If you’re a highly compensated executive at a nonprofit and in a position to influence how much you earn, you may be at risk.
Nonprofit executives who are paid what might be considered excess benefits in their compensation packages could be subject to a substantial penalty tax. What could these penalty taxes mean for your organization and what do they mean for you? How can you avoid them? The penalty taxes, called Intermediate Sanctions, were enacted into law in 1996 to address situations in which influential “insiders” were unjustly enriched from charities. Previously, the only action the IRS could take for this excessive compensation was to threaten revocation of exemption, which only hurt the organization and its community—not the wrongdoer. But now, Intermediate Sanctions provide the Internal Revenue Code (IRC) an additional, powerful tool to deal with this.
For so-called “excess benefit transactions,” or compensation earned by key persons that is in excess of fair market value, the Internal Revenue Code imposes a 25 percent tax. If the arrangement is not corrected—which usually means paying back the excess with interest—a 200 percent tax can apply. But here’s the kicker: the tax is levied on the executive who is considered able to substantially influence the organization—not on his/her organization. Additionally, board members who approve of such compensation while knowing that it is excessive can also be at risk for a penalty tax.
The taxes are imposed on a Disqualified Person (DP)—someone who can substantially influence an organization—when he/she enters into an excess benefit transaction with either a 501(c)(3), 501(c)(4) organization or an entity that the organization controls. By definition, officers and board members are DPs and, depending on the organization’s leadership structure, other positions can also be categorized as such. Just because a person is highly compensated does not necessarily make the individual a DP, however. For instance, if the person does not participate in any management decisions affecting the organization as a whole, and if he/she does not control a discrete segment of the organization that represents a substantial portion of the activities, assets, income or expenses of the organization, the person may not qualify as a DP.
An excess benefit transaction could be unreasonable compensation or a transaction between a DP and an organization, such as a loan, lease or sale. And, if an executive receives an economic benefit that is not documented as compensation, then it could be classified as an automatic excess benefit. For example, if an executive takes her entire family of five on a 10-day trip to Hawaii so that she can attend a two-day educational conference and none of the personal expenses are reported as compensation, those expenses may constitute an automatic excess benefit, even though her overall compensation may be considered reasonable.
Given these substantial risks, what can nonprofits and their leaders do to guarantee that they are in compliance? When the IRS examines nonprofits, the organization under scrutiny has to prove that compensation is reasonable. The only exception is if the organization has previously established the “Rebuttable Presumption of Reasonableness,” which shifts the burden to the IRS to prove that compensation is unreasonable. There are three simple steps to establish the Rebuttable Presumption: (1) have an authorized independent board or committee make compensation decisions; (2) have the authorized body use comparable data; and (3) have the decision and its process contemporaneously documented.
Actually establishing the Rebuttable Presumption can be tricky. In the recently released IRS College and University Compliance Project Report, the IRS indicated that approximately 20 percent of the institutions examined failed to establish it. Oftentimes, comparability data fell short because the surveyed schools were not similarly situated. For example, the report indicated that the institutions were not similar to the comparables on factors such as location, endowment size, revenues, total net assets or number of students. Also, compensation studies did not document the selection criteria for the schools compared, or they failed to specify whether the compensation amounts included benefits other than salaries, which must be taken into account for purposes of IRC 4958. The total compensation package must be compared and includes salary, deferred compensation, car and housing allowances, etc.
Moving forward, states such as New York appear to be adopting rules regarding how nonprofit organizations should set compensation levels for executives. (See the article on page 13 for more on this issue.) Hopefully, this will be an incentive for more organizations to use a process that will minimize their risk of sanctions.
Nonprofits can even use for-profit comparables as long as they can show how they are relevant. If the comparables include the Forms 990 of other organizations, make sure that the relevancy of the institution and the comparability of the executive’s duties are being documented and that the Forms 990 are in the files. The IRS is looking for a process. What metrics does your organization use to establish compensation packages?
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*This article originally appeared in BDO USA, LLP’s “Nonprofit Standard Newsletter – Fall 2013“. Written by Laura Kalick, JD, LLM, BDO CPA. Copyright © 2013 BDO USA, LLP. All rights reserved. http://www.bdo.com