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June 23, 2018 12:00 AM

Not-for-profit health systems working to get around tax on high exec pay

Tara Bannow
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    Not-for-profit health systems—no strangers to paying top dollar for talented executives—are using sophisticated methods to avoid the penalties on high employee compensation.

    Effective tax year 2018, the Tax Cuts and Jobs Act imposes a 21% excise tax on not-for-profit compensation that exceeds $1 million, a threshold that encompasses just about all major not-for-profit health systems.

    Total CEO pay, including bonuses, retirement and other benefits, across the top 25 largest not-for-profit health systems averaged about $5.1 million in 2016, the most recent year for which data are available. That's up from $4.5 million in 2015.

    The tax is significant. This year, a $5.1 million salary, for example, would hit a health system with a roughly $860,000 tax. Bernard Tyson, CEO of Oakland, Calif.-based Kaiser Permanente, made about $10 million in total compensation in 2016. A 21% tax on all of his pay over $1 million would be $1.9 million—perhaps not a huge hit to a $73 billion organization.

    St. Louis-based SSM Health's former CEO Bill Thompson made nearly $2 million in 2016, which would yield a roughly $200,000 tax this year. Again, likely not significant for a $6.5 billion operation.

    But for smaller health systems, the new tax, which applies to all W-2 reportable compensation, could bring pain.

    "If they're going to have to pay this excise tax, where is that going to come from?" asked Elliot Dinkin, CEO of consulting firm Cowden Associates. "It's not budgeted."

    The law also includes a calculation whereby health systems can be taxed for providing excessive parachute payments to high-paid employees upon their departures. Patrick Fry, who retired as Sutter Health's CEO in January 2016, received $10.6 million in deferred retirement pay that year, bringing his total compensation to nearly $13.5 million.

    Doug Mancino, a partner with the law firm Seyfarth Shaw, said that's precisely the kind of payment that would likely trigger a substantial tax today.

    "That's meaningful money," he said.

    INTERACTIVE: Total compensation for the CEOs of the largest not-for-profit health systems.

    Tricks for lowering tax exposure

    Luckily for them, health systems have savvy tax experts recommending maneuvers that will reduce their exposure to the new tax. Even then, systems must tread carefully to ensure they're staying within the law.

    The first step many health systems took shortly after Congress passed the tax law was to rush through hefty compensation payouts at the end of 2017 that would have otherwise been subject to the tax this year.

    "Everyone that I've spoken to wanted to take advantage of the opportunity to accelerate to avoid any excise tax," said Tom Flannery, a senior client partner with the healthcare consultancy at Korn Ferry. He wouldn't name specific clients.

    Flannery said he expects 2017 health system financial disclosures will show higher executive compensation, followed by lower compensation in 2018 and 2019, after which pay will likely climb back up.

    The move appears to be allowable under the new law, and fits with the goal of any prudent board: to minimize non-healthcare-related payments, Flannery said.

    "If you had the opportunity to avoid paying a tax, would you do it?" he asked.

    In some cases, systems accelerated seven-figure deferred compensation packages that had accrued over a number of years, Mancino said. He also wouldn't name specific clients, but said such accelerations should have buy-in from both the companies and the affected employees.

    Section 409A of the Internal Revenue Code is designed to prevent artificial acceleration of deferred compensation agreements. Health systems would have needed to use specific exceptions to that section in order to use the accelerations legally, Mancino said.

    Some health systems are also getting around the excise tax by replacing traditional deferred compensation packages with what are known as split dollar loan arrangements. Under such arrangements, employers make substantial loans to executives that go toward their life insurance premiums. Loans are not considered wages, and are thus not subject to the excise tax.

    Split dollar loan arrangements then allow those executives to, upon retirement, borrow accumulated, non-taxable cash from those life insurance companies every year. The cash borrowing has to be done within prescribed limits so that the employer and the executives' beneficiaries are paid the full benefits under the life insurance policy upon the executive's death, Mancino said.

    Those arrangements are a "win-win" for employees and employers alike, Mancino said, with employees getting the same economic benefit from the loans as they would under deferred compensation.

    "This becomes a very, very attractive option," Mancino said.

    Major health systems like Kaiser Permanente, Sutter Health, SSM Health, Dignity Health and Baylor Scott & White Health said they aren't using either tactic.

    "We plan to administer our total rewards package as it exists today and continue to abide by all appropriate tax reporting guidelines," Sutter spokeswoman Karen Garner wrote in an email.

    Congress has asked the IRS to write rules preventing not-for-profit organizations from avoiding the excise tax by letting people perform services other than as employees, or by paying people through pass-through entities such as partnerships, limited liability companies or S corporations, Mancino said.

    He said health systems have for years classified medical directors as independent contractors rather than employees, which tends to be a front-burner issue in hospital audits. Mancino said he expects the IRS will determine that performing services through a limited liability company will be subject to the excise tax if the compensation for those services exceeds $1 million.

    "There's a lot of techniques that are in use today that will probably be scrutinized if it appears they are being used in an abusive fashion," he said.

    There are a number of unresolved questions surrounding the new law that the IRS is expected to clarify when it issues proposed regulations at the end of the month. For example, the law includes an exemption for providing medical care, which raises the question of whether physician compensation that exceeds $1 million would be subject to the tax, especially if a portion of their time is spent on administrative duties.

    "The question is, would those administrative duties related to medical services be deductible or not?" Flannery pondered. "There is a level of uncertainty around some of these issues."

    CEO pay fluctuations

    Several not-for-profit health system CEOs made more or less in 2016 than the prior year because of the health system's performance or payouts from deferred compensation packages.

    The reason Joel Allison, the former CEO of Dallas-based Baylor Scott & White Health, made about $700,000 less in 2016 than in 2015 was because the health system did better in 2015 when it came to meeting its performance goals in areas such as finances and patient satisfaction, said Julie Smith, a spokeswoman for the health system.

    At Kaiser, although Tyson's $10 million total compensation in 2016 far exceeded his $6 million package in 2015, most of the increase was due to bonus and incentive pay, retirement and other deferred compensation. His base pay was $1.3 million in 2016.

    Tyson's $4 million pay hike resulted from an incentive program that dates back to his hiring as CEO in 2013. It also reflects changes to retirement and other deferred compensation, according to a statement from the health system, which also noted that the board aims to provide a reasonable and competitive program for executives of similar size and complexity.

    The most recent numbers also reiterate the dramatic variation in not-for-profit CEO compensation, with Tyson, Ascension's Anthony Tersigni, Sutter's Patrick Fry and Dignity Health's Lloyd Dean making more than $10 million in total compensation in 2016. Others are paid more modestly. Dr. Ram Raju, the former CEO of the nation's largest public health system, New York City Health & Hospitals, made about $504,000 that year.

    Most health systems contacted by Modern Healthcare said they set CEO compensation largely based on what their competitors are paying in an effort to stay competitive and attract top people. But Flannery said that method won't be enough going forward. Health system boards need to consider the return on investment they're getting with respect to what they're paying CEOs, which necessitates a higher focus on their performance, he said. Health systems should incorporate quality monitoring, including patient satisfaction and physician engagement performance, into their compensation decisions, Flannery said.

    "Most of our clients are becoming much more sophisticated in how they're thinking through their executive compensation," he said, "and not relying on traditional approaches."

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