| The IRS believes that some officers and other | | | | donor relations. Many charitable boards need guidance |
| employees may be taking advantage of their | | | | on pay levels due to the subjective nature of |
| influential positions by setting their own compensation | | | | determining reasonable compensation, complex facts |
| at above-market levels. The IRS has begun a | | | | and the desire to avoid IRS scrutiny. An opinion letter |
| wide-spread initiative to find those overpaid | | | | from an independent party can give board members |
| individuals. | | | | comfort that pay levels are in line with the market, |
| The IRS is primarily using Internal Revenue Code | | | | reduce turnover, and help avoid the excise taxes by |
| section 4958, which allows them to impose excise | | | | creating a rebuttable presumption that the |
| taxes on the excessive portion of compensation paid | | | | compensation is reasonable. |
| to a charity's employee. These excise taxes are | | | | If the compensation is presumed to be reasonable |
| referred to as "intermediate sanctions" since they are | | | | under the excess benefit rules, section 4958 excise |
| less severe than having the IRS revoke the charity's | | | | taxes can then be imposed only if the IRS develops |
| tax-exempt status. | | | | sufficient contrary evidence to rebut the charity's |
| These excise taxes are aimed at unreasonable | | | | evidence. In other words, the burden shifts to the |
| compensation paid to a "disqualified person." A | | | | IRS to prove that the compensation was |
| disqualified person is anyone who was "in a position | | | | unreasonable. |
| to exercise substantial influence over the affairs" of | | | | The charity's board must meet three requirements to |
| the tax-exempt organization at any time during the | | | | create a rebuttable presumption that compensation is |
| five-year period prior to the transaction, and the | | | | reasonable: |
| family members of any such person. Note that it is | | | | 1. The compensation must be approved in advance |
| not necessary that the person actually exercised | | | | by an independent board or board committee |
| substantial influence, only that he or she was in a | | | | without the disqualified person participating, |
| position to do so. | | | | 2. Appropriate comparability data that documents the |
| Over-paid independent contractors may be subject | | | | arms' length nature of the transaction, such as |
| to the excise tax also. This could include CPAs and | | | | compensation surveys, must be relied upon, and |
| attorneys if they meet the definition of disqualified | | | | 3. The basis for approval must be documented in |
| person. | | | | writing, such as through board minutes. |
| The Code refers to the unreasonable portion of | | | | A qualified compensation consultant can help the |
| compensation as an "excess benefit transaction" | | | | board meet these requirements by providing |
| because the individual is getting a benefit | | | | comparability data and documenting it in an opinion |
| (compensation) in excess of the value of the | | | | letter. In preparing opinion letters, the compensation |
| services he or she provides for that compensation. | | | | professional should take into consideration all relevant |
| Expect the IRS to look particularly closely at | | | | facts and circumstances including, but not limited to: |
| compensation amounts paid to: officers who also sit | | | | 1. Compensation levels paid by similar organizations, |
| on the charity's Board of Trustees, relatives of major | | | | both taxable and tax-exempt, for comparable |
| donors, long-term employees who have cut back | | | | positions; |
| their hours, employees who receive performance | | | | 2. The availability of similar employees in the |
| bonuses, and anyone who has a hand in setting his or | | | | geographic area; |
| her own compensation level. Certain industries are of | | | | 3. Current compensation surveys compiled by |
| special interest to the IRS. For example, hospitals | | | | independent firms; and |
| may be examined because market conditions have | | | | 4. Any written offers from similar employers |
| pushed their officers' compensation to higher levels in | | | | competing for the services of the disqualified person. |
| recent years. | | | | Other relevant factors usually include the size of the |
| Under Code section 4958(a)(1), the IRS can impose a | | | | organization, the geographic area it serves, and the |
| 25% excise tax on the unreasonable portion of an | | | | qualifications and duties of the employee. |
| individual's compensation. (This excise tax is in addition | | | | The opinion letters serve another important purpose. |
| to federal and state income taxes, and FICA tax the | | | | Reg. 53.4958(d)(4)(iii) provides protection for the |
