Tax concerns with physician sign-on bonuses

With the recent surge in mergers, acquisitions and reorganizations of health care entities, along with the recruitment of new personnel, a tax-exempt health care provider must remain aware of potential tax pitfalls before entering a new transaction. Failure to consider the rules and regulations governing compensation paid by exempt organizations could trigger costly excise taxes, sanctions on excess private benefit and even loss of exemption.

Excess compensation and section 4960 excise tax

As outlined in section 4960, an exempt organization must pay a 21 % excise tax on compensation in excess of $1 million paid to a covered employee, and any excess parachute payments paid to a covered employee. For purposes of section 4960, a covered employee is any current or former employee of the organization who is one of the five highest compensated employees of the organization for the taxable year or was a covered employee for any preceding taxable year beginning after Dec. 31, 2016. In enacting the legislation, Congress recognized that many hospitals and medical practices, particularly those with surgical specialties, will need to compensate certain medical professionals at an amount exceeding the $1 million limit to recruit and retain qualified professionals. Accordingly, section 4960(c)(3) excludes any remuneration paid to a licensed medical professional for the performance of medical services (including the time-consuming task of medical billing).

Although the carve out for medical services eliminates the section 4960 excise tax on compensation paid to many highly paid physicians, the rules are less lenient for physicians providing nonmedical services to the organization, such as those serving as hospital administrators or department chairs. If a covered employee performs both medical and nonmedical services, the organization must make a reasonable allocation between the compensation paid for medical and nonmedical services, provided that such allocation is not made in the compensation agreement.

Sign-on bonuses and section 4960

While wages paid to a physician for medical services performed exceeding $1 million would be excluded from section 4960 compensation, the rules on bonuses remain ambiguous. The crux of the matter is determining whether the bonus is deemed to have been paid for the performance of medical services, or as an incentive for employment. Particularly regarding sign-on bonuses, where no actual services have been performed, an otherwise exempt compensation arrangement could trigger 4960 tax liabilities.

Consider these two types of signing bonus arrangements

Since section 4960 is a relatively new law, there is very little guidance with respect to sign-on bonuses for medical professionals, leaving only the tax law and regulations to be relied upon when determining what is taxable or excluded. Under the section 4960 regulations, remuneration is deemed to be paid (and 4960 taxes may apply) when the compensation is not subject to a substantial risk of forfeiture. The regulations clarify that payment is subject to a substantial risk of forfeiture “if entitlement to the amount is conditioned on the future performance of substantial services.”

With this in mind, it is apparent that if the bonus was paid with the condition that the doctor remain employed at the hospital for a certain (substantial) period, then there would be a substantial risk of forfeiture, and the sign-on bonus would be excluded from section 4960 compensation until the risk of forfeiture lapsed. Conversely, if the bonus were paid with no claw-back provisions or service conditions, it would likely constitute taxable compensation for purposes of section 4960.

Reasonable compensation

A tax-exempt entity must ensure that compensation paid to officers or other controlling persons is reasonable, and that the organization does not use any part of its net earnings to benefit a private shareholder or individual, a concept known as private benefit or inurement. While most tax-exempt organizations do not give lavish gifts to private individuals, any excessive compensation and benefits paid by a tax-exempt hospital, including sign-on bonuses may constitute unreasonable compensation. In Rev. Rul. 97-21, the IRS expressly agreed that, as part of a plan to build an OB/GYN practice, a tax-exempt hospital was permitted to pay sign-on bonuses to help recruit talent. In determining the permissibility of sign-on bonuses, the IRS will consider all relevant facts and circumstances in deciding what is reasonable. For example, given today’s economic and labor climate, an argument could be made that signing bonuses have become an industry standard across the health care field. Accordingly, it may be appropriate for an organization to follow market norms when recruiting top talent to stay competitive and provide sign-on bonuses to physicians as part of a reasonable compensation package.

The takeaway

Tax-exempt health care providers are faced with the unique challenge of needing to pay competitive salaries to hire and retain medical professionals, while remaining in line with the rules pertaining to reasonable and excess compensation. Seeking professional guidance and staying informed about compensation arrangements will help protect your organization and ease the tax compliance burden.