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Navigating Smart Business / Board Governance Strategies to Prepare for and Defend a Nonprofit Tax-Exempt Regulatory Review on Executive Compensation

February 15, 2022 9:57 AM | Dena A Culpepper (Administrator)

The stakes are higher today than they have ever been before regarding executive compensation and the scrutiny imposed by the federal and state governments and the national news media. Negative media reaction and public outcry in cases of executive compensation packages viewed as excessive, regardless as to whether they really are, has set the stage for government regulators, the Internal Revenue Service and State Attorney General Offices to investigate, audit and suppress abuses. As a result of their findings, more federal and state statutes and regulations concerning not-for- profit executive compensation is being enacted.

Actions taken by State Legislatures and Attorney General Offices in various states, like New Jersey and New York, to limit executive compensation and media reported investigations of not-for-profit organizations to rein in suspected abusive executive compensation practices are acting as a stimulus for even more government regulation. As a result, this is causing many not-for-profit boards across the country to examine their board governance strategies and practices concerning executive compensation and how they will pay their top people in the future.

So, who oversees and regulates who?

Many tax-exempt nonprofit organizations such as 501(c)(3) charitable organizations which may include certain foundations, 501(c)(4) Quasi-governmental organizations, 501(c)(14) State Chartered Credit Unions and 501(c)(6) Business and Trade Associations, are:

· Required to file an annual tax information return – Form 990 or 990EZ depending on the size of the organization

· Subject to Section 4958 of the Internal Revenue Code regarding Intermediate Sanctions - except for 501(c)(6) Business and Trade Associations and Private Foundations.

· Subject to Private Inurement requirements

· Subject to impermissible private benefit transaction rules

· Under IRS scrutiny for 457 Deferred Compensation Plans

· Under IRS scrutiny for excessive and unreasonable executive compensation practices

When reviewing not-for-profit executive compensation, what positions are potentially under scrutiny? Depending on who is scrutinizing whom, the compensation of officers, directors, trustees, key employees, and the highest compensated employees and independent contractors rise to the top of the list.

Officers typically would include Chief Executive Officers, Presidents, Executive Directors, Sr. Pastors, Chief Operating Officers, Chief Financial Officers and Vice Presidents and/or Key Leadership Employees who have responsibilities like an officer when managing a significant segment or activity for the organization.

Directors and former directors paid for their serves on the Board are also included. Based on Internal Revenue Service guidelines, compensation paid more than $10,000 per year could put a board director or trustee under the microscope.

Highly compensated employees can also be on the list when their total compensation exceeds $150,000 as a Key Employee or when one of the top five highest compensated employees other than executives / officers are earning more than $100,000.

Over the last few years, the Internal Revenue Service has added additional staff to increase its efforts to audit and investigate tax exempt not-for-profit organizations as it looks for excessive and abusive executive compensation practices and programs. And as stated earlier, state legislators, regulators and Attorney Generals have been continually active imposing rules and regulations on the compensation of leaders, directors, trustees and the highly compensated.

If you are on the Board for a tax-exempt nonprofit organization, you must be concerned about personal liability for participating in approving compensation actions deemed excessive by IRS. Under section 4958 of the Internal Revenue code, the code imposes “Intermediate Sanctions” in the form of excise taxes on “disqualified persons” which include officers, senior leaders, highly compensated, etc. whose organization engages in impermissible and excessive benefit transactions on behalf of them. Section 4958 also penalizes board directors and trustees who knowingly approve excess compensation and/or impermissible benefit transactions. However, please note that (501(c)(6) Business and Trade Associations and Private Foundations are not subject currently to Section 4958 of the IRS code but are subject to Private Inurement Requirements and Excess Benefit Transaction findings. As a result, board directors and trustees of business and trade associations are not personally penalized for knowingly approving excessive compensation and /or impermissible benefit transactions but beware that the (501(c)(6) Business and Trade Associations are still investigated and held liable for excessive compensation and benefits.

As defined, an impermissible excessive benefit transaction is one in which the economic benefit provided directly or indirectly to a disqualified person exceeds the value received by the organization, including the value from the performance of services. This includes the payment of excessive compensation or an impermissible benefit transaction that is deemed unreasonable.

Potential penalties for participating in such actions can include:

  • Being personally liable for returning the value of the excess compensation or benefits back to the organization
  • Paying an excise tax of either:
  • 25% of the value of the excessive benefit if returned prior to receiving a deficiency notice from the IRS
  • 200% of the value of the excessive benefit if the benefit or compensation is returned after receiving the IRS deficiency notice

· Board Director or Trustee liability for approval of an excessive compensation and

/or benefit transaction:

  • Assessment of a 10% tax on the Director or Trustee who knowingly approves an excessive benefit transaction
  • Liability under section 4958(a)(2) is joint and several and capped at $20,000 per transaction
  • Revocation - Loss of Tax Exemption

So, what compensation components and economic benefits should be considered to

determine whether a person’s compensation is reasonable?

