The laws regarding nonprofit compensation are another element that can make compensation a disliked topic in an organization. The penalties are severe and there are no precise formulas for generating a compensation plan. With public charities, the IRS mainly focuses on certain individuals such as directors and key employees. Excess compensation to these individuals can be grounds for the IRS to revoke an organization’s tax-exempt status under the private inurement rule. Even if an organization is able to avoid revocation of its tax-exempt status, the individuals involved may still be subject to excise taxes on the excess benefit called intermediate sanctions. (See I.R.C. Section 4958). Whether compensation is excessive is determined on a case-by-case basis and the organization generally bears the burden to show the compensation is reasonable. However, organizations may shift the burden of proof to the IRS to show that compensation is not reasonable by taking the required steps to establish a rebuttable presumption of reasonableness.
The current environment is characterized by a heightened scrutiny on nonprofit compensation. Consequently, nonprofit organizations look to best practices to help ensure compliance with the law. Last week I listened in on GuideStar’s webinar, “Best Practices in Nonprofit Compensation,” presented by Karl E. Emerson, of counsel at Montgomery, McCracken, Walker & Rhoads, LLP, and Chuck McLean, Vice President of Research at GuideStar, who shared some best practices for setting nonprofit compensation. Emerson highlighted that the recent actions taken by the IRS include significantly increasing its enforcement efforts in this area, assessing millions of dollars in penalties for these types of violations, and also indicating it will include an excess compensation analysis in every future financial audit it conducts. Although the IRS is the only body that can revoke tax-exempt status or levy excise taxes, Emerson notes that in most states, the Attorney General has the authority to question the reasonableness of compensation. All of this makes best practices that much more important and useful.
Emerson points nonprofits organizations to advice from Bruce R. Hopkins, a leading authority in tax-exempt organizations, in his treatise The Law of Tax-Exempt Organizations (9th edition):
Factors commonly considered to evaluate the reasonableness of an insider’s compensation
- The compensation paid by similar organizations, both exempt and taxable, for equivalent positions in the same community or geographic area;
- The charity’s need for the particular services of the person in question;
- The uniqueness of the person’s background, education, training, experience, and responsibilities;
- Whether the compensation was approved by an independent board of directors;
- The size and complexity of the charity’s income and assets and the number of employees the charity has;
- The person’s prior compensation arrangements;
- The person’s job performance;
- The relationship of the person’s compensation to the compensation paid to the charity’s other employees; and
- The number of hours the person spends performing his or her job.
Steps for avoiding private inurement penalties
- Describe fully and accurately all aspects of the insider’s total compensation package;
- Explain exactly how the charity determined the insider’s total compensation package;
- Describe adequately and accurately the insider’s duties and responsibilities;
- Provide adequate documentation, such as comparable salaries paid by similar organizations, that show the reasonableness of the insider’s compensation;
- Show through appropriate documentation that the charity’s governing body approved the amount of the insider’s compensation and that the insider or someone related to the insider did not participate in the process;
- Show that the amount of the insider’s total reportable compensation agrees with the amount reported on the insider’s Form W-2 or Form 1099 to avoid an automatic excess benefit transaction; and
- Show through appropriate documentation that the insider’s use of any of the charity’s assets, such as a cars, real estate, credit cards, laptops, or cell phones, for other than fulfilling the charity’s exempt purposes, were properly included in his or her compensation and properly included in the insider’s Form W-2 or Form 1099, again, in order to avoid penalties for automatic excess benefit transactions.
Highlights from Emerson on excess compensation rules include:
- “Total compensation” for purposes of the excess compensation analysis includes all forms of compensation: wages and salary in addition to bonuses, fringe benefits, royalties, deferred compensation, etc.
- “Fair and reasonable” requires an “approximately equal exchange of benefits between the charity and the insider so that the insider does not receive an unreasonable or unwarranted benefit from the charity”
- Affirmative actions by board member(s) as well as participation such as a board member’s silence or inaction where he or she has a duty to speak or act are grounds for the IRS to impose an excise tax penalty on such board member(s). A board member is not considered to have participated in an excess benefit transaction, however, if he or she opposed the transaction (e.g., objected to the transaction as noted in the board meeting minutes).
