To minimize the risk of engaging in an excess benefit transaction related to compensation paid in connection with an organization exempt from income tax under Section 501(c)(3) of the Internal Revenue Code of 1986, as amended (an "Exempt Organization"), the compensation should be (1) approved by a committee of the board of directors composed of persons who have no conflict of interest with respect to the disqualified person; (2) determined and based upon specific data that establishes that the compensation is reasonable; and (3) documented in the committee's minutes. If these steps are followed, a rebuttable presumption is established that such compensation is reasonable. Furthermore, all compensation payable to disqualified persons must be properly reported to the IRS to avoid characterization as an excess benefit.
The disqualified person is entitled reasonable compensation for the services rendered to the exempt organization. Reasonable compensation is the amount that would ordinarily be payable for like services by a like organization under like circumstances. This determination is typically made as of the date of the award of the compensation. The parties to a transaction are entitled to rely on a rebuttable presumption of reasonableness with respect to a compensation arrangement involving a disqualified person if the arrangement was approved by the board of directors or trustees (or a committee thereof) prior to payment of the compensation.
With regard to compliance, the following steps should be considered by the board. First, a committee of the board should be established to determine the compensation and benefits of the key employees of the Exempt Organization. The members of the committee should not have a conflict of interest with respect to the Exempt Organization or persons employed by the Exempt Organization. For smaller organizations, it may be appropriate for the committee to be comprised of the entire board, excluding members who may have a conflict of interest. Although it is permissible for the disqualified person to participate in the meeting to present information and to answer questions regarding such employee's compensation, the disqualified person should not be present during debate or during any vote.
The committee should determine the compensation and benefits for all key employees, typically the executive staff members of the Exempt Organization. The committee should have available job descriptions as well as any performance reviews of these staff members. In addition, the Committee should have available all of the compensation payable to such disqualified persons including all fringe benefits payable to such key employees. Thus, for example not only should base pay be evaluated but also retirement plan contributions, health insurance, and any car allowance or other similar benefits all must be considered as part of the compensation pair to the key employee. In determining the level of compensation, all compensation must be taken into account.
The committee must determine the compensation and benefits of these key employees based upon the compensation payable to other similarly situated persons. To the extent comparable institutions or positions exist (both taxable and tax-exempt employers) and compensation data can be obtained, such data would be helpful in establishing reasonable compensation levels. For a larger organization, that is, where gross receipts are greater than one million dollars, a committee has appropriate data as to comparability if, given the knowledge and expertise of its members, it has information sufficient to determine whether the compensation arrangement will result in the payment of reasonable compensation. Relevant information would include, but is not be limited to, compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions; the availability of similar services in the geographic area of the applicable tax-exempt organization; independent compensation surveys compiled by independent firms; and actual written offers from similar institutions competing for the services of the disqualified person. For smaller organizations, the board may rely upon data from three comparable organizations in the same or similar communities for similar services.
Unfortunately, in many cases, it is difficult if not impossible to locate comparable compensation information.
The written records of the committee should articulate the reason for the level of compensation adopted by the committee or the reason for the payment of additional compensation in the case of a bonus. At the minimum, the minutes should reflect the following:
a. The terms of the transaction that was approved and the date it was approved;
b. The members of the committee who were present during debate on the transaction or arrangement that was approved and those who voted on it (The actions taken with respect to consideration of the transaction by anyone who is otherwise a member of the governing body or committee but who had a conflict of interest with respect to the transaction or arrangement should be noted as well) ;
c. The comparability data obtained and relied upon by the committee and how the data was obtained; and
d. If the committee determines that reasonable compensation for a specific arrangement is higher or lower than the range of comparable data obtained, the committee must record the basis for its determination.
For a decision to be documented concurrently, records must be prepared by the next meeting of the committee occurring after the final action of the committee. Records must be reviewed and approved by the committee as reasonable, accurate and complete within a reasonable time after circulation.
Additionally, fringe benefits for key employees and board members should be reviewed to ensure that taxable benefits are properly reported. Incentive compensation and other revenue sharing arrangements should be reviewed in light of the regulations.
Penalty taxes can apply even if compensation is reasonable with respect to taxable benefits received by disqualified persons if those benefits are not reported as wages on Forms W-2, 1099 or 1040. The payment of personal expenses and benefits to a disqualified person will be treated as compensation for purposes of the penalty provisions only if it is clear that the organization intended the payment as compensation for services.[1]The intermediate sanctions place a high premium on identifying all benefits paid or provided to disqualified persons to assure that they are properly reported in a timely manner.
Taxpayer Impact
Exempt Organizations should develop a compliance plan to minimize the exposure of the organization's executives, board members and other insiders to excess benefit transactions. As a first step, each organization should identify all the persons who may be considered disqualified persons. The compliance plan should also include a procedure for approval of all business and compensation decisions with persons having substantial influence over the organization. The process should include the steps outlined above that raise the rebuttable presumption of the reasonableness as to the value of the compensation or transaction.
The compliance plan should be reviewed periodically as the law (case law, IRS interpretations etc.) concerning the intermediate sanctions evolves. A policy should also be developed with respect to the reimbursement of any intermediate sanctions penalties imposed on the organization's officers and directors and the organization's payment of insurance premiums on policies providing coverage on such penalties.
[1]Penalties for failure to report taxable benefits would still be applicable.
PartnerFor the past thirty years Joe Walker has represented many closely-held companies in all aspects of their business arrangements. This representation ranges from simple shareholder agreements dealing primarily with estate ...
