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Tax Issues in Compensating the Tax-Exempt Executive
OCG can help your organization work with Regulatory Compliance and Compensation of Tax-Exempt Executives.

When discussing the compensation of a tax-exempt executive, there are some contemporary developments to consider.

  • Federal legislative action
  • Regulatory action by state attorneys general
  • Public perceptions influenced by media reports

Regulatory Compliance

When considering the regulatory compliance, the current IRS practice should be reviewed.

Targets of Interest:

  • Public charities
  • Private foundations

Regulatory Arsenal

  • Private inurement rules – for public charities and private foundations
  • Private benefit rules – for public charities and private foundations
  • Intermediate sanctions rules and regulations (Internal Revenue Code Section 4958) – for public charities
  • Self-dealing rules and regulations (IRC Section 4941) – for private foundations

Two Important Doctrines To Know

Private Inurement Doctrine:

–“no part of the organization’s net earnings may inure in whole or in part to the benefit of any private shareholder or individual.”

Private Benefit Doctrine:

–“an organization is not considered organized for a proper statutory purpose (e.g., religious, charitable, scientific, etc.) unless it serves a public rather than a private interest.”

In terms of both breadth and applicability, the private benefits doctrine is the most wide-ranging of the private benefits rules. The doctrine is not limited to just monetary benefits. It applies to any individual to whom the organization may endow a benefit of any kind that is more than just incidental, either qualitatively or quantitatively.

It is under the umbrella of the private benefit doctrine that the private inurement doctrine falls. The private inurement doctrine is far more specific involving only individual classified as “disqualified persons,” but is often overlooked as the private benefit doctrine overlaps and incorporates it. Organizations need to be cautious of poor governance practices that can worsen the likelihood of private inurement violations.

Application to Executive Compensation of Tax-exempt Entities

Executive employees and other key employees of a tax-exempt organization are generally considered to have a personal and private interest in the activities of the organization, and, therefore, payments to such employees can result in a violation of the doctrines. No violation will occur if the organization pays “reasonable compensation” for services actually rendered.

Internal Revenue Code Section 4958 applies where unreasonable compensation is paid to “disqualified persons.”

Section 4958 of the Internal Revenue Code imposes an excise tax on excess benefit transactions between a disqualified person and an applicable tax-exempt organization. The disqualified person who benefits from an excess benefit transaction is liable for the excise tax. An organization manager may also be liable for an excise tax on the excess benefit transaction.

The IRS Perspective On “Reasonable Compensation”

A question to consider might be:

“Would an inactive, independent investor consider the factor favorably and wish to pay the compensation to retain the executive?”

Factors To Consider For All Types of Entities
  • Executive’s role.
  • Executive’s compensation compared to similar employees in similar organizations.
  • Character and condition of organization.
  • Internal consistency of compensation to all employees.
  • [Existence of conflict of interest allowing organization to disguise dividends as compensation.]

Excess Benefit Transactions

The IRS defines an Excess Benefit Transaction as:

“…a transaction in which an economic benefit is provided by an applicable tax-exempt organization, directly or indirectly, to or for the use of a disqualified person, and the value of the economic benefit provided by the organization exceeds the value of the consideration received by the organization.”

-Source: IRS

Another way to look at this transaction is to consider if it is:

  • An economic benefit is provided by an organization, directly or indirectly, to or for the use of a disqualified person, and
  • The value of the economic benefit provided by the organization exceeds the value of the consideration received by the organization in return for providing the benefit.

Courses of IRS Action from Violation(s)

Pre-1996 (before enactment of IRC Section 4958)
  • No action, or
  • Loss of organization’s tax-exempt status.
Post-1995 (after enactment of IRC Section 4958)
  • No action, or
  • Excise taxes against individuals, and/or
  • Loss of organization’s tax-exempt status.

Risks to Organization from Violation of IRC Section 4958

The direct financial effect of violations may be nil, however, there are some indirect effects of public public disclosure such as:

  • Negatively impacted reputation – This is usually the organization’s most important and valuable asset.
  • Negative impact on an organization’s fundraising efforts.

Vulnerability lasts though a 3-year statute of limitations. It will end on the third anniversary of the last allowed filing date. For example, it would end on November 15, 2019 for a 2015 tax return.

Intermediate Sanctions and Executive Compensation

IRC Section 4958 applies where unreasonable compensation is paid to “disqualified persons,” which the IRS defines as:

“…any person who was in a position to exercise substantial influence over the affairs of the applicable tax-exempt organization at any time during the lookback period. It is not necessary that the person actually exercise substantial influence, only that the person be in a position to do so.”

