The New York State Department of Health released the first proposed regulations to implement the governor’s January 2012 Executive Order imposing a cap on the use of state funds for administrative expenses and executive compensation. We previously reviewed the Executive Order (see related link below). The regulations have a substantial effect on the way in which state contractors will conduct their business, and, in the case of nonprofit organizations, how their boards will govern them. The regulations are effective for the period beginning January 1, 2013, and comments are due by July 16, 2012.
The Department of Health’s proposed regulations provide an initial indication of how the Executive Order will be implemented, and how providers will be forced to adjust. At least eight other state agencies are responsible for promulgating regulations that will apply to their service providers. Those regulations could differ from one another, making compliance for organizations that receive funding from more than one state agency more difficult.
Executive compensation limits
The stated purpose of the Executive Order is to limit state support of executive compensation to $199,000 for all providers (whether for-profit or nonprofit). The regulatory scheme, however, is complicated and difficult to apply. It bears little relationship to the decade-old structure under federal tax law for tax-exempt organizations in assuring the reasonableness of compensation.
The proposed regulations apply to providers that receive state funds averaging more than $500,000 annually during the reporting period year and two prior years (for a three-year “reporting period”) and that received at least 30% of their total in-state revenues for the most recent “reporting period” from state funds. There is no indication of what is considered “in-state” revenue. So it is unclear, for example, whether the origin of revenues such as charitable contributions will need to be tracked. State authorized payments of federal funds are included when calculating these thresholds.
For the many organizations that are part of a larger health system, the thresholds are consolidated at the parent level. Control definitions will become important in applying the limitation. While tax-exempt organizations have become accustomed to additional reporting requirements for related organizations in the revised IRS Form 990, the proposed regulations will require more expansive reporting. For example, a related organization under the proposed regulations includes one where a provider appoints 25% or more of the related organization’s officers, directors, trustees, or employees. This is a much lower threshold than the simple majority required for most other reporting. Subcontractors and agents that are related organizations of providers are also subject to the regulations to the extent they receive state funds from the provider during the reporting period.
Another key difference between state and federal reporting is the calculation of compensation. The proposed regulations include as executive compensation all forms of cash and noncash payments or benefits, given directly or indirectly to an employee. The definition includes salary, bonuses, dividends, and certain employee benefits, as well as other financial arrangements (such as the provision of vehicles, entertainment, travel, housing, and use of the organization’s property, among others). The proposed regulations make no reference to the compensation reported on Form 990 or Form W-2, the impact of an accountable reimbursement plan, or non-taxable fringe benefits. The existing structure for identifying and measuring executive compensation will need to be modified to include the new state standard.
Individuals covered by the limitation include any director, trustee, managing partner, or officer whose salary or benefits are allocated, in part or whole, as administrative expenses. Also included are employees who received compensation of more than $199,000, whose salaries or benefits are allocated, in part or whole, as administrative expenses. “Administrative expenses” are those costs related to a provider’s overall management and overhead that are not related directly to the provision of program services. In other words, only an employee whose salary is 100% attributable as an expense of program services is free from the limitation. Once again, the proposed regulations do not bear any relationship to the definitions of officers or key employees set forth in comparable IRS regulations.
The proposed regulations include a robust waiver regime, inviting further administrative discretion into the application of the regulations. The Department will grant a waiver, allowing a provider to exceed the $199,000 limit, “only where a covered provider has demonstrated compelling circumstances supporting such a waiver, and has provided any documentation requested by the department. . . . ” The proposed regulations list five factors that the Department deems relevant to the waiver decision, one of which is a description of “the provider’s efforts, if any, to secure executives with the same levels of experience, expertise and skills for the positions of covered executives at lower levels of compensation.”
This necessarily invites the state into decisions by the governing board and senior management on the retention of existing employees; query whether there is an obligation to renegotiate contracts or terminate them when current employee compensation rises above the $199,000 limit. The proposed regulations also allow the Department or its designee and the Director of the Division of the Budget to consider additional factors that they may deem relevant when considering a request for a waiver.
Waivers will be valid for a specified duration and can be automatically revoked if the provider increases the subject compensation by more than 5%. Waivers might also be revoked at the discretion of the Department upon receipt of additional relevant facts and circumstances, the nature of which is not specified in the proposed regulations.
In their current form, the proposed regulations demonstrate the intent not only to impact state funding of executive compensation, but support from private sources as well. It would appear that unless an entity has secured a discretionary waiver, any provider supplementing executive compensation over $199,000 with private funds must demonstrate to the satisfaction of the Department that it has secured board or committee approval of the compensation based on appropriate comparability data (including the votes of at least two independent directors or committee members) and limited that compensation to below the 75th percentile of comparable compensation as determined by the Department and the Director of the Division of the Budget. It is entirely unclear how the state will assess—with at least the same degree of precision as do individual governing boards—the myriad factors that establish compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions, the availability of similar services in the geographic area, and so on.
