Prepared for the American Hospital Association and American College of Healthcare Executives by Hogan & Hartson, L.L.P.

EXECUTIVE COMPENSATION:A Primer for Establishing Reasonable Compensation

Recent Events in Non-profit ExecutiveCompensationCongressional ActivitiesSen. Charles E. Grassley (R-IA), ranking mem-ber of the Senate Finance Committee, amongothers, has expressed a keen interest in execu-tive compensation at tax-exempt organizations.In 2005, Sen. Grassley sent a questionnaire to

10 of the nation's largest non-profit hospitalsseeking information on their charitable activi-ties, patient billing practices, ventures with for-profit companies and executive compensationpractices. The questionnaire requested adetailed breakdown of the travel expenses ofeach hospital’s five highest-paid employees,and all salaries and other benefits provided tothese individuals over the previous three years,as well as reimbursements made to employeesfor country club membership dues.

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IntroductionExecutive compensation practices at non-profit organizations recently have comeunder increased scrutiny from legislators,regulators, the media and even the generalpublic. This scrutiny has taken the form ofcongressional hearings, investigative reportsand increased Internal Revenue Service (IRS)monitoring. It sometimes has resulted in liti-gation and has spawned new IRS reportingrequirements for executive compensationbeginning in tax year 2008.

As a hospital leader, it is imperative that you beprepared to provide the leadership necessary toassure policymakers, your Board and the com-munity you serve that the compensation prac-tices at your organization meet the higheststandards established by the IRS for tax-exemptorganizations. The IRS has published final reg-ulations for determining whether compensa-tion can be presumed to be fair and reasonable.All hospital leaders of tax-exempt institutionsshould follow these IRS procedures.

This document describes in some detail thepressures recently brought to bear on executivecompensation practices, including congres-sional hearings and reports and new IRSreporting requirements. It then provides acomprehensive overview of the fiduciary dutiesof the Board and officers of tax-exempt hospi-tals and the IRS’ procedures for establishing

that executive compensation practices result infair and reasonable compensation.

Corresponding documents available at www.aha.org and www.ache.org/ceoresources.cfmprovide additional information that may beuseful to you as you review your organization’scompensation practices.

l “Excess Benefit and Reasonable Compen-sation: An Analysis of the IntermediateSanctions Rules” provides a detailed legalanalysis of the IRS’ intermediate sanctionsrules that are the most definitive IRS’ guid-ance on executive compensation. Thisdocument will be particularly useful foryour legal and compliance staffs.

l “Compensation Compliance Checklist:What Steps Should a CEO Take to AssureCompliance with Legal Standards andReporting Obligations?” lays out the stepsthat every CEO should take to assure com-pliance with IRS standards and reportingobligations around executive compensation.

l The final resource, “Sample Compen-sation Committee Charter,” provides asample charter your Board can use toestablish a specific body to discharge theBoard's responsibilities relating to com-pensation of the executive officers.

In 2006, the Government Accountability Office(GAO) issued a report titled "NonprofitHospital Systems: Survey on ExecutiveCompensation Policies." As a result of thisreport, Sen. Grassley determined that hospitalBoards of Directors are not aware of their rolesregarding executive compensation and that theIRS should perform more "critical audits" ofcompensation practices, including the provi-sion of certain fringe benefits. Sen. Grassleyalso highlighted the "widespread practice" ofhospitals providing supplemental executiveretirement plans and other deferred compensa-tion to their CEOs and other top executives.Finally, as a result of the report, Sen. Grassleyrecommended reforms to the requirements fora rebuttable presumption in connection withdetermining reasonable compensation for offi-cers and directors.

In 2007, in response to an IRS report on non-profit organizations' executive compensationpractices (from a survey of 50 public charities),Sen. Grassley stated that tax-exempt organiza-tions are failing to file the required IRS sched-ules detailing compensation paid to officersand employees. According to Sen. Grassley, theIRS chief counsel has promised to revisit guid-ance and regulations regarding executive com-pensation after the IRS completes its study. TheIRS recently announced that its ExemptOrganizations Compliance Unit would sendcompliance questionnaires to about 400 col-leges and universities and will examine execu-tive compensation practices, among otherissues.