  • Base salary
  • Fees
  • Incentive compensation and bonuses – short-term and long-term
  • Retirement benefits
  • Nonqualified deferred compensation plans
  • Supplemental Executive Retirement Plans
  • Health and welfare benefits – medical, dental, life insurance, short-term / long-term disability
  • Other employee benefits – Paid Time Off - where there is a cash value opportunity for cash in or paid at the time of retirement or termination
  • Taxable and nontaxable fringe benefits, except fringe benefits described in section 132 of the tax code
  • Executive benefits and perquisites
  • Expense allowances or reimbursements
  • Housing allowance or residence for personal use
  • Below market loans
  • Foregone interest on loans
  • Moving and relocation expenses
  • Payment of liability and indemnification insurance premiums
  • Severance payments

In determining whether compensation is reasonable, what factors have been considered by courts and other regulatory agencies?

  • The employer’s compensation philosophy and policy for employees and leaders
  • Comparing compensation for like industries, like business segments, and like employers
  • Utilization of reputable compensation and benefits survey sources and compensation experts to determine the reasonable value of the compensation paid and to be paid and which is sufficient to satisfy the fiduciary responsibility of the governing body to conduct appropriate due diligence. Survey sources may include both taxable and tax-exempt organizations to allow comparisons to similar positions at similarly situated organizations. It is also important to know that when the organization’s staff performs the analysis for the Board on behalf of those executives in the organization that they report to, the organization and the Board run the risk of conflict of interest in discerning executive compensation.
  • This in effect could negate certain government protections – (i.e., The Rebuttable Presumption of Reasonableness) that is created for the Board by performing and executing the due diligence necessary to perform its governance and fiduciary responsibilities.
  • Scope, size, financial position, geographic location and complexity of the

employer’s business / organization

  • Industry categories (NAICS and SIC Codes) of the employer and like employers
  • Actual written job and compensation offers from similar organizations competing for executive talent
  • The nature of the work being performed and the employee’s qualifications
  • The performance of the employee/executive and the business / operational performance of the organization
  • General economic conditions at the time total compensation are awarded or changed

When is compensation viewed as reasonable? The fair market value of economic benefits received for the performance of services is considered reasonable compensation, which is the value that would ordinarily be paid for like services by a like enterprise under like circumstances.

As a Board Director, Church Elder, Trustee, or CEO of a tax-exempt organization, why would you want to consider creating a Rebuttable Presumption of Reasonableness for your organization and will it protect your organization from governmental scrutiny?

An important governance strategy exists that every organization subject to intermediate sanctions and/or tax-exempt regulatory compliance regarding executive compensation should consider. This strategy is called the Rebuttable Presumption of Reasonableness.

The basis for creating a “rebuttable presumption” can be found at 26 CFR 53.4958-6 - Rebuttable presumption that a transaction is not an excess benefit transaction.

In determining the reasonableness of compensation under the Rebuttable Presumption of Reasonableness, compensation is presumed to be reasonable, and a property transfer is presumed to be at fair market value when three requirements for establishing the rebuttable presumption are met. They are:

1. The compensation arrangement must be approved in advance by an authorized governing body of the applicable tax-exempt organization, which is composed of individuals who do not have a conflict of interest concerning the transaction

2. Prior to making its determination, the authorized governing body obtained and relied upon appropriate compensation and benefit survey data as to comparability of compensation paid

3. The authorized governing body adequately and timely documented the basis for its determination for the compensation decisions concurrently with making that determination.

The documentation of the authorized body should include the terms of the transaction and the date of its approval, the members of the authorized body present during the debate and their vote on the transaction, the comparability data obtained and relied upon, the actions of any members of the authorized body having a conflict of interest, and documentation to support the basis for the determination.

When done correctly, the Rebuttable Presumption of Reasonableness shifts the burden of proof between the tax-exempt, not-for-profit organization’s governing body and the Internal Revenue Service concerning executive compensation.

The Internal Revenue Service may refute the presumption of reasonableness only if it develops sufficient contrary evidence to rebut the probative value of the comparability data relied upon by the authorized body. As a result, the practice of creating one lends itself to an excellent governance strategy to follow even if it may not directly affect regulatory compliance of your organization.

How do we avoid excessive executive compensation and what are some effective business strategies and best practices to follow?

To ensure that your executive compensation decisions will stand up to the scrutiny of government regulators and agencies, media, and others, you may want to consider adopting some of the following strategies and best practices.