The proposed regulations also limit the use of state funds to pay the administrative costs of a provider. As provided in the Executive Order, a provider must initially use no less than 75% of the state funds it receives for “program services expenses.” This percentage increases 5% per year until it reaches 85% in 2015.
“Program services expenses” are those incurred in direct connection with the provision of program services, and include: salaries and benefits of staff providing the services; costs associated with quality assurance and supervisory personnel; and expenses incurred in direct relation to the provision of services (e.g., travel, direct care supplies, legal expenses related to the provision of services, etc.). “Administrative expenses” are those incurred in connection with the provider’s overall management and necessary overhead that are not directly related to the provision of program services. Specifically included in administrative expenses are the salaries and benefits of staff performing administrative and coordination functions that cannot be attributed to particular program services; legal expenses that cannot be attributed directly to the provision of program services; and expenses for office operations that cannot be attributed directly to the provision of program services (e.g., office equipment and supplies, dues, licenses, subscriptions, insurance, audit services, etc.).
Capital expenses; real estate rental and maintenance; and equipment rental, depreciation, and interest expenses are specifically excluded when calculating both “program services expenses” as well as “administrative expenses.”
This regulatory regime relies on waivers as well. Again, the Department will only grant waiver requests that demonstrate a “compelling” reason to do so based on five specified factors, including “the provider’s efforts, if any, to find other sources of funding to support its administrative expenses and the nature and extent of such efforts and funding sources.” The standard apparently compels an organization to exhaust fundraising efforts and other revenue generation (including unrelated business income) before tapping taxpayer resources. The Department also has authority to consider any other factors it may deem relevant to its analysis.
Both compliance with and requests for waivers from the administrative cost restrictions may prove to be the most challenging aspects of the new regulations for covered providers. Providers likely will need to make more frequent and on-going decisions regarding administrative costs, as compared to executive compensation. They also will face difficult accounting and financial decisions as they categorize certain expenses as administrative or related to program services. Finally, all of these considerations and decisions must be regularly documented and monitored if the provider is to apply for a waiver or to protect itself against a claim of non-compliance.
Reporting, enforcement, and penalties
Providers will be required to file annual reports indicating the public funds they have received, how much they have paid their executives, and their administrative expenses during the reporting period. The form used to make this report will be available online and according to the proposed regulations will only need to be filed once by a provider even if it receives funding from multiple state agencies. Failure to report or a failure to correct a report may result in the termination of a state contract for state funds or authorized payments.
Non-compliance with the limitation requirements will result in a notice to the provider. The provider will then have an opportunity to submit information to document compliance or to correct any non-compliance. If a final determination of non-compliance is made, the provider must submit a “corrective action plan” to the Department. The provider will be given at least six months to implement corrective actions. The proposed regulations provide for an appeal process if a provider wishes to challenge the final determination.
Penalties for non-compliance include: ordering the provider to use state funds for program services; revoking a provider’s license to perform services; and terminating funding agreements with the state. The Department also has discretion to impose other penalties it deems appropriate.
Providers need to educate themselves and their governing boards on the impact of these proposed regulations. Given the novelty and impact of the regulations, providers’ comments to the relevant state agencies will be vital. The current cost structure and accounting systems of each provider need to be reviewed and the impact of the proposed regulations identified. Possible changes in structure should be considered, and, if appropriate, implemented.
Unfortunately, providers will need to continue to make substantial investments in administrative systems necessary to comply with the regulations. Many of these systems will be new and will not bear a strong relationship to those systems already adopted, for example, with respect to executive compensation.
There are several steps that a provider can take to ensure compliance. The most important is to take stock of the provider’s existing compensation arrangements and administrative expenses. Key factors in tracking and monitoring systems:
- Calculation of state funds and “in-state” revenues received by the provider per year;
- Identification of employees whose compensation is allocated in part to administrative expenses, including employees of related entities and subcontractors;
- Implementation of processes to monitor compensation of individuals noted above;
- Implementation of procedures to approve compensation levels above the $199,000 limit;
- Identification and proper classification of administrative expenses; and
- Implementation of monitoring systems to track administrative expenses as a percentage of covered operating expenses.
Nixon Peabody attorneys continue to monitor these important developments and are prepared to explain how these changes to New York law could directly impact your organization. Stay tuned for registration details regarding an upcoming informational webinar we will be hosting in the coming weeks.