Executive compensation has been, and contin-ues to be, a high-priority item for congression-al oversight.

IRS InitiativesThe IRS also has undertaken a number of ini-tiatives aimed at examining executive compen-sation practices at non-profit organizations.

Hospital Compliance ChecklistIn 2005, the IRS sent a compliance checklist tohundreds of tax-exempt hospitals to help deter-mine how much “community benefit” tax-exempt hospitals provide in return for theirexemption from federal income taxation. Thecompliance checklist included a number ofquestions regarding a hospital’s compensationpractices.

Form 990In December 2007, the IRS released a com-pletely redesigned “Form 990, Return ofOrganization Exempt from Income Tax,” whichconsists of a core form and 16 related sched-ules. Final instructions for Form 990 werereleased in August 2008. Non-profit hospitalsand other tax-exempt organizations arerequired to begin using the Form 990 (andmost of the schedules) for the 2008 tax year.

The new Form 990 includes extensive addition-al reporting on executive compensation paid byexempt organizations. As required in previousyears, organizations must list their officers,directors, trustees, key employees and the fivehighest-compensated individuals, and reportcompensation paid by the organization and anyrelated organizations. They now also mustreport any compensation from unrelatedorganizations for services rendered to the filingorganization. In addition, the new Form 990requires reporting of detailed informationregarding compensation for these people andthe organization’s compensation practices.

For example, the new Form requires an organ-ization to report (and describe) whether it pro-vided any of the following for people whosecompensation must be reported on Form 990:

l First-class or charter travel.l Travel for companions.

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l Housing allowance or residence for per-sonal use.

l Payments for business use of personal res-idence.

l Tax indemnification and gross-up pay-ments.

l Health or social club dues or initiation fees. l Discretionary spending accounts.l The provision of personal services (e.g.,

maid, chauffeur, chef). l Severance or change in control payments.l Supplemental non-qualified retirement

plans and equity-based compensationarrangements.

l Compensation contingent on revenues,net earnings or other non-fixed paymentsof the organization or any related organi-zation.

The new Form 990 also asks whether an orga-nization’s process for determining the compen-sation of top management officials, officers andkey employees includes review and approval byindependent directors, review of compensationcomparability data, and written records ofdeliberation and the compensation approved.

Executive Compensation ComplianceInitiativeIn 2004, the IRS launched an enforcement effortto identify and halt abuses by tax-exempt organ-izations that pay excessive compensation andbenefits to their officers and other insiders. TheExecutive Compensation Compliance Initiativeinvolved compliance checks of approximately2,000 non-profit organizations. In March 2007,the IRS released a final report on its findingsfrom the first two parts of the initiative. A reporton the last part is forthcoming.

The compliance checks found significantreporting errors and omissions by non-profit

organizations. While the project did notuncover widespread excess benefit transactionsor instances of self-dealing, the IRS assessed$21 million of excise taxes in connection withthe checks. As a result, the project report rec-ommended that a compensation component beincluded in future compliance initiatives. Italso recommended revisions to Form 990 tofacilitate accurate and complete reporting ofcompensation.

Government Accountability OfficeReportIn 2006, the GAO released a report summariz-ing its findings from a survey of executive com-pensation policies and practices at 65 non-profit hospital systems. The survey and reportwere part of Congress’ “continuing efforts tooversee the activities of the nonprofit sector.”The study’s key questions involved the type ofcorporate governance structure in place forexecutive compensation, the basis for executivecompensation and benefits, and the internalcontrols on approval, payment and monitoringof executive travel and entertainment expenses,gifts and other perquisites.

The responses showed many similarities in thepolicies and procedures in place at the varioushospital systems, with more variation of poli-cies regarding travel and entertainmentexpenses. The report did not draw any conclu-sions with respect to the adequacy or sufficien-cy of any policy, or whether any hospital systemwas complying with applicable laws.