These typically include:

  • Voting members of governing body;
  • President, chief executive officer, chief operating officer;
  • Treasurer, chief financial officer;
  • Any person with substantial influence;
  • Any family member of the foregoing;
  • Any entity in which 35% of the interests are owned by any of the foregoing.
Initial Tax

IRC Section 4958 imposes an initial excise tax on both the disqualified person and any participating “organization manager” (i.e., officer, director, trustee), based upon the portion of the compensation which is deemed “unreasonable.”

For a disqualified person, that tax equals 25% of the “unreasonable” portion. For participating “Organization managers” that tax equals lesser of 10% or $20,000, with joint and several liability.

Additional Tax

An additional tax in an amount equal to 200% of the “unreasonable” portion is imposed on the disqualified person if such person fails to pay back “unreasonable” portion within the “taxable period.” A “taxable period” generally means the period beginning with the date of the transaction and ending on the date of assessment.

Potential Individual Exposure of a Disqualified Person:
  • Repayment of original excess benefit, with interest, plus
  • 25% initial tax, plus
  • 200% additional tax, plus
  • 10% tax (to $20,000) if also participated as an Organization Manager

And, the organization may not reimburse the disqualified person for any portion of these penalties.

Determination of Reasonable Compensation under IRC Section 4958; apply general Section 162 standards (facts and circumstances test)
  • All forms of cash and non-cash compensation taken into account (e.g., salary, fees, bonuses, severance payments, deferred compensation).
  • Compensation and payments from entities controlled by the organization (ownership greater than 50%) also taken into account.
  • Non-taxable employee benefits under Section 132 excluded.
Regulatory Exemptions

Initial Contract (or First Contact):

–Intermediate sanctions do not apply to fixed payments under the first contractual relationship between the organization and a new disqualified person.  Extension, renewal, or material change to initial contract results in loss of exemption.

Lower Paid Employees: 

–Intermediate sanctions generally do not apply to payments to employees making less than $115,000.

Regulatory Safe Harbor

Rebuttable Presumption of Reasonableness:

– Compensatory payments to disqualified persons are presumed reasonable if:

    • Payments are approved by disinterested governing body.
    • Governing body relied upon appropriate comparability data.
    • Basis for determination adequately documented at time of approval.

Reliance on Professional Advice: 

– Organization manager not generally liable under Section 4958 if such manager relied upon written opinion of professional.

What Does All This Mean to My Organization?

The Positives:

Safe harbor enables organization to safely set executive compensation at commercially competitive levels.

–Increased retention of key executives.

–Increased ability to attract qualified executive employees.

The Negatives:

–IRS likely to be more aggressive in scrutinizing compensation payments.

–Compensation payments must be more closely monitored and examined to ensure compliance with Intermediate Sanctions.

–Failure to “protect” compensation decisions may constitute breach of fiduciary duty.

What Do I Need to Do to Protect My Organization and its Managers?

Prudent Steps:

–Maintain compensation committee of the board that does not include executive employees (including CEO).

–Maintain records of reasonable compensation.

–Use formal, structured, consistently applied program.

–Document required performance.

–Use independent consultant to assess competitive opportunities, design compensation program, and establish performance/pay relationships.

–Obtain and retain written professional opinions.

Example Case Study

ABC Foundation is a scientific research foundation, a not-pro-profit organization, several different entities, and performs cutting-edge medical research. It has a unique board of trustees members with responsibilities that include trustee involvement and day-to-day management of the organization and its entities:

  • Operations Managers
  • Chief Executives
  • Patent Attorneys
  • Chief Legal Counsel

The Concern: intermediate sanctions rules may impose penalties if compensation is found to be unreasonable.

Overall Requirements:

–Perform compensation research and analysis

–If compensation is found to be reasonable, support with professional opinion

–Primary client contact with foundation’s legal counsel (to protect privilege)

Methodology

–Compile survey data (not-for-profit and for-profit examples)

–Develop peer group of organizations in the for-profit sector by industry, primary business, and organization size.

–Analyze data (position responsibilities, hybrid approach when comparing positions, and proxy analysis of publicly-traded-for-profit organizations)

–Consult with legal counsel on findings

–Provide written opinion, with supporting data

Responsibilities of board or appropriate committee

–Approves compensation

–Obtains and rely upon “appropriate comparability data”

–Adequately document its basis for its decision

Appropriate comparability data

–Compensation levels paid by similarly situated organizations, tax-exempt and for-profit, for comparable positions

–Availability of similar services in the area

–Current compensation surveys by independent firms

–Written offers by competitors

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