Authors: David W. Sands, CVA, Will Kaufmann, JD, MBA, and Fred M. Lara, CFA, ASA, CVA
Organizations that qualify as public charities under Internal Revenue Code 501(c)(3) are eligible to become exempt from federal corporate income taxes and, subsequently, similar state and local taxes. As it pertains to a tax-exempt organization’s compensation practices, one of the government’s concerns is that the reduced business expense associated with tax-exempt status will translate to increased compensation of the organization’s employees (i.e., inurement to the benefit of private individuals) at the expense of the government and taxpayers, as opposed to utilizing this benefit to further the objectives of the charity. For this reason, the IRS promulgated rules generally applicable to executive compensation plans of tax-exempt organizations.
The IRS rules govern the practice of establishing reasonable compensation and also define excessive compensation and associated penalties. The reasonable compensation requirement applies to all key employees (as further described below) of tax-exempt organizations. The Tax Court first considered the reasonable compensation issue in 1917.[1] As established by the IRS, the reasonable compensation standard applies to the aggregate of all compensation received by a key employee (i.e., a person without whom a company would cease to operate, and distinguished from a “covered employee”). The concern over reasonable compensation may be over- or under-compensation depending on the organization at issue. For example, for-profit corporations may implement compensation plans that, for reporting purposes, under-pay executives to reduce exposure to payroll taxes, while nonprofit organizations can utilize tax-avoidance to over-pay executives with the objective of inurement and private benefit.
For nonprofit organizations, if compensation is not reasonable under the facts and circumstances, it is considered an excess benefit (i.e., the value of the benefit exceeds the value received in exchange for said benefit). The IRS can impose penalties in the form of intermediate sanctions, which are directed at the individual rather than the organization. The intermediate sanctions range from (i) an initial tax equal to 25% of the excess benefit[2] to (ii) an additional tax equal to 200% of the excess benefit is imposed if the initial tax is not paid within the taxable period.[3] Organizational managers may also be subject to lesser intermediate sanctions if they approve excess benefit transactions knowingly, willfully, and without reasonable cause.[4]
In the worst-case scenario, an organization can also be stripped of its tax-exempt status. The IRS highlights six (6) key areas that put organizations at risk of losing tax-exempt status: “private benefit/inurement, lobbying, political campaign activity, unrelated business income (UBI), annual reporting obligation, and operation in accordance with stated exempt purpose(s).”[5]
Under the Internal Revenue Code, organizations can meet a rebuttable presumption of reasonable compensation to avoid penalties on tax-exempt status.[6] “Reasonable compensation” is defined as the amount that would ordinarily be paid for like services by like organizations in like circumstances.[7] A test of reasonableness is comprised of a two-prong approach:
- An amount test, focusing on the reasonableness of the total amount paid; and
- A purpose test, examining the services for which the compensation was paid.
These two (2) prongs are not separate issues, focusing on different facts. Rather, the various factors in a particular situation taken together determine whether either or both of the tests is satisfied.[8]
Compensation must be reasonable in the aggregate, and the IRS pays particular attention to (i) deferred compensation, (ii) performance bonuses, and (iii) fringe benefits.[9] In regard to the amount test, key positional and organizational factors may include:
- Amount of responsibility
- Qualifications
- Size of business in sales dollars
- Contribution to profits
- Intent
- Ratio of salaries to net income
- Compensation paid in prior years
- Accumulated earnings
- Expert testimony
- Actual salaries paid
- Number of owners
- Number of related parties[10]
Given these numerous considerations, nonprofit organizations must establish reasonable compensation plans for covered employees in the event of government inquiry. The IRS, however, does not provide specific guidance for determining whether compensation is reasonable. Instead, the IRS indicates that reasonable compensation should be based on what someone in a similar position would earn at an organization of the same size and a similar mission or field of activity. Based on the above-listed factors, internally determining reasonable compensation may prove difficult, as the following simple questions may require significant analysis and experience to answer:
What is considered a comparable organization? Is it dependent solely on revenue or should additional metrics be considered, and which ones?[11]
- What is a reasonable comparable revenue “band” or “range” for comparison purposes?
- Should an organization’s expected future growth be taken into consideration when establishing comparability?
- What defines the appropriate geographic region to be considered?
Once the group of comparable organizations has been established and the compensation data for each position has been arrayed, the next step is selecting the appropriate compensation benchmark. According to the IRS, median compensation is considered reasonable unless there is rationale to exceed this level. However, the IRS does not specifically identify what factors may be considered for setting compensation above the median, nor does the IRS indicate how far above the median is reasonable. Furthermore, even if above-median compensation is supportable, such compensation levels may trigger an excise tax,[12] which is another factor to consider with in the overall context of the organizational operation. We further explore the excise tax issue in this separate article.
Nonprofit organizations can and should implement other tools to monitor and maintain consistent and compliant executive compensation practices. Executive compensation can vary significantly in a given year due to performance related compensation practices as well pre-defined annual increases in compensation. With annual compounding and lack of periodic review, pay that was once reasonable could soon exceed market value. Periodic reviews of compensation plans can help ensure that compensation remains in line with the market.
Nonprofit organizations should also consider the intent of a compensation package. For example, is compensation designed to promote growth of the organization, or increase the quality of service? Establishing a formal and well-thought out organization-wide compensation policy, or compensation philosophy, sets a stake and aids in the assessment of reasonable compensation.
Determining and maintaining appropriate compensation packages for executives is mission-critical for nonprofit organizations. Whether it is assessing the reasonableness of compensation, formulating a roadmap for compensation best practices, or establishing a compensation policy or plan, HealthCare Appraisers is here to help. Each nonprofit’s scenario is unique, so please reach out today for more information on how we can assist with your executive compensation plan needs.