- A charity with annual gross receipts of less than $1 million that uses comparability data of three comparable organizations in the same or similar communities for similar services is an example of appropriate comparability data as required by the rebuttable presumption.
- There is no rule prohibiting a nonprofit from using comparables from the for-profit sector. Note though this is a controversial topic. [Ed. Some believe compensation by nonprofits, with assets bound by charitable trust, should not be compared with compensation by for-profit entities, which are generally unregulated. Others find it appropriate based on the rationale that the nonprofit sector competes with the for-profit sector for these individuals.]
- Board member compensation is the exception rather than the rule for nonprofit organizations. If an organization compensates board members, it must be able to justify the reasonableness of such compensation.
Highlights from McLean regarding the use of compensation statistics include:
- Comparable data can be based on a variety of factors. For example, GuideStar’s 2010 Nonprofit Compensation Report allows organizations to find comparable data based on geography, annual expenses, gender, and organization type.
- An average compensation statistic is more susceptible to being skewed when there are few organizations in the category (e.g., two people making $50,000 and one individual making $300,000). The larger the number of organizations included, the more reliable the data.
- A median is generally more reliable than an average. A smaller the gap between the average compensation and median compensation within a group, the more reliable the data.
- There is an unequal amount of comparable data available to organizations. For example, CEO/Executive Director compensation is far more commonly reported on Form 990 than, for example, top Public Relations or Technology positions. Additionally, major metropolitan areas have more reported data available on that geographic.
- The IRS is looking for outliers and its best source of compensation data is Form 990 data. Therefore, the more that an organization is at the higher end of the range of Form 990 comparables, the more careful it should be in taking the necessary steps and recording and maintaining the proper documentation for the rebuttable presumption of reasonableness.
- Compensation statistics are useful for satisfying the rebuttable presumption for routine compensation packages. They are not as useful if the compensation package is particularly complicated.
McLean and Emerson also suggested the following resources for finding comparables:
- GuideStar – Provides electronic copies of filed Form 990s to registered users. Additionally, GuideStar has just released its 2010 Nonprofit Compensation Report (http://www2.guidestar.org/rxg/products/guidestar-nonprofit-compensation-report.aspx) based on over 99,000 Form 990s (2008) for purchase.
- ERI Economic Research Institute – Provides salary survey, cost of living comparison data, and executive compensation survey data for compensation planning to its subscribers.
- IRS Form 990s – Requires disclosure of compensation of officers, directors, trustees, key employees, highest compensated employees, and independent contractors. Beginning in 2008, the revised Form 990 also requires an organization to disclose to the IRS how it sets executive compensation. This information may be useful for other organizations evaluating their own compensation approach and plan.
Both Emerson and McLean emphasized that the laws and closer attention to compensation do not prevent an organization from paying on the higher end of the salary range for similar positions in similar organizations (e.g., higher total compensation can be reasonable given an employee’s experience and expertise). It does however mean that an organization should be able to justify that compensation is fair and reasonable under the circumstances. Additionally, an organization might be able to avoid such situations by looking towards other solutions. For example, providing career development and career path visibility does not necessarily come in the form of compensation and therefore could add great value for some employees while not counting towards “total compensation” in the eyes of the IRS. Ultimately, to best protect the organizations as well as those serving the organization, compensation plans should be a thoughtful decision that addresses both the strategic and best practices elements.
Part One of this post "Compensation Strategies for Nonprofit Organizations" can be found here.
Emerson’s presentation slides on “The Private Inurement Prohibition, Excess Compensation, Intermediate Sanctions, and the IRS’s Rebuttable Presumption: A Basic Primer for 501(c)(3) Public Charities” can be viewed here.
McLean’s presentation slides on “How the GuideStar Compensation Report Can Help You To Determine Appropriate Executive Compensation” can be viewed here.
A recording GuideStar’s webinar, “Best Practices for Nonprofit Compensation,” can be accessed here.