August 04, 2008
The Internal Revenue Service now keeps a close eye on charities and social welfare organizations to ensure that their tax-exempt status is not abused. One of the primary factors the IRS examines is the amounts of compensation and benefits provided by these tax-exempt organizations to their key employees.
The IRS believes that some officers and other employees may be taking advantage of their influential positions by setting their own compensation at above-market levels. The IRS has begun a wide-spread initiative to find those overpaid individuals.
The IRS is primarily using Internal Revenue Code section 4958, which allows them to impose excise taxes on the excessive portion of compensation paid to a charity’s employee. These excise taxes are referred to as intermediate sanctions since they are less severe than having the IRS revoke the charity’s tax-exempt status.
These excise taxes are aimed at unreasonable compensation paid to a disqualified person. A disqualified person is anyone who was in a position to exercise substantial influence over the affairs of the tax-exempt organization at any time during the five-year period prior to the transaction, and the family members of any such person. Note that it is not necessary that the person actually exercised substantial influence, only that he or she was in a position to do so.
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Over-paid independent contractors may be subject to the excise tax also. This could include CPAs and attorneys if they meet the definition of disqualified person.
The Code refers to the unreasonable portion of compensation as an excess benefit transaction because the individual is getting a benefit (compensation) in excess of the value of the services he or she provides for that compensation.
Expect the IRS to look particularly closely at compensation amounts paid to: officers who also sit on the charity’s Board of Trustees, relatives of major donors, long-term employees who have cut back their hours, employees who receive performance bonuses and anyone who has a hand in setting his or her own compensation level. Certain industries are of special interest to the IRS. For example, hospitals may be examined because market conditions have pushed their officers’ compensation to higher levels in recent years.
Under Code section 4958(a)(1), the IRS can impose a 25 percent excise tax on the unreasonable portion of an individual’s compensation. (This excise tax is in addition to federal and state income taxes, and FICA tax the employee has to pay on that compensation.) If the unreasonable portion is not repaid promptly after the 25 percent tax is imposed, section 4958(b) provides for an excise tax equal to 200 percent of the unreasonable portion.
In addition, Code section 4958(a)(2) allows the IRS to impose an excise tax on an organization manager (officer, director or trustee) who participated in permitting the unreasonable compensation, unless such participation was not willful and was due to reasonable cause. This tax is 10 percent of the unreasonable portion of the compensation. It was limited to $10,000 per excess benefit transaction until the Pension Protection Act of 2006 raised that limit to $20,000. Those organization managers who knowingly allow the excessive compensation are jointly and severally liable for this excise tax. Of course, the last thing any volunteer board member wants is to be personally exposed to a tax.
Note that both the 25 percent and the 10 percent excise taxes are imposed upon the individuals, not the charity.
To let everyone know that they are serious about this, the IRS announced that it was proposing over $21 million in section 4958 excise taxes on forty disqualified persons and organization managers at twenty-five charities.
In addition to the monetary impact, publicity resulting from these penalties can be disastrous for a charity.
For all these reasons, charities need to be very careful about how much they pay and how the amounts are determined. But, setting levels of compensation for key employees is difficult for charitable Boards of Trustees since most board members are not familiar with the complexities of compensation analysis. And, determining appropriate cash compensation levels for key employees at a charity may be more challenging than doing so at for-profit companies since charities do not offer stock options, profit-sharing plans and some of the other incentives rewarded to executives at for-profit entities.
Yet pay levels and benefits at charitable organizations must keep up with the market to prevent turnover, since turnover among key employees is costly, disruptive and damaging to donor relations.
Many charitable boards need guidance on pay levels due to the subjective nature of determining reasonable compensation, complex facts and the desire to avoid IRS scrutiny. An opinion letter from an independent party can give board members comfort that pay levels are in line with the market, reduce turnover and help avoid the excise taxes by creating a rebuttable presumption that the compensation is reasonable.
If the compensation is presumed to be reasonable under the excess benefit rules, section 4958 excise taxes can then be imposed only if the IRS develops sufficient contrary evidence to rebut the charity’s evidence. In other words, the burden shifts to the IRS to prove that the compensation was unreasonable.
The charity’s board must meet three requirements to create a rebuttable presumption that compensation is reasonable:
- The compensation must be approved in advance by an independent board or board committee without the disqualified person participating,
- Appropriate comparability data that documents the arms’ length nature of the transaction, such as compensation surveys, must be relied upon and
- The basis for approval must be documented in writing, such as through board minutes.
A qualified compensation consultant can help the board meet these requirements by providing comparability data and documenting it in an opinion letter. In preparing opinion letters, the compensation professional should take into consideration all relevant facts and circumstances including, but not limited to:
- Compensation levels paid by similar organizations, both taxable and tax-exempt, for comparable positions;
- The availability of similar employees in the geographic area;
- Current compensation surveys compiled by independent firms and
- Any written offers from similar employers competing for the services of the disqualified person.
Other relevant factors usually include the size of the organization, the geographic area it serves and the qualifications and duties of the employee.
The opinion letters serve another important purpose. Reg. 53.4958(d)(4)(iii) provides protection for the organization managers against the 10 percent excise tax even if the compensation is determined to be unreasonable. To get this protection, the managers must obtain an opinion letter stating that the compensation consultant believes that if the compensation amount is challenged by the IRS, it would more likely than not be upheld in court. Other requirements must be met as well. Although this does not guarantee that the compensation will not be found to be unreasonable, obtaining and using such an opinion letter can protect the officers and board members from personal exposure to the 10 percent excise tax.
U.S. Treasury Department Circular 230 requires that certain disclosures are included in the opinion letter. Under section 10.35(e)(3), the disclosure usually includes a statement saying that the letter contains a limited scope opinion as defined by Circular 230 (Title 31 Code of Federal Regulations, Subtitle A, Part 10, revised as of September 26, 2007). The letter also includes a statement that the opinions expressed in the letter are limited to the one or more federal tax issues addressed in the letter, and that additional issues may exist that could affect the federal tax treatment of the transaction or matter that is the subject of the opinions and the opinions do not consider or provide a conclusion with respect to any additional issues; and, with respect to any significant federal tax issues outside the limited scope of the opinion, the opinion was not written and cannot be used for the purpose of avoiding penalties.
The opinion letter should also include a statement of independence from the compensation professional.
This article provides an overview of the complex rules governing compensation paid by charities. With emphasis on corporate governance now at an all-time high, advisors and board members should become familiar with these rules and carefully monitor the compensation and benefits of employees and contractors. The steps taken by a charity to avoid the excess benefit transaction excise taxes can also be useful in an audit by a state regulatory agency, and in responding to inquiries from potential donors.
Stephen D. Kirkland, CPA, CMC, CFC is a compensation consultant with Atlantic Executive Consulting Group, LLC, based in Columbia, South Carolina. He helps businesses and tax-exempt organizations structure compensation plans for their executives. He also serves as an expert witness in U.S. Tax Court cases involving the reasonableness of executive compensation across the United States. He can be reached through www.ReasonableComp.biz.