Below is a follow-up by Jeffrey S. Tenenbaum, Esq., Chair of the Nonprofit Organizations Practice Group at Venable, LLP, to a handful of questions submitted by participants during the June 19, 2012, webinar “The Next Generation of Nonprofit Executive Compensation: The Keys to Withstanding IRS Scrutiny.” To view the presentation or listen to the recording of the webinar brought to you by GuideStar Membership, please click here.
Q: What titles are considered executives?
A: Any senior executive at a nonprofit who receives high compensation – “high” is all relative, of course – can get caught up in this. It is not limited to CEOs, although they tend to have the highest compensation in an organization.
Jeffrey S. Tenenbaum, Esq.
These rules [regarding private inurement and intermediate sanctions] relate to anyone who is a “disqualified person”; anyone who is in a position to exercise “substantial influence over the organization” can be considered a disqualified person for these purposes. Also, when considering whether an individual may be subject to intermediate sanctions, the IRS will look to the individual’s responsibilities, not just the individual’s title, to determine whether the individual has substantial influence over the organization’s activities. For instance, an organization’s chief executive cannot avoid intermediate sanctions through the elimination of the chief executive title.
Q: I heard from an executive that his bonus is based on his bottom line, starting when they have the first dollar of surplus. This seems like something the IRS would not like – private inurement maybe?
A: You are exactly right that that can constitute private inurement, and can jeopardize the tax-exempt status of the organization (and potentially result in penalty taxes – intermediate sanctions – on the executive if the entity is a (c)(3) or (c)(4) organization).
There are ways to structure incentive compensation programs to avoid these risks. Probably the most important part of that structure is to put a global cap on how much compensation the executive can earn, to ensure that total compensation paid is reasonable and at or below fair market value. There are other important steps to take as well.
Q: When an executive’s salary is determined to be excessive, what factors are considered in determining monetary penalties for board members? How does the IRS development factual basis for challenging compensation as excessive?
A: There is a 10% (collective) penalty under the Section 4958 intermediate sanctions rules that can be levied on organization managers (including board members and other disqualified persons) who knowingly approve compensation that is deemed to be excessive.
There are three important aspects to the imposition of this penalty on a board member: (1) the compensation must be excessive; (2) the board member had to approve the transaction; and (3) the board member had to know that the compensation was excessive.
To prove that an amount of compensation is excessive, the IRS has “valuation” experts who come in and do their own compensation analysis to determine what THEY believe is reasonable. See the “rebuttable presumption of reasonableness” section of our presentation for how to shift the burden of proof back to the IRS.
To prove that a board member approved the transaction, the IRS will review the facts relating to the approval of the compensation to determine whether the board member voted to approve the compensation. However, if a board member voted against approving the compensation or abstained from the vote, it is unlikely that the board member will be subject to any penalties under this provision.
Finally, to demonstrate that the board member knowingly approved the excessive compensation, the IRS will develop evidence that demonstrates that the board member either knew or should have known that the approved amount of compensation was excessive. With respect to this final factor, an opinion of a compensation expert indicating that the amount of compensation is reasonable will be a significant factor in demonstrating that the board did not “knowingly” approve the conference of an excessive benefit.
Q: How frequently should an outside consultant be hired to conduct a comparability study if there are fairly modest annual increases?
A: It really all depends on how much the total compensation pushes the reasonableness envelope. If far below any risky level, then probably every 3-5 years would be fine. If you are pushing the envelope, then I would say every 1-2 years at a minimum. We have a number of clients who, when pushing that envelope, commission annual reports.
Q: How do we handle compensation for individuals who are not on the 501(c)(3)’s actual payroll, but provide services to the organization through third party; do you recommend our Board review their individual compensation as well? Or just the aggregate fees paid to the third party?
A: This is a very tough question. There is a lot of debate and discussion over that now, particularly as it relates to management companies hired to provide the “staffing” for nonprofits. Also, this will largely depend on the particular facts of each situation. Right now, just make every effort to ensure that the amount you pay to the third party is reasonable and appropriate.
Q: If a new organization is being formed and has no big money yet, can the Executive Director run a bill of compensation for his services and collect later, when money is available?
A: Yes, but you have to do it very carefully and the overall compensation for the time worked cannot be excessive and must be justified.
Q: Where can we find information on what types of benefits are taxable?
A: This is a very complex question and answer, and one beyond the scope of what I can answer here. But, go to www.irs.gov. I suspect the IRS has a good, basic publication on which benefits are taxable (generally) and which are not. Also feel free to contact me off-line.
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