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Wednesday, August 5, 2009
Mosaic

 

Executive Compensation and the IRS:
Does Your Organization Meet the “Reasonable” Standard?

The revised Form 990 that is required to be used for the 2008 fiscal year (tax returns filed in 2009 and 2010) has been designed to be much more than a financial document. It is now the primary source of information about an organization’s governance, operations, and programs and is open to public inspection and therefore serves as a key tool by the IRS, state charity officials and the public. The expansion of the Form 990 is due in large part to the new governance (Board of Directors) objectives that are included for the first time.

Although the IRS does not require charities to have governance and management policies, the IRS will review an organization’s application for exemption and their annual Form 990’s to determine whether the organization has implemented policies relating to executive compensation, conflicts of interest, investments, fundraising, documenting governance decisions, document retention and destruction, and whistleblower claims.

One of the biggest and potentially dangerous issues facing a tax-exempt organization is the determination of executive compensation. Intermediate sanctions (excise taxes) exist to curb abuses in this area. A charity may not pay more than “reasonable compensation” for services rendered. Although the IRS does not require charities to follow a particular process in determining the amount of compensation to pay its officers, directors, trustees, key employees and others in a position to exercise substantial influence over the affairs of the charity, it should be determined by persons who are knowledgeable in compensation matters and who have no financial interest in the determination.

The IRS regulations provide extensive guidance on compensation arrangements and establish a “rebuttable presumption” that payments under a compensation agreement are “reasonable” IF the following “safe harbor” conditions are met:

  • The compensation arrangement is approved in advance by the tax-exempt organization’s governing body (or committee thereof), that is composed of persons who do not have a conflict of interest with respect to the arrangement,
  • The governing body relies on appropriate comparable data in deciding whether to approve the compensation and
  • The governing body prepares contemporaneous documentation and recordkeeping with respect to deliberations and decisions regarding the compensation arrangement.

A governing body or committee has appropriate comparable data IF, given the knowledge and expertise of its members, it has information sufficient to determine whether a transaction is at FMV or the compensation is “reasonable.”

For organizations with revenue under $1M, the revised Form 990 requires that reasonable compensation be determined by reviewing at least three, relevant, current comparables. There is no specific guidance for organizations with budgets >$1M, so any tax- exempt organization of this size can develop a Compensation Policy around the desired number of comparables in its Executive Compensation Review Process.

One method to assist in determining “reasonableness” of compensation is to obtain compensation surveys or studies from outside compensation consultants for this purpose. The IRS will look to the independence of any compensation consultant used, and the quality of the study, survey, or other data, used to establish the executive compensation.

Organizations should take immediate steps to ensure accurate and complete compensation reporting in order to avoid IRS scrutiny.

Dewey & Kaye is prepared to assist your organization with assessing the reasonableness of all compensation levels as well as any other aspects of the newly revised Form 990.

Please contact us by calling 412.434.1335 or visiting us on the web at http://www.deweykaye.com.

Paul E. Block C.P.A., / J.D. is a Manager at McCrory & McDowell, LLC specializing in the tax aspects of Not-For-Profit clients. Contact Paul at pblock@mccmcd.com.