  • Make executive compensation transactions a priority in board / trustee governance meetings
  • Use caution when entering transactions with highly compensated employees and disqualified persons – CEO, Sr. Pastors, Pastor, CFO, COO, President, Executive Director, Vice Presidents, Etc. Be sure to conduct the appropriate due diligence in reviewing market survey data or in hiring a compensation consulting expert to assist in making informed total compensation recommendations and decisions
  • Use the Rebuttable Presumption of Reasonableness procedures to shift the burden of proof to the IRS – Government Agency – Attorney General. This is a tax-exempt accepted practice provided by the Federal Government which could provide your organization with added fire power in the event of an audit or regulatory review.
  • Establish a Board Compensation or HR Committee to create a dedicated review of your compensation actions with members who understand the components of a total compensation strategy and package.
  • Create a customized executive compensation philosophy and policy for the organization. Failure to do so could cause major cost problems that need not occur.
  • Use appropriate and relevant comparable compensation and benefit survey data to conduct a total compensation review for the executive team and highly compensated.
  • Adopt a comprehensive Conflicts of Interest Policy to help protect directors, trustees and officers from liability.
  • Adopt a Travel and Expense Reimbursement Policy for all employees and leaders.
  • Use an independent consultant to determine fair market rates for total compensation and benefits. By contracting with a reasoned third-party compensation consulting firm, this will help to ensure impartiality and to avoid any opportunity for a conflict of interest by utilizing in-house sources who report up through organization officers and leadership.
  • Board compensation, if any, should also be reviewed by outside third-party advisors.
  • Be sure to adequately and thoroughly document the basis for any executive or highly compensated compensation transactions and governing body decisions on compensation actions. This would include terms of the approved compensation transaction, date of approval, board/trustee/committee minutes, a thorough description of the expert report on comparability data used to make the decisions including who or how the data was obtained.

Whether the Board, Trustees, Elders, Leadership, or HR/Compensation Committee is overseeing the due diligence process of annually reviewing the compensation of the organization’s leadership and highly compensated, in the end, it is the board/trustees/elders that carry the legal burden associated with improper compensation. To maintain not-for-profit tax-exempt status and avoid tax penalties, it is incumbent upon the governing body to ensure that leaders and board members (as applicable) are paid fair and reasonable compensation.

Good governance does not have to be difficult to ensure the payment of fair and reasonable compensation and to satisfy regulatory compliance. However, Board Directors, Trustees, Elders and CEOs / Sr. Pastors must be thoughtful, open to successful board governance strategies and best practices, transparent and consistent in the application of sound and reasonable executive compensation programs to ensure compliance success.

About the Author:

Bob Cartwright, SPHR / SHRM-SCP, is founder, president, and chief executive officer of Intelligent Compensation, LLC, a compensation and business management consulting firm located in the greater Austin, Texas area. Since 1996, Mr. Cartwright has managed numerous assignments for a wide variety of clients including those in high technology, manufacturing, services, information technology, health care, retail, construction / facility management, telecommunications, legal, energy, media, publishing, non- profits, public entities, municipalities, financial services, oil and gas, real estate, and aerospace / defense. He has 30+ years of diversified experience in compensation, human resources and business management which includes the development of total compensation strategies, wage and salary plans, executive compensation strategies and studies, incentive compensation plans, and performance management systems.

Mr. Cartwright’s professional affiliations include Advisor to the State Director / Business Development – Texas Society for Human Resource Management State Council (Texas SHRM); Past Board Chair, Texas Association of Business; SHRM National volunteer; Past Member of the Total Rewards, Compensation, & Benefits National Expertise Panel and National Volunteer Leader on Veteran Employment –Society for Human Resource Management (SHRM). He is also a sought-after speaker and is often quoted as a business / compensation expert in newspapers and print media around the country.

Intelligent Compensation, LLC specializes in conducting executive compensation reviews, audits, and studies for Leadership and Boards of Directors for Nonprofit - Tax-exempt organizations across the U.S. Organizations served include 501(c)(3) Charitable organizations, Churches, State Credit Unions, and Private Foundations; 501(c)(6) Business, Professional, and Trade Associations, Bureaus, Chambers of Commerce, and Quasi-Governmental Entities and Authorities; and 501(c)(1) Federal Credit Unions. Intelligent Compensation also provides services to For-Profit companies in most every industry and our analysts and consultants provide our clients with over 35 years of experience in creating personalized business strategies, practical ideas, and customized business solutions to organizations who want to maximize their operational performance and organizational effectiveness through strategically aligned, performance-based compensation programs, and sound compensation and business management practices.