Independent Sector Organization –Panel on the Non-Profit SectorIn 2005, the Independent Sector Organizationconvened the Panel on the Non-Profit Sector.Its report incorporated input from thousandsof individuals from the charitable communityand proposed various actions by charitableorganizations, Congress and the IRS. Thereport recommended imposing penalties on

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Board members who “should have known” thatan amount of executive compensation wasunreasonable (currently, penalties are onlyimposed on Board members who knew thecompensation was unreasonable), and increas-ing penalties for parties who approve or receiveunreasonable compensation. The report alsorecommended requiring non-profit organiza-tions to disclose in greater detail on Form 990all compensation received by officers and high-ly compensated employees. Finally, the reportrecommended that non-profit organizationsrevise and strengthen various policies withrespect to corporate governance.

LitigationPeople v. GrassoFrom June through July 2008, the New Yorkcourts dismissed six claims brought by the NewYork Attorney General against Richard A.Grasso, former CEO of the New York StockExchange (NYSE). The Attorney Generalargued that the payment of $139.5 million toMr. Grasso for the years 2000-2002 was unrea-sonable under New York’s not-for-profit corpo-ration law. This compensation rivaled theNYSE’s net income over the same period. Theclaims were dismissed after the court of appealsheld that the Attorney General did not havestanding to sue under New York law. The courtdid not touch on the issue of whether the com-pensation was reasonable; however, its shortruling suggested that the size of the compensa-tion package alone was not sufficient basis forits reduction, even if it seemed unreasonable onits face. Some commentators have argued thatPeople v. Grasso exemplifies courts’ reluctanceto get involved in determining what is reason-able compensation.

Maryland CareFirst BlueCrossBlueShield CEO CompensationIn July 2008, the Maryland insurance commis-sioner cut in half the $18 million severancepackage paid to former CareFirst BlueCross

BlueShield CEO William L. Jews. The commis-sioner held that the compensation package vio-lated a 2003 Maryland law that limits compen-sation at CareFirst to “fair and reasonable” pay.The law regulating Jews’ pay was passed after heunsuccessfully attempted to privatize the com-pany in 2003. The move was blocked on thegrounds that it would illegally enrich top exec-utives. Jews’ original $18 million severance rep-resented nearly seven times his total compensa-tion in 2006, which the insurance commission-er stated was “simply too much money to pay tothe departing CEO of a nonprofit company.”

Fiduciary Duties of Boardof Directors and Officersof HospitalsA corporation is governed by the laws of itsstate of incorporation. State corporate princi-ples generally include a duty of care and a dutyof loyalty, each of which is described below. Inaddition, a duty of obedience has been recog-nized in recent years. These duties apply bothto directors and officers, requiring that officersprovide adequate information to the Board inorder to aid the directors in their fiduciaryduties. An officer or director who is found tohave violated his or her fiduciary duties may beheld personally liable to the organization forany losses that resulted from the violation.

This section illustrates the fiduciary duties ofdirectors and officers.

Duty of CareThe duty of care generally requires that an officeror director act in a reasonable, informed mannerwhen making Board decisions and overseeingthe corporation’s management. The duty requiresan officer to be informed and discharge his orher duties in good faith, with the care an ordinar-ily prudent person in a like position would exer-cise under similar circumstances.

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The phrase “like position,” as used by the IRS,refers to what a theoretical person with thesame characteristics, e.g., background andexperience, would have done in the same posi-tion. The phrase “under similar circumstances”means that an officer who has specializedexpertise would be held to a higher standardthan one who does not. Each officer and direc-tor shares equally in the responsibility of theBoard to act in the best interests of the organi-zation. An officer or director may not vote sole-ly on the basis of what another thinks, even ifthat other person has special expertise; eachdirector or officer must use his or her inde-pendent judgment to evaluate any positiontaken by another person.

Directors and officers must undertake reason-able inquiry to learn what they need to know tomake an informed decision. Further, directorsand officers should see that there are proce-dures in place to ensure that adequate informa-tion is available to the Board. An officer ordirector may rely on information and reportsreceived from Board committees, officers,employees and outside advisors or experts thathe or she reasonably believes to be reliable andcompetent, but cannot blindly rely on financial,legal and other advisors.