| employee has to pay on that compensation.) If the | | | | organization managers against the 10% excise tax |
| unreasonable portion is not repaid promptly after the | | | | even if the compensation is determined to be |
| 25% tax is imposed, section 4958(b) provides for an | | | | unreasonable. To get this protection, the managers |
| excise tax equal to 200% of the unreasonable | | | | must obtain an opinion letter stating that the |
| portion. | | | | compensation consultant believes that if the |
| In addition, Code section 4958(a)(2) allows the IRS | | | | compensation amount is challenged by the IRS, it |
| to impose an excise tax on an "organization manager" | | | | would "more likely than not" be upheld in court. Other |
| (officer, director or trustee) who participated in | | | | requirements must be met as well. Although this does |
| permitting the unreasonable compensation, unless | | | | not guarantee that the compensation will not be |
| such participation was not willful and was due to | | | | found to be unreasonable, obtaining and using such an |
| reasonable cause. This tax is 10% of the | | | | opinion letter can protect the officers and board |
| unreasonable portion of the compensation. It was | | | | members from personal exposure to the 10% excise |
| limited to $10,000 per excess benefit transaction until | | | | tax. |
| the Pension Protection Act of 2006 raised that limit | | | | U.S. Treasury Department Circular 230 requires that |
| to $20,000. Those organization managers who | | | | certain disclosures be included in the opinion letter. |
| knowingly allow the excessive compensation are | | | | Under section 10.35(e)(3), the disclosure usually |
| jointly and severally liable for this excise tax. Of | | | | includes a statement saying that the letter contains a |
| course, the last thing any volunteer board member | | | | "limited scope opinion" as defined by Circular 230 |
| wants is to be personally exposed to a tax. | | | | (Title 31 Code of Federal Regulations, Subtitle A, Part |
| Note that both the 25% and the 10% excise taxes | | | | 10, revised as of September 26, 2007). The letter |
| are imposed upon the individuals, not the charity. | | | | also includes a statement that the opinions expressed |
| To let everyone know that they are serious about | | | | in the letter are limited to the one or more federal |
| this, the IRS announced that it was proposing over | | | | tax issues addressed in the letter, and that additional |
| $21 million in section 4958 excise taxes on forty | | | | issues may exist that could affect the federal tax |
| disqualified persons and organization managers at | | | | treatment of the transaction or matter that is the |
| twenty-five charities. | | | | subject of the opinions and the opinions do not |
| In addition to the monetary impact, publicity resulting | | | | consider or provide a conclusion with respect to any |
| from these penalties can be disastrous for a charity. | | | | additional issues; and, with respect to any significant |
| For all these reasons, charities need to be very | | | | federal tax issues outside the limited scope of the |
| careful about how much they pay and how the | | | | opinion, the opinion was not written and cannot be |
| amounts are determined. But, setting levels of | | | | used for the purpose of avoiding penalties. |
| compensation for key employees is difficult for | | | | The opinion letter should also include a statement of |
| charitable Boards of Trustees since most board | | | | independence from the compensation professional. |
| members are not familiar with the complexities of | | | | This article provides an overview of the complex |
| compensation analysis. And, determining appropriate | | | | rules governing compensation paid by charities. With |
| cash compensation levels for key employees at a | | | | emphasis on corporate governance now at an all-time |
| charity may be more challenging than doing so at | | | | high, advisors and board members should become |
| for-profit companies since charities do not offer | | | | familiar with these rules and carefully monitor the |
| stock options, profit-sharing plans and some of the | | | | compensation and benefits of employees and |
| other incentives rewarded to executives at for-profit | | | | contractors. The steps taken by a charity to avoid |
| entities. Yet pay levels and benefits at charitable | | | | the excess benefit transaction excise taxes can also |
| organizations must keep up with the market to | | | | be useful in an audit by a state regulatory agency, |
| prevent turnover, since turnover among key | | | | and in responding to inquiries from potential donors. |
| employees is costly, disruptive, and damaging to | | | | |