Physician Compensation Series: Reasonable Compensation

Compensation paid to physicians can be the result of various payroll methodologies, and with that, it’s necessary to understand the concept of reasonable compensation.

What is Reasonable Compensation?

Reasonable compensation is defined differently based on its context. Simplistically, in terms of deductibility, it is the amount of compensation paid so that it would be deductible under section 162 of the Internal Revenue Code. In relation to business valuation, reasonable compensation is a hypothetical amount intended to represent the amount a non-owner of a company would be paid for the same services. For non-profits, the IRS defines reasonable compensation as the amount that would ordinarily be paid for like services by like enterprises under like circumstances. Stark and AKS focus on assuring that payments do not include “excess benefits.” Although the aforementioned definitions vary, the overarching theme is the correlation of payment to services rendered.

First, the amount paid to physician owners takes on additional significance depending on the structure of the entity from which compensation is being paid. There are different tax motivations for an S-corporation versus a C-corporation for example. Second, the determination of reasonable compensation is a critical step in calculating the value of a practice in relation to a potential sale. Third, when Medicaid and Medicare funds are received for services the practice must be in compliance with the Stark Law and Anti-Kickback Statutes. Non-profit entities must comply with Internal Revenue Service guidelines.

The Correlation of Reasonable Compensation and Entity Structure

• C-Corporations – Profits of a C-corporation are taxable to the entity. Therefore, it is common for the profits to be paid as salary to avoid having the income taxed at the corporate level and then be taxed at the personal level if paid as a dividend. In this context, the compensation paid might be greater than “reasonable compensation.” Physician practices should be aware if their compensation is based on a performance metric during the year, but bonused at year-end based on ownership interest to minimize any corporate profitability, the bonus could be challenged by a taxing authority.
• S-Corporations – The Internal Revenue Service’s concern with S-corporations, is not that salary is too high (as in the case of C-corporations) but rather that salary is too low. Because S-corporations are not taxed at the entity level, there is an incentive to let the income pass through to the owner in an effort to avoid employment tax. Therefore, the IRS would rather see compensation paid to the owner in order to collect the Social Security and Medicare taxes. An owner physician could find themselves facing difficult questions if a non-owner physician was paid W-2 wages greater than the owner physician, especially in relation to the underlying practice metrics.
• LLC’s – Unlike the C and S corporations listed above, LLCs are taxed as partnerships and the income is subject to self-employment tax. As a result, from a federal tax savings perspective, reasonable compensation is not an issue.

Reasonable Compensation as a Business Valuation Consideration

Typically, when a business valuation is performed, a reasonable compensation adjustment is made. This adjustment is often made because of the tax advantages being sought (as discussed above) and because profits are often taken in the form of compensation. Reasonable compensation is often referred to a replacement compensation and is intended to capture the salary that would be paid to a non-owner for the same services performed by the owner physician. This is relevant in the determination of income available to be capitalized for purposes of determining value. For example, if a physician desires to sell his or her practice, and breaks even using actual compensation of $500,000, there is no profit to capitalize. If on the other hand, reasonable compensation is determined to be $350,000, the pre-tax adjusted profit is $150,000, which would be capitalized in the determination of value.

Reasonable Compensation in Relation to Stark and Anti-Kickback Statutes

Physician/members of independent groups typically had only to worry about compensation structures to the extent that they could be challenged by the IRS as discussed above. In more recent years, as physicians sold their practices and became employed by hospitals or some other form of health system, the concept of reasonable compensation had newfound significance. Specifically, whether the compensation paid met the requirements of the Internal Revenue Service, Stark and Anti-Kickback Statutes.

The Stark Law prohibits a physician from making referrals of designated health services covered by Medicare to an entity in which a financial relationship exists, unless a specific exception applies. Violations could lead to civil penalties. The Anti-Kickback Statutes forbid the payment or even the solicitation of payment (or remuneration) to induce referrals of services covered by Medicare and Medicaid, unless safe harbor requirements are met. Lastly, non-profit entities such as hospitals, can only pay reasonable compensation for services rendered based on his or her own productivity. Hospitals especially, must guard against paying for referrals. It is for this reason that employment arrangements exist between hospitals and physicians.

The aim of Stark, AKS and the IRS is for compensation to be paid based on personal productivity and not for ancillary services or payment of referrals. In relation to tax-exempt entities, the IRS deems physician compensation to be reasonable if:

• The compensation arrangement is approved by the tax-exempt entity in advance.
• The entity relied upon comparable data in the development of the arrangement.
• The basis for the arrangement is documented concurrently with the establishment of the compensation arrangement.

Reasonable, or fair market value compensation is often developed using third party surveys. Those surveys are usually relatively specific to production, specialty, geographic location, years in practice and other measures. As a result, physicians are often compensated in relation to certain metrics such as wRVU’s thereby directly correlating compensation to services rendered.

Summary

Reasonable compensation is an oft used term, whose significance varies based upon the context in which it is used. The US Treasury uses reasonable compensation to either limit the deductibility of owner compensation or challenge the lack of a deduction. The business valuation community uses it to determine the profitability and cash flow of a practice, in the determination of value. Finally, it is used in the healthcare environment to capture the compensation related to productivity in an effort to minimize payments for forbidden items, such as referrals.