Overview

The federal tax code empowers the IRS to review executive compensation arrangements in not-for-profit organizations, to require corrective actions and to penalize affected executives and board/committee members if compensation is deemed to be "excessive". This provision - section 4958 of the tax code - was enacted on July 30, 1996. This legislation is designed to "minimize" excessive compensation payments to executives of social welfare [501(c)(4)] and public charity [501(c)(3)] organizations.

Under the final regulations, effective as of January 23, 2002, compensation is assumed to be reasonable so long as the group approving the arrangement is without conflicts of interest, appropriate data is used in the analysis of pay, and all actions are appropriately documented. Assuming these guidelines are met, the burden of proving compensation is excessive falls on the IRS.

Excess Benefit

An excess benefit is a transaction in which the value of the economic benefit to the disqualified person exceeds the value of the services rendered, or is not "comparable" to similar benefits paid by similar tax-exempt organizations. Compensation is considered reasonable if the amount paid would ordinarily be paid for like services, by like enterprises, under like circumstances.

Economic benefits - even if they are reasonable - may be treated as "automatic" excess benefits unless the exempt organization has clearly indicated via written contemporaneous substantiation that the benefit is compensation for services when the benefit is paid. An example of an automatic excess benefit is the payment of personal expenses that are not reported. Reporting the economic benefit by the organization and the executive on appropriate federal tax forms signifies intent that the benefit is viewed as compensation and, therefore, will not be considered an automatic excess benefit.

A transaction that would be an excess benefit if engaged in directly by the exempt organization will still be an excess benefit if accomplished indirectly either through a controlled entity or an intermediary.

Definition of Compensation

Compensation for IRC 4958 purposes includes all economic benefits (i.e., salary; fees; bonuses; severance payments; deferred compensation upon vesting; medical, dental and life insurance; disability benefits; fringe benefits except those specifically excluded; "non-accountable" plan expense allowances and the economic benefit of a below market loan) provided by an organization in exchange for the performance of services, whether or not includible for income tax purposes. Code section 132 (e.g., cafeteria subsidy, parking, moving expense reimbursement) fringe benefits and expense reimbursement under an "accountable plan" are not included. Only the amount of total compensation deemed to be excessive is subject to penalties.

Disqualified Person

A disqualified person is any person who, during the five-year period ending on the date of the transaction in question, was in a position to exercise substantial authority over the affairs of an organization. The regulations stipulate that the role of the position is the determining factor but cite as examples of disqualified persons, the following: CEO, President, Chief Operating Officer, Treasurer or Chief Financial Officer.

Organization Manager

An organization manager includes anyone who is an officer, director or trustee of the organization, or anyone having similar responsibilities. An organization manager also includes anyone who is not an officer, director or trustee but who nonetheless serves on a committee of the board and who is responsible for determining the reasonableness of a transaction and this determination is relied upon by the organization.

Penalties

The penalties are severe for an excess benefit. In all cases, the excess benefit must be corrected. The correction amount equals the sum of the excess benefit, plus interest on the excess benefit at a rate that equals or exceeds the applicable Federal rate, compounded annually.

In addition to making the correction, a penalty equal to 25% of the excess benefit is levied on the individual who received the excess benefit. If the correction is not made within an agreed-to period, an additional tax equal to 200% of the excess benefit may be imposed on the individual. Organization managers are liable - jointly and severally - for an amount equal to 10% of the excess benefit, capped at $10,000 per transaction.

If the excess benefit is deemed an "automatic" excess benefit, the 25% and 200% tax is imposed on the entire benefit.

Safe Harbor

Compensation is presumed to be reasonable, under the safe harbor concept, if:

• An authorized body without conflicts of interest approves compensation before it is effective
• The Board/Committee uses appropriate data to establish comparability
• Documentation of the process/decisions is adequate. A record of the determinations must be prepared within 60 days of the final actions or before the next meeting, whichever is first, and include:
  • The terms of the transaction and the date approved
  • Members of the authorized body present at the time of approval and those who voted
  • Comparability data (both taxable and nontaxable organizations) and how the data was obtained
  • The reasons for paying more or less than the comparability data
  • Actions taken if a member of the authorized body has a conflict of interest

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