When a director or officer acts in a mannerthat is consistent with his or her duties of careand loyalty, decisions generally are presumedto be valid under the business judgment rule.The courts have developed this presumptionpartly as a result of their reluctance to “secondguess” the ordinary business decisions of direc-tors and officers. Generally speaking, such per-sons are not liable for actions or decisions thatare later proven to be unwise or unsuccessful ifthey were made:

l in good faith and without a conflict ofinterest;

l on a reasonably informed basis; and

l with a rational belief that the action ordecision is in the best interests of the cor-poration.

However, some commentators have suggestedthat it is unclear to what extent the businessjudgment rule applies to non-profit organiza-tions1 and that there should be “more rigorousjudicial scrutiny” of transactions in which direc-tors may have potential conflicts of interest.2

Duty of LoyaltyThe duty of loyalty generally requires thatdirectors and officers exercise their powers ingood faith and in the best interests of theorganization, rather than in their own inter-ests or for the benefit of another person.Breaches of the duty of loyalty typicallyinvolve fraud, self-dealing, misappropriationof corporate opportunities, improper diver-sions of corporate assets and similar matters.

Conflicts of interest involving directors orofficers are not inherently illegal. The duty ofloyalty focuses on the manner in which theparties consider and determine the proprietyof the transaction. One area of concern fornon-profit corporations is a director or offi-cer’s role in the review or approval of anytransaction or arrangement that may appearto benefit one non-profit corporation withwhich that director is affiliated over anothernon-profit corporation with which that direc-tor also is affiliated. While the director maynot stand to receive personal gain, the direc-tor may be subject to a claim that the directordid not act in the best interests of one of theorganizations.

Furthermore, a duty of confidentialityrequires that directors and officers keep con-fidential all matters relating to the non-profitorganization until publicly disclosed in aproper fashion.

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Duty of ObedienceAs noted above, the duty of obedience has beenrecognized for non-profit organizations inrecent years, though the duty rarely has beenenforced. The duty generally requires that thedirector or officer is faithful to the organiza-tion’s purposes and goals, and that the missionof the organization is carried out.

Reasonable Compensationand Penalties for ExcessBenefit Arrangements un-der IRS CodeIn 1996, Congress enacted the Taxpayer Bill ofRights 2, which granted the IRS, for the firsttime, the authority to impose “intermediatesanctions” on certain individuals who use theassets of a Section 501(c)(3) tax-exempt organ-ization, including tax-exempt hospitals, forimproper personal gain. (For a detailed analysisof the intermediate sanctions rules, see “ExcessBenefit and Reasonable Compensation: AnAnalysis of the Intermediate Sanctions Rules.”)The intermediate sanctions rules expose to per-sonal liability certain “insiders,” called disqual-ified persons, and exempt organization man-agers. These rules provide specific guidance inthe application of the general prohibitions onprivate benefit and private inurement bySection 501(c)(3) organizations.

If a hospital engages in a transaction or com-pensation arrangement for insiders that is not“reasonable” as measured by fair market valuestandards, penalties can be imposed on theindividual receiving the compensation as wellas on those who approved it. More specifically,disqualified persons initially are subject to a taxof 25 percent of the amount of the excess bene-fit, and are further subject to an additional taxof 200 percent of the excess benefit if the trans-action or arrangement is not “corrected” withina designated time period. In addition, the man-

agers of the exempt organization are subject toa tax of 10 percent of the excess benefit if theyknowingly participated in an excess benefittransaction or arrangement, unless the partici-pation was not willful and was due to reason-able cause.

What is an Excess BenefitArrangement?If compensation is provided by the hospital,directly or indirectly, to a disqualified personand the compensation exceeds the fair marketvalue of the performance of services receivedby the hospital, an “excess benefit” has beenawarded. This definition also includes anyproperty transfer or transaction between a dis-qualified person and a tax-exempt organiza-tion.

Who is Covered by the Excess BenefitRules?As defined in IRS regulations, a disqualifiedperson is any person who was in a position toexercise substantial influence over the affairs ofthe organization at any time during the five-year period ending on the date of the arrange-ment. Disqualified persons also include amember of the family of a person who was in aposition to exercise such influence, and an enti-ty controlled 35 percent or more by disqualifiedpersons.

