Executive Compensation Limits under the ARRA: A Sign of Things to Come for Not-for-Profit Healthcare Organizations?

March 12, 2009

The American Reinvestment and Recovery Act of 2009 (“ARRA”), which became law on February 19, 2009, restricts executive compensation for certain entities participating in the federal government’s Troubled Asset Relief Program (“TARP”). Generally, these restrictions limit the types and value of certain compensation paid to executives and other highly compensated individuals in these entities. The TARP entities are required to abide by these restrictions as a condition of receiving federal funds under the ARRA. Several of the specific limitations on executive compensation in the ARRA are as follows:

  • Prohibits the payment of any bonus, retention award or incentive compensation to certain highly compensated employees as long as any TARP related obligations are outstanding;
  • Prohibits any payment to senior executive officials or any of the next five most highly compensated employees upon termination of employment for any reason, as long as any TARP related obligations remain outstanding; and
  • Prohibits TARP participants from deducting annual compensation paid to senior executives when such compensation exceeds $500,000.

Certain not-for-profit organizations, including not-for-profit hospitals, abide by rules related to the restriction of compensation to certain executives as a condition of maintaining their federal tax-exempt status under Section 501(c)(3) of the Internal Revenue Code. Specifically, not-for-profit organizations which have been granted tax-exempt status are not allowed to pay unreasonable compensation to certain “disqualified persons.” Payment of unreasonable compensation to a “disqualified person” will be considered an excess benefit to that individual subjecting that person and other individuals who approve such plan to penalties under the Internal Revenue Code. In addition, the not-for-profit organization may have its tax-exempt status revoked for providing an excessive benefit. A “disqualified person” is any person who at the time during the five year period ending on the date of the compensation transaction is in a position to exercise substantial influence over the organization. Such individuals include, but are not limited to, board members, officers, directors, and other individuals with ultimate decision making authority.

A not-for-profit organization may follow certain procedures set forth in the regulations promulgated pursuant to Section 4958 of the Internal Revenue Code to create a rebuttable presumption of reasonableness of the compensation. The organization is not required to follow these procedures, but, in doing so, it can create a type of safe harbor to establish a presumption that compensation payments to disqualified persons are not excessive. The procedures are as follows:

  • The body responsible for setting the compensation level must obtain compensation comparability data for the position of the individual receiving the compensation;
  • Comparability data used may be based on surveys, documented compensation of persons holding similar position and in similar organizations, expert studies or other comparable data;
  • Individuals who will approve the amount of the compensation must not have any personal interest in the compensation; and
  • Once the board or other decision making body has approved the compensation, it must document the basis for its determination of the compensation within sixty days of the decision or the date of the next meeting of the decision making body, whichever is later.

The organization will benefit from following these procedures as it creates a rebuttable presumption that the compensation provided to the disqualified person is reasonable.

The executive compensation limits in the ARRA differ markedly from those limitations on executive compensation for not-for-profit organizations, such as not-for-profit hospitals. Specifically, they differ in that the restrictions under the ARRA prohibit certain types of payments to executives, such as bonuses or payments upon termination, and limit the amount a company may deduct as a payment of compensation to an executive to $500,000, which will likely encourage the company to place a limit on the amount of compensation to the executive. In contrast, the limitations on executive compensation for not-for-profit organizations are not substantive limitations, but rather procedures designed to ensure that comparable not-for-profit organizations compensate their executives in a comparable manner. Regardless of their form and effect, however, both limitations exist as a condition of the entity receiving some benefit from the federal government.

There are perceived benefits and drawbacks to both approaches to limiting executive compensation. One such benefit of the restrictions under the ARRA is that they generally treat each company in the same manner, without taking into account the company’s size. This creates an assumed level of reasonableness of compensation for executives of all companies which the government has approved and can monitor. The government does not have such ability under the “rebuttable presumption” framework. Conversely, many could perceive this limit to be a drawback arguing that complex health care systems require the expertise and oversight of the most talented minds in the country. That argument, however, could be countered by the perspective that the U.S. President has a $400,000 salary and his responsibilities are incredibly important as well as vast and challenging.

Additionally, with fixed compensation limits, the ARRA restrictions limit any method or temptation to over-compensate an individual, especially as the companies are required to allow stock-holders to participate in a non-binding vote on the compensation paid to certain executives. Under the “rebuttable presumption” procedures, not-for-profit hospitals may find salary data based on hospitals of similar size or location to support payments to an individual who may not perform a similar level of services for the hospital to justify such a salary. Therefore, non-profit hospitals have flexibility in determining executive compensation. Given the restrictions on payments following termination and bonuses for certain companies under the ARRA, the companies cannot spread out payments to individuals or allow certain types of incentive-based pay, such as bonuses. The “rebuttable presumption” procedures allow for such compensation, and still contain loose restrictions on total compensation levels based upon comparable organization’s payment practices.

Regulators should consider these drawbacks and advantages when deciding whether to apply one model or the other in different scenarios. Indeed, companies themselves may prefer one approach versus the other and may consider lobbying for the implementation of a certain set of standards.

For more information on this and related regulatory and business matters, please visit the McGuireWoods Stimulus Package section, or contact the authors from our Compensation for Tax Exempt Organizations group.