Governance: Compensation
3rd in a Series
As a follow-up to our initial tax tip in this series entitled “Governance Issues for Tax-Exempt Organizations”, which was released on April 25, 2012, WithumSmith+Brown has compiled a list of what we believe to be “best practices” with respect to each topic included in the Federal Form 14114, Governance Check Sheet. This tax tip focuses on Form 14114, Part 3, Compensation.
UNDER THE MICROSCOPE OF THE IRS
The Internal Revenue Service (“IRS”) is always concerned with the amount of compensation and benefits paid to officers and key employees of tax-exempt organizations. The IRS places priority on reviewing cases where compensation is suspected of being non-fair market value and unreasonable. Recently, the IRS has created new offices, such as the Exempt Organizations Electronic Initiatives Office, to acquire data sources that will assist in more easily comparing executive compensation paid by tax-exempt organizations.
Executive compensation and benefit issues are also subject to the intermediate sanctions regulations. These intermediate sanctions regulations apply to a non-fair fair market value transaction (an excess benefit) between either an Internal Revenue Code §501(c)(3) or §501(c)(4) tax-exempt organization and a disqualified person (a person in the position to exercise substantial influence over the affairs of the organization, such as a Board member, Chief Executive Officer, Chief Operating Officer, Chief Financial Officer and other individuals). Under the intermediate sanctions regulations Board or Board committee members or officers could be subject to personal liability, jointly and severally, up to $20,000 for each excess benefit transaction in instances where they are found to have knowingly, willfully, and without reasonable cause participated in or approved an excess benefit transaction. The individual receiving the excess benefit is subject to a first tier tax of 25% of the amount of the excess benefit and could be subject to a second tier tax of 200% of the amount of the excess benefit if the excess benefit is not returned to the organization; together with interest. An excess benefit transaction must also be disclosed on the tax-exempt organization’s Form 990, Supplemental Schedule L, Transactions with Interested Persons. These factors make it crucial for tax-exempt organizations to concentrate their efforts on adhering to best practices with respect to their compensation policies.
COMPENSATION ARRANGEMENTS
Copies of the IRS Form 990; IRS Notfor-Profit Governance Best Practices document and Federal Form 14114, Governance Check Sheet, can each be accessed at the healthcare services section of our Firm’s website.
Part 3 of Form 14114 begins with question number thirteen which addresses the compensation arrangements for all officers, directors, trustees and key employees and the review and approval process as it relates to these individuals. It is recommended that the charitable organization provide sufficient compensation to these individuals. The IRS does not recommend a specific process for determining the compensation amounts but the process should involve individuals who are considered independent and are free from any conflicts of interest with the organization.
Tax-exempt organizations are encouraged to follow the elements of the rebuttable presumption of reasonableness test in determining compensation. The test involves the following three factors:
- The compensation arrangement is approved in advance by an “authorized body” of the tax-exempt organization which is composed entirely of individuals who do not have a “conflict of interest” with respect to the compensation arrangement;
- The authorized body obtained and relied upon “appropriate data as to comparability” prior to making its determination; and
- The authorized body “adequately documented the basis for its determination” concurrently with making that determination.
The satisfaction of these factors enables the tax-exempt organization to receive a presumption that the compensation and benefits paid to certain individuals is reasonable and fair market value. This effectively shifts the burden of proof to the IRS to prove that the compensation and benefits paid to certain individuals by the tax-exempt organization was not-fair market value and unreasonable.
RELIANCE ON COMPARABILITY DATA
Question fourteen on Form 14114 addresses the method of collecting comparable data used to make compensation decisions and the reliance on it for those decisions. Many organizations utilize independent firms to perform compensation studies on the organization to ensure that compensation is comparable with peers in the industry. Note the compensation consultant should be engaged by the compensation committee and not the organization itself directly. We recommend that a tax-exempt organization have an updated or completely new compensation study performed every 3 years. Taxexempt organizations should also initiate an RFP process and rotate consultants periodically to ensure independence. In-house comparability studies can also be completed by utilizing internet resources. The free websites of Guidestar (www.Guidestar.org), Urban Institute (www.urban.org) and the Economic Research Institute (ERI-nonprofit-salaries.com) which, for a small fee, provide benchmarking tools.
DOCUMENTATION
The final question in Part 3 of Form 14114 (question fifteen) addresses whether the organization adequately documents the basis for all of its compensation decisions. The meeting minutes of the committee should adequately document both the review and approval process of each element of executive compensation and benefits on an individual by individual basis. The documentation must also be prepared contemporaneously. The meeting minutes must be prepared within the later of sixty (60) days or the next committee meeting.
The questions in this part of Form 14114 are specifically addressed on the Federal Form 990, in Part VI, Section B, Question 15. This question asks if the process for determining compensation for the CEO, Executive Director, top management official, and other officers and key employees of the organization includes review and approval by independent persons, comparability data and contemporaneous substantiation of the deliberation and decision. The tax-exempt organization must check a box and answer “yes” or “no” to this question. In addition, the tax-exempt organization is asked to provide an explanation of this process in Schedule O.
Both the IRS and our firm recommend that tax-exempt organizations answer the question “yes” and, in its explanation, address and explain all three parts of the rebuttable presumption of reasonableness to show that it has completed the due diligence and that the compensation and benefits provided to the officers and key employees is reasonable and fair market value. Answering “no” to this question is not currently a violation of any legal or tax requirement but is an admission that the organization has failed to adhere to the best practices outlined in IRS regulations. In this instance an organization is more likely to have the IRS initiate a review of its executive compensation practices. In addition, Schedule J, Compensation Information, includes, in Part I, Question 3, various checkboxes that are required to be answered with respect to the compensation of the organization’s Chief Executive Officer/Executive Director. These checkboxes relate to various elements used in determining compensation and should correlate with Form 990, Part VI, Question 15.
For more information on the topics discussed or services we can provide, please contact:
Scott Mariani, JD, Partner
Practice Leader
973.898.9494 ? [email protected]
Questions or comments?
E-mail us at [email protected]
To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
Learn More About our Healthcare Services>> 
How Can We Help?