Persons Having Substantial InfluenceA person is in a position to exercise substantialinfluence over an organization if that personhas the powers or responsibilities, or holds thetype of interests, described in one of the follow-ing categories:

l Presidents, chief executive officers or chiefoperating officers: An individual mayserve in one of these capacities, regardlessof title, if that person has or shares ulti-mate responsibility for implementing the

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decisions of the governing body or super-vising the management, administration oroperation of the applicable organization.

l Treasurers and chief financial officers: Anindividual may serve in one of these capac-ities, regardless of title, if that individualhas or shares ultimate responsibility formanaging the organization’s financialassets.

l Individuals serving on the governing bodywho are entitled to vote.

l Persons with a material financial interestin a provider-sponsored organization if ahospital that participates in the provider-sponsored organization is an applicabletax-exempt organization.

Facts Suggesting Substantial InfluenceIf a person does not fall within the above-described categories, the determination ofwhether he or she is a disqualified persondepends on all of the facts and circumstances,such as whether:

l the person’s compensation is primarilybased on revenues derived from activities ofthe organization that the person controls;

l the person has or shares authority to controlor determine a substantial portion of theorganization’s capital expenditures, operat-ing budget or compensation for employees;

l the person has managerial control over adiscrete segment of the applicable exemptorganization and the segment represents asubstantial portion of an applicableexempt organization’s activities, assets,income or expenses (e.g., the head of ahospital’s cardiology department is a dis-qualified person where that particulardepartment is a principal source ofpatients and revenue for the hospital);

l the person is a substantial contributor tothe organization;

l the person owns a controlling interest(measured by vote or value) in a corpora-tion, partnership or a trust that is a dis-qualified person; or

l the “person” is a non-stock organizationcontrolled, directly or indirectly, by one ormore disqualified persons.

What is Reasonable Compensation?Compensation paid to a disqualified personwill not be regarded as an excess benefit if thetotal compensation paid is reasonable.Reasonable compensation is defined as “anamount that would ordinarily be paid for likeservices by like enterprises, whether taxable ortax-exempt, under like circumstances.”Compensation includes but is not limited to:

l all forms of cash and non-cash compensa-tion, including salary, fees, bonuses andseverance payments paid;

l all forms of deferred and non-cash com-pensation that is earned and vested;

l the amount of premiums paid for liabilityor any other insurance coverage; and

l all other benefits such as medical, dental,life and disability insurance.

Initial Contract ExceptionThe intermediate sanctions rules are not appliedto any fixed payment made pursuant to a bindingwritten contract between the hospital and a partywho was not a disqualified person immediatelyprior to entering into the contract (e.g., a newly-hired chief executive officer of an organization).

Timing Rules for DeterminingReasonableness of Compensation Paidto Disqualified Persons Reasonableness is determined with respect toany fixed payment at the time the parties enterinto the contract. For non-fixed payments, rea-

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sonableness of compensation is based on all thefacts and circumstances, up to and including cir-cumstances as of the date of the non-fixed pay-ment. These general timing rules apply to prop-erty subject to a substantial risk of forfeiture.Therefore, if the property is subject to a substan-tial risk of forfeiture and satisfies the definitionof fixed payment, reasonableness is determinedat the time the parties enter into the contractproviding for the transfer of the property.However, if the property is not a fixed payment,then reasonableness is determined based on allthe facts and circumstances, up to and includingcircumstances as of the date of payment.

Revenue-sharing ArrangementsThe regulations do not provide any guidanceon the controversial topic of “revenue-sharing”transactions or arrangements in which com-pensation is calculated by reference to theexempt organization’s revenues. Such arrange-ments are often entered into between physi-cians and hospitals. The IRS continues toreserve the revenue-sharing arena for possiblefuture consideration in additional regulations.In the meantime, revenue-sharing arrange-ments will continue to be subject to the generalrules governing excess benefit transactions.

