Bloomberg Law
April 18, 2023, 8:45 AM

Lessons for Nonprofit Executive Pay in Pottstown Hospital Ruling

Mike Semes
Mike Semes
Alexander Reid
Alexander Reid
Matthew Elkin
Matthew Elkin

In Pottstown Sch. Dist. v. Montgomery Cty. Bd. of Assessment, the Pennsylvania Commonwealth Court denied a nonprofit hospital’s property tax exemption. Following this February ruling, every Pennsylvania nonprofit should examine its executive compensation structure and intercompany service agreements to determine whether it continues to qualify as an institution of purely public charity.

In reversing the trial court’s decision, the appellate panel reasoned that the “eye-popping” executive compensation paid by the hospital’s parent company, as well as the fees for services paid to it, caused the hospital to fail the state’s constitutional exemption requirement that an entity “operate entirely free from private profit motive.”

Specifically, the panel found that more than $1 million in base salary plus a bonus, “40% of [which was tied] to [Pottstown] Hospital’s financial performance[,] is sufficiently substantial to indicate a private profit motive.”

The case involves Reading Health System, now known as Tower Health LLC, which purchased Pottstown Hospital LLC from Community Health Systems in 2017. At that time, both CHS and Pottstown Hospital operated as for-profit entities, but Tower Health qualified for federal income tax exemption under Section 501(c)(3). Following the purchase, the Pottstown Hospital operated under Tower Health’s federal income tax exemption.

The commonwealth court noted that “the trial court was troubled by the compensation of Tower Health’s executives but nonetheless granted the property tax exemption, believing itself constrained” by the commonweal;th court’s precedent, though it viewed its precedent to require “consideration of whether the amount of executive compensation is reasonable, and the extent, if any.”

Applying that analysis, the appeals court did “not accept the suggestion that the executive salaries at issue must be deemed reasonable merely because they do not exceed the 90th percentile for such salaries [and] agree with the trial court’s characterization of the Tower Health executive salaries at issue as ‘eye-popping.’” The court added that “tying 40% of the bonus incentives to Hospital’s financial performance is sufficiently substantial to indicate a private profit motive.”

The panel reached its conclusion in part because it was troubled by the intercompany service fees Tower Health charged Pottstown Hospital. Specifically, it found:

  • The trial court failed to consider “any evidence regarding the reasonableness of the charges imposed by Tower Health for the management and administrative services it provided to Hospital.”
  • The fees Tower Health charged Pottstown Hospital “grew exponentially from year to year.”
  • The hospital “never studied the charges to determine whether the administrative and management fees charged by Tower Health were fair or reasonable for the services provided.”

As a result, the panel concluded that Pottstown Hospital didn’t meet its burden of proving that it operated entirely free from a profit motive and therefore didn’t qualify as an institution of purely public charity.

Pennsylvania imposes a constitutional requirement—different from and independent of the federal exemption standard—for property tax exemption. To meet the Pennsylvania constitutional requirement of being an “institution of purely public charity” and thus entitled to property tax exemption, an entity must show that it:

  • Advances a charitable purpose;
  • Donates or renders gratuitously a substantial portion of its services;
  • Benefits a substantial and indefinite class of persons who are legitimate subjects of charity;
  • Relieves the government of some of its burden; and
  • Operates entirely free from private profit motive.

The only issue in this case was whether Pottstown Hospital operated entirely free from private profit motive. This area of Pennsylvania tax law is fraught with uncertainty underscored by the fact that the Court of Common Pleas of Montgomery County granted Pottstown Hospital’s property tax exemption in this case.

On the other hand, the Court of Common Pleas of Chester County denied the exemption under substantially similar facts in companion cases involving several other hospitals Tower Health purchased from CHS in the same 2017 transaction. The Chester County cases, however, were dismissed on procedural grounds on appeal.

This decision may be vulnerable on appeal because the Commonwealth Court didn’t explain its rationale for basing its decision on the excessive compensation of Tower Health executives while tacitly accepting the reasonableness of Pottstown Hospital’s executive compensation. Nor did the panel adequately explain how the escalating fees Pottstown Hospital paid to Tower Health caused Hospital to operate for a “private profit motive.”

Tower Health and its parent are also nonprofit entities that are required to pay only reasonable compensation and to reinvest and not distribute their profits. The profit of Pottstown Hospital (the entity whose status was at issue) is inversely proportional to the fees it paid to Tower Health.

This case’s significance makes it likely that it will be appealed, and that the Supreme Court of Pennsylvania will agree to hear it. Assuming that happens, the court likely won’t render its decision for another 18 to 24 months, and the uncertainty will continue.

The case is: Pottstown Sch. Dist. v. Montgomery Cty. Bd. of Assessment, Pa. Commw. Ct., No. 289 A.3d 1142, 2/10/23

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Mike Semes is of counsel at BakerHostetler and is a professor of practice at Villanova University Charles Widger School of Law in the graduate tax program.

Alexander Reid is the national team leader of BakerHostetler’s tax-exempt organizations and charitable giving team. His clients include tax-exempt including colleges and universities, health and hospital systems, private foundations, arts and cultural institutions, and trade associations.

Matthew Elkin is a partner with BakerHostetler. He advises tax-exempt organizations and other businesses and high-net-worth families with charitable and social goals, focusing on matters including charitable investment funds, social enterprises, impact investing, and endowment investment programs and policies.

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