Not-for-profits must closely monitor the line between reasonable and excessive compensation. With the increasing IRS scrutiny on compensation levels, not-for-profits must be vigilant to ensure their pay and other transactions to key personnel remain reasonable.
All transactions between tax-exempt organizations and “disqualified persons” must reflect fair market values. If fair value is not used, the transaction may be considered an excess benefit transaction; with regard to compensation matters, this means pay to disqualified persons may be considered unreasonable or excessive. Disqualified persons include named officers and any voting member of the organization. Additionally, any person or family member of a person who within five years of a potential excess benefit transaction had substantial influence over the not-for-profit, and entities that are at least 35 percent controlled by previously mentioned person(s),are identified as disqualified persons.
In addition to risking the not-for-profit’s tax-exempt status, excess benefit transactions result in financial penalties for not-for-profits’ key personnel. The disqualified person has to pay a 25 percent penalty on the excess benefit, which can increase up to 200% if the excess benefit is not corrected. Organizational managers, such as officers, directors and trustees, pay a 10 percent penalty on the excess benefit, which is capped at $20,000.
To protect your not-for-profit’s leadership and board from excess benefit risk and penalties, consider the following best practices.
Stick to the Rebuttable Presumption Procedures
The burden of proof for excess benefit transactions shifts to the IRS when not-for-profits follow the rebuttable presumption procedures. The rebuttable presumption requires:
- Compensation to be approved in advance by an independent, authorized body without conflicts of interest;
- The authorized body bases compensation on appropriate data; and
- The authorized body concurrently and adequately documents the basis for making determination of compensation.
Reasonable compensation should reflect organizational characteristics, the economic environment and the nature of the disqualified person’s responsibilities, background and experience. Compensation considerations should also include compensation data from key personnel in similar organizations and documentation for how those organizations were selected. Organizational size (e.g., budget, employee headcount, etc.), industry and location are common criteria for identifying similar organizations.
Monitor Federal and State Regulatory Developments
Look no further than the IRS’s recent compliance reports to determine what regulators may be targeting in their examination of your Form 990. In its 2009 Hospital Compliance Project, the IRS mailed 2,000 notices asking for more information about how compensation was determined, which contributed to the IRS increasing 990 reporting requirements.
Results from the 2013 Colleges and University Compliance Project showed a lack of appropriate comparability data to be a critical flaw. The IRS noted several instances in which organizations failed to:
- Evaluate compensation among similarly situated peers;
- Document the methodology of selecting comparable peers; and
- Understand the various elements of compensation (e.g., base pay, bonuses, long-term incentives) and assess the reasonableness of each.
We expect that although the projects targeted hospitals, colleges and universities, the findings from the projects will affect the not-for-profit sector as a whole.
State governments are also taking note of not-for-profit executive pay. New York governor Andrew Cuomo issued an executive order on executive compensation for state-funded not-for-profits that not-for-profits should keep an eye on as well. The regulations went into effect on January 1, 2013 and affect not-for-profits that are more than 30 percent state-supported and receive more than $500,000 in state funds. These organizations cannot use more than $199,000 in state funds to pay for executive compensation. At least 75 percent of state funds must go toward program services, which increases to 85 percent in 2015. The regulations are being challenged in court, but they nevertheless show that executive compensation in the not-for-profit sector may be an issue more states tackle.
Protect Your Organization
We recommend you use professionals to assist with the rebuttable presumption for compensation to help safeguard your leadership board and trustees from excess benefit transaction risks. You should also be sure your board of directors approves in advance any contract for a suspected disqualified person and relies on appropriate data in making pay-related decisions. The conclusion of the board approval should also be documented. Lastly, be sure your Form 990 is accurate and complete to avoid compliance concerns.
For more information about how you can mitigate your risk of excess benefit transactions, please contact us.
Priya Kapila is a manager in CBIZ Human Capital Services in the St. Louis office of CBIZ MHM. She can be reached at 314.692.2249 or firstname.lastname@example.org.