Physician CompensationHospital recruitment of physicians is an area towhich the IRS has paid particular attentionwith respect to unreasonable compensation orother forms of inurement. Guidance in thisarea, however, is relatively sparse. For example,in a 1973 revenue ruling, the IRS held that incertain circumstances, any personal benefitderived by a physician will not detract from thepublic purpose of a health care organization,lessen the public benefit flowing from its activ-ities, or be considered to be a prohibited privatebenefit.3 In this particular situation, the com-munity was totally lacking in local medicalservices and the organization found that thelack of adequate facilities was a significant fac-tor in the inability of the community to induce

a doctor to locate in the community. Theorganization entered into an arrangement toinduce a physician to locate to the communityby erecting a medical services building andoffering reasonable rent, which was negotiatedin good faith, although it was less than whatwould be necessary to provide a normal returnon the investment in the facility.

In 1997 the IRS provided five scenarios illus-trating how hospitals can avoid violating therequirements for exemption under section501(c)(3) when they provide incentives torecruit physicians to join their medical staff orto provide medical services in the community.4

Four of the five scenarios satisfied the require-ments for exemption. The hospitals in each sit-uation demonstrated a specific need for certaindoctors or medical care in their service areasand engaged in activities bearing a reasonablerelationship to promoting and protecting thehealth of the community. The hospital in thescenario that did not satisfy the IRS require-ments had engaged in physician recruitingpractices that were in violation of anti-fraudregulations.

In 2002, the IRS released an information letterdetailing the factors that will be considered indetermining whether incentive-based compen-sation arrangements result in private inurementor impermissible private benefit.5 These factors,listed below, emphasize that, in addition tobeing reasonable, compensation arrangementsmust also include features that further protectagainst private inurement and impermissibleprivate benefit:

l Was the compensation arrangement estab-lished by an independent board of direc-tors or an independent compensationcommittee?

l Does the compensation arrangement withthe physician result in total compensationthat is reasonable?

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l Is there an arm’s length relationshipbetween the health care organization andthe physician, or does the physician partic-ipate impermissibly in the management orcontrol of the organization in a mannerthat affects the compensation arrange-ment?

l Does the compensation arrangementinclude a ceiling or reasonable maximumon the amount a physician may earn toprotect against projection errors or sub-stantial windfall benefits?

l Does the compensation arrangement havethe potential for reducing the charitableservices or benefits that the organizationwould otherwise provide?

l Does the compensation arrangement takeinto account data that measures quality ofcare and patient satisfaction?

l If the amount a physician earns under thecompensation arrangement depends onnet revenues, does the arrangementaccomplish the organization’s charitablepurposes, such as keeping actual expenseswithin budgeted amounts, where expensesdetermine the amounts charged for chari-table services?

l Does the compensation arrangementtransform the principal activity of theorganization into a joint venture betweenit and a physician or group of physicians?

l Is the compensation arrangement merely adevice to distribute all or a portion of theorganization’s profits to persons who are incontrol of the organization?

l Does the compensation arrangement servea real and discernable business purpose ofthe exempt organization, such as toachieve maximum efficiency and economyin operations, that is independent of anypurpose to operate the organization for theimpermissible direct or indirect benefit ofthe physicians?

l Does the compensation arrangementresult in no abuse or unwarranted benefits

because, for example, prices and operatingcosts compare favorably with those of sim-ilar organizations?

l Does the compensation arrangementreward the physician based on services thephysician actually performs, or is it basedon performance in an area where thephysician performs no significant func-tions?

How Can a “Presumption ofReasonableness”6 be Established?Payments under a compensation arrangement,a property transfer or any other benefit or priv-ilege between a hospital and a disqualified per-son shall be presumed to be reasonable if thefollowing three requirements are met:

l The compensation arrangement or termsof the property transfer are approved bythe organization’s governing body, or com-mittee of the governing body, or partyauthorized by the governing body, and thedecision-making body is composed entire-ly of individuals who do not have conflictsof interest with respect to the compensa-tion arrangement or transaction.

l The governing body, or committee there-of, or party authorized by the governingbody obtained and relied upon appropri-ate comparability data on total compensa-tion before making its decision.

l The governing body, or committee there-of, or party authorized by the governingbody adequately documented the basis forits determination concurrently with mak-ing that determination.

Once the presumption is established, the IRSmay rebut the presumption with additionalinformation showing that the compensationwas not reasonable or that the transfer was notat fair market value. Failure to establish the

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“presumption of reasonableness” does not cre-ate an inference that the transaction is anexcess benefit transaction.

