Reasonable Compensation Reviews Are Very Important
By Michael Siebenhaar, JD,
Gone are the days of nonprofit organizations operating under the radar. Whether it's from the board of directors, donors, various legislative bodies or the IRS, nonprofits today are facing greater operational scrutiny. One of the areas most commonly under the microscope at nonprofits is executive compensation.
Not surprisingly, the call for increased transparency and accountability of nonprofits is mirroring the trend in for-profit companies. And as with public companies, the government has been leading the charge. The Senate Finance Committee is calling for increased oversight of nonprofits and the Internal Revenue Service (IRS) has stepped up its auditing of compensation of top executives. In fact, the IRS announced that it would audit 2,000 nonprofits during 2005, including foundations, healthcare organizations, and others. This audit is based in part on Internal Revenue Code (IRC) of 1986, as amended, IRC Section 4958, which imposes fines for unreasonable compensation paid to a "disqualified person."
In part to limit their own personal liability, nonprofit management and board of directors are requesting studies to benchmark compensation and document the processes in place to determine pay. As a result, nonprofits are undertaking significantly more reasonable compensation studies than they have in previous years.
To help nonprofits navigate this new terrain, here's an outline of what non-profit executives and board members need to know about the IRS and Section 4958, and reasonable compensation reviews.
Complying with IRC 4958
IRC Section 4958 outlines a process that a board of directors for a nonprofit described in section 501(c)(3) or section 501(c)(4) can follow to reduce its exposure to penalties relating to unreasonable compensation. By following these three steps, a nonprofit can position itself to create a rebuttable presumption that the compensation is reasonable:
The independence requirement is met for a board or committee member if that person (a) is not the disqualified person whose compensation is being decided (or related to that person); (b) is not in an employment relationship subject to the direction or control of such disqualified person; (c) is not receiving compensation or other payments subject to approval by such disqualified person; (d) has no material financial interest affected by the compensation arrangement; and (e) does not approve a compensation arrangement for such disqualified person who, in turn, approved or will approve a transaction with that person.
Second, to satisfy the requirement relating to appropriate comparability data, the governing body or committee must obtain and rely on relevant data such as: compensation levels paid by similar organizations (taxable and tax-exempt) for functionally comparable positions; the availability of similar services in the geographic area of the organization; current compensation surveys compiled by independent firms; or actual written offers from similar organizations for the services of the disqualified person. Smaller charities (with annual gross receipts of less than $1 million) are required to obtain less data.
Finally, to satisfy the documentation requirement, the governing body or committee must maintain written or electronic records describing: the terms of the compensation arrangement; the date approved; the names of the persons on the governing body who were present during the discussion and who voted on it; the data relied upon in making the decision; and the actions taken by anyone with a conflict of interest with respect to the arrangement.
These records must be prepared before the later of the next meeting of the body or 60 days after the decision. The governing body or committee must then review these records within a reasonable time thereafter.
If these three criteria are met, the compensation will be presumed reasonable for purposes of IRC Section 4958, unless the IRS can rebut this presumption by showing that the compensation is unreasonable.
If compensation to a "disqualified person" (defined as any member of an organization exercising "substantial influence") is determined to be unreasonable, and therefore an "excess benefit transaction" under Section 4958, then the disqualified person will have to return the excess compensation to the organization and pay an excise tax equal to 25 percent of the excess benefit. An additional excise tax equal to 200 percent of the excess benefit is imposed if the transaction is not corrected within the required period. Correction generally is accomplished by repaying the excess amount plus a payment for the loss of use of the money (reasonable interest rate).
Boards of directors also have more at stake than their personal reputation. A 10 percent excise tax is imposed on any "organization manager" who participates in an excess benefit transaction knowingly, willfully and without reasonable cause. An organization manager is defined as any officer, director, or trustee of the organization, including any person who regularly exercises authority to make administrative or policy decisions on behalf of the organization.
The excise taxes on disqualified persons and organization managers can be avoided if the excess benefit is corrected in a timely fashion and if it is established to the satisfaction of the IRS that the excess benefit was due to reasonable cause and not to willful neglect.
Michael Siebenhaar, JD, CPA, MBA (email@example.com) is a senior executive compensation advisor in KPMG LLP's Compensation and Benefits Practice. The views and opinions expressed in the column are those of the author and do not necessarily represent the views and opinions of KPMG LLP in the United States. The information contained in this article is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.