 count for this purpose.

4 I.R.C. § 4960(c)(3)(A).

5 I.R.C. § 4960(c)(3)(B).

6 Notice 2019-09, Q&A 15(a), available at

7 Notice 2019-09, Q&A 15(c).

8 Id.

9 Id., Q&A 15(d).

10 Id.

11 Id.

12 Id.

13 I.R.C. § 4960(c)(4)(A).

14 Notice 2019-09, Q&A 8(a).

15 I.R.C. § 4960(c)(4)(C).

16 Notice 2019-09, Q&A 10(b).

17See I.R.C. § 4958(c)(1)(A).

18 I.R.C. § 4958(f)(1)(A).

19 Notice 2019-09, Q&A 36.

20 Notice 2019-09, Q&A 37.

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

About the Author

James R. Malone, Jr. is a Principal in the Firm’s Tax Controversy Practice, representing clients in disputes with federal, state and local tax authorities in both administrative proceedings and in court. His clients include businesses, non-profits, individual taxpayers, accountants, and tax preparers.

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