What is an Adequate ApprovalProcess?The governing body is the Board of Directors,trustees or equivalent controlling body of thetax-exempt organization. The Board mayauthorize a committee of the Board membersto act on behalf of the Board to the extent per-mitted by state law. If the organization’s con-trolling documents or state law requires Boardapproval of an arrangement or transaction,then committee approval will not be sufficient.The Board also may authorize other parties toact on its behalf in approving compensationarrangements or property transfers, provided itspecifies procedures and such delegation isallowed under state law.

As required, decision-makers may not have aconflict of interest. A person will not have aconflict if he or she:

l is not the disqualified person, or anyonerelated to or benefiting from the compen-sation arrangement;

l is not in an employment relationship sub-ject to the direction or control of any dis-qualified person participating in or bene-fiting from the compensation arrange-ment;

l is not receiving compensation or otherpayments subject to approval by any dis-qualified person participating in or bene-fiting from the compensation arrange-ment; and

l has no material financial interest affectedby the compensation arrangement ortransaction.

If a Board authorizes a compensation commit-tee, it should establish a specific charter for the

committee. The charter should reflect therequired process for consideration andapproval of compensation. (See “SampleCompensation Committee Charter.”)

What is Appropriate ComparabilityData?In making a determination as to reasonablenessof compensation or fair market value, the Boardor committee must have obtained and reliedupon appropriate data as to compensation com-parability. Appropriate data includes compen-sation paid by similarly situated organizations,both taxable and tax-exempt, for functionallycomparable positions; the availability of similarservices in the geographic area of the applicabletax-exempt organization; current compensationsurveys compiled by independent firms; actualwritten offers from similar institutions compet-ing for the services of the disqualified person;and independent appraisals of the value ofproperty that the applicable organizationintends to purchase from, or sell or provide tothe disqualified person.

What is Sufficient Documentation?For a decision to be documented adequately,the written or electronic records of the Boardor committee must specify:

l the terms of the compensation that wasapproved and the date it was approved;

l the members of the governing body orcommittee who were present during dis-cussion of the arrangement that wasapproved and those who voted on it;

l the comparability data obtained and reliedupon by the governing body or committeeand how the data was obtained; and

l the actions taken with respect to thearrangement by anyone who is a memberof the governing body or committee, butwho had a conflict of interest with respectto the arrangement.

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The requirement of concurrent documentationmeans that records must be prepared by thelater of the next meeting of the Board or com-mittee or sixty (60) days after the final Board orcommittee approval of a particular arrangementor property transfer. Such records must bereviewed and approved by the Board or com-mittee as reasonable, accurate and completewithin a reasonable time period thereafter.

When Can the “Presumption ofReasonableness” be Established?The regulations state that a organization canestablish a rebuttable presumption of reason-ableness with respect to fixed payments (or cal-culated pursuant to a fixed formula) at the timethe parties enter into the contract. Likewise,under a special rule, the presumption of rea-sonableness can be established for paymentsmade pursuant to a deferred compensationarrangement such as a qualified pension, prof-it-sharing or stock bonus plan when the partiesenter into the contract for services.

In contrast, for non-fixed payments, the pre-sumption can only be established after discre-tion is exercised, the exact amount of the pay-ment is determined and the three requirementsfor the rebuttable presumption are satisfied. Theregulations do include a limited exception fornon-fixed payments subject to a cap. Under thisexception, the presumption of reasonablenesscan be established for non-fixed payments if:

l prior to approving the contract, the govern-ing body obtains comparability data show-ing that a fixed payment up to a certainamount would be reasonable compensation;

l the maximum amount payable under thecontract including fixed and non-fixedpayments does not exceed the reasonablecompensation amount; and

l the other requirements for establishing thepresumption of reasonableness are satisfied.

Preparing for New Form990 ReportingIn addition to compensation reporting forBoard members, officers and the five highest-compensated employees, the new Form 990requires the reporting of information on “keyemployees.”

