If you are familiar with Form 990, you are familiar with its question about compensation policies. Part VI, Section B of the 990, Question 15 asks if the organization’s process for determining the compensation of the organization’s top management official and other officers and key employees includes “a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision.” What exactly does this mean and why is it important?
Compensation is a weighty issue for any organization but especially so for nonprofit organizations. Organizations exempt under sections 501(c)(3) (public charities) and 501(c)(4) (civic leagues and social welfare organizations) could endanger their exempt status if they pay excessive compensation (known as inurement of benefit). In addition, persons that receive excessive compensation and potentially organization managers that approve such compensation can be subject to significant excise taxes if they receive or approve the payment of excess compensation (the excess benefit rules).
The IRS has indicated that compensation will be reviewed in every exempt organization examination. Normally the organization would have the burden of proving to the IRS that its compensation is reasonable. However, the IRS has established a safe harbor for compensation determinations. If an organization satisfies all the safe harbor requirements, the burden of proof shifts and the IRS must instead prove that the organization’s compensation is unreasonable. It is therefore advisable for exempt organizations to comply with the safe harbor.
Safe Harbor Requirements
- The first safe harbor requirement is approval in advance by an independent body. The entire board or executive committee may review and approve compensation, or a compensation committee may be appointed if allowed under the organization's bylaws. All members of the board or committee must be independent with respect to the employee whose compensation is being reviewed.
- The board or committee must obtain and review comparability data before approving compensation. Any similarly situated organization, for-profit or non-profit, with a functionally comparable position can be used for comparison. Comparability data can include compensation reported on Form 990 by similar organizations, current compensation surveys compiled by independent firms or actual written offers received from similar institutions competing for the services of a similar employee.
For organizations with less than $1 million of gross receipts for the three prior tax years, data from at least three comparable organizations in the same or similar communities should be reviewed. No minimum number of comparisons is provided for organizations with more than $1 million of gross receipts, but logically more than three would be appropriate.
- The final safe harbor requirement is documentation. The decisions of the board or committee authorizing compensation must be detailed in writing, and include (a) all terms of the compensation package and the date of approval; (b) the names of all members present during the discussion and the names of those who voted; (c) the comparability data relied upon and how it was obtained, and (d) any conflicts of interest of members with respect to the transaction and how they were addressed. If the compensation agreed upon differs from the comparability data, the record should indicate the reasons for such difference.
The documentation must be recorded before the latter of the next meeting of the authorized body or 60 days after the action was taken. The board or committee must review and approve the minutes as reasonable, accurate and complete within a reasonable time thereafter.
Paying excess compensation can subject both management employees and the board members to stiff excise taxes, as well as potentially endanger the organization’s tax-exempt status. It’s therefore advisable to put the safe harbor standards detailed above into place in case the organization is subject to an IRS examination.
Please contact one of RubinBrown’s Not-For-Profit professionals for more information regarding the compensation determination safe harbor.
• What You Need to Know about Nonprofit Executive Compensation
• Governance and Related Topics – 501(c)(3) Organizations
• Intermediate Sanctions (IRC 4958) Update
• IRS Regulation 26 CFR 53.4958-6
Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.
All Not-For-Profit News Not-For-Profit Overview