A “key employee” is an employee of the organ-ization, other than an officer, director ortrustee, who:

l receives reportable compensation from theorganization and all related organizationsexceeding $150,000 for the year (the“$150,000 Test”);

l has responsibilities, powers or influenceover the organization as a whole that is sim-ilar to those of officers, directors or trustees;

l manages a discrete segment or activity ofthe organization that represents 10 percentor more of the activities, assets, income orexpenses of the organization, as comparedto the organization as whole; or has orshares authority to control or determine 10percent of more of the organization’s capi-tal expenditures, operating budget or com-pensation for employees (collectively, the“Responsibility Test”); and

l is one of the 20 employees (that satisfiesthe $150,000 and the Responsibility Test)with the highest reportable compensationfrom the organization and related organi-zations for the calendar year ending withor within the organization’s tax year.

The Form 990 also requires reporting of com-pensation to former officers, key employeesand trustees whose compensation meets cer-tain thresholds. Reportable compensationincludes compensation from the organizationand related organizations and compensationfrom any unrelated entity if it provided servic-es to the reporting organization.

Note: To assure compliance with IRS standards of professional practice, Hogan & Hartson, L.L.P., disclos-es to you that any federal tax advice in this communication was not intended or written to be used,and cannot be used, for the purpose of avoiding federal tax penalties; and, if used to promote, mar-ket, or recommend any transaction, investment or matter, the advice was written to support thepromotion or marketing of the transaction or matters addressed. Taxpayers should seek advice,based on their particular circumstances, from an independent tax advisor.

Special thanks to Deborah T. Ashford, Esq., of Hogan & Hartson, L.L.P., for her work in drafting thisprimer and the corresponding documents. Thanks also to David Bjork of Integrated HealthcareStrategies for his review of and comments on this primer.

Footnotes1 Daniel L. Kurtz, Safeguarding the Mission: The Duties and Liabilities of Officers and Directors on Nonprofit Organizations, C726 ALI-ABA 15,

30 n.31 (Apr. 9, 1992); Revised Model Nonprofit Corporation Act § 8.30, Official Comment § 3 (“While the application of the business judgmentrule to directors of nonprofit corporations is not firmly established by the case law, its use is consistent with section 8.30.”).

2 Harvey J. Goldschmid, The Fiduciary Duties of Nonprofit Directors and Officers: Paradoxes, Problems, and Proposed Reforms, 23 J. Corp. L. 631,648 n.19 (1998).

3 Rev. Rul. 73-313.4 Rev. Rul. 97-21.5 IRS Info. 2002-0021.6 The applicable regulations refer to this concept as a “rebuttable presumption” of reasonableness; however, for clarity “presumption of reasonable-

ness” is used throughout this discussion.VIIAs referenced in Code Section 414(q)(1)(B)(i). For 2007, this amount is $100,000.

ReferencesInternal Revenue Service, Report on Exempt Organizations Executive Compensation Compliance Project – Parts I and II (March 2007), availableat http://www.irs.gov/pub/irs-tege/exec._comp._final.pdf.

U.S. Government Accountability Office, Nonprofit Hospital Systems: Survey on Executive Compensation Policies and Practices, GAO-06-907R(June 30, 2006), available at http://www.gao.gov/new.items/d06907r.pdf.

Independent Sector Organization, Panel on the Nonprofit Sector: Strengthening Transparency, Governance, Accountability of CharitableOrganizations, at 66 (June 2005), available at http://www.nonprofitpanel.org/Report/final/Panel_Final_Report.pdf.

People v. Grasso, No. 120, 2008 N.Y. LEXIS 1821 (N.Y. June 25, 2008), available at http://www.nycourts.gov/ctapps/decisions/jun08/120opn08.pdf.

Ins. Comm’r for Md. V. CareFirst, Inc., Md. Ins. Admin., MIA-2007-10-027 (July 14, 2008), available at http://www.mdinsurance.state.md.us/sa/doc-uments/MIA-2007-10-027-CareFirstFinalOrderall07-08.pdf.

Internal Revenue Service, EO CPE Text, Reasonable Compensation (1993), available at http://www.irs.gov/pub/irs-tege/eotopici93.pdf.

Internal Revenue Service, EO CPE Text, Physician Incentive Compensation (2000), available at http://www.irs.gov/pub/irs-tege/eotopicc00.pdf.

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