Nonprofits and Executive Compensation

Nonprofit organizations are often surprised that their executive compensation practices can be subjected to Internal Revenue Service (IRS) scrutiny. Executive compensation is more than an executive’s salary, compensation includes an executive’s retirement plan, any deferred compensation, and other fringe benefits. Over the past several years, the IRS has increasingly investigated the executive compensation practices of nonprofit organizations. In addition, nonprofit executive compensation is a common risk-area flagged for audit by the IRS.  IRS scrutiny of excessive executive compensation is not just a concern of large nonprofits with substantial resources but for small nonprofits as well.

If the IRS finds that a nonprofit has paid its executives excessively, the IRS can levy penalties against that nonprofit. In extreme instances, the IRS may revoke a nonprofit’s tax exempt status. In reviewing a nonprofit’s executive compensation practices, the IRS examines whether the compensation violates the IRS’s rules on private inurement or excess benefit transactions. In general, the law of private inurement states: that no part of an organization’s net earnings shall inure to the benefit of any private individual or shareholder that has personal or private interests in the organization’s activities. The IRS focuses on whether such individuals receive any monetary or other pecuniary benefits in excess of fair market value.  Excess benefit transactions fall under Internal Revenue Code statute § 4958—“Taxes on excess benefit transactions”. Under § 4958, certain exempt organizations are prohibited from paying excessive compensation to “disqualified persons”.  A disqualified person is any person within the organization who is in a position to exercise substantial influence over that organization (e.g., chief executive officer, executive director, chief financial officer, etc.). Family members of disqualified persons employed at the non-profit are also considered disqualified persons. Special rules apply to disqualified persons who have a 35% controlling interest in corporations, partnerships, and trusts and estates.

The penalties for a person who received an excess benefit are: (1) the value of the excess benefit must be returned to the organization; and (2) an excise tax of 25% of the excess benefit, if the value of the excess benefit was returned to before IRS issued its notice of the deficiency, or 200% of the excess benefit, if the value of the excess benefit was returned after the IRS issued its notice of the deficiency. Furthermore, any individual who knowingly approved the excess benefit transaction is subject to a 10% tax on the excess benefit.

To avoid excess benefit penalties, nonprofits must establish a “rebuttable presumption of reasonableness”. In other words, nonprofits need to institute proper governance procedures regarding its executive and disqualified person compensation decisions. Proper governance procedures must include: (1) creating an independent governing body, such as a compensation committee of the board, to approve all executive and disqualified persons’ compensation decisions; (2) the governing body uses comparable data when determining compensation decisions; and (3) the governing body contemporaneously documents their compensation decisions. See Treas. Reg. 53.4958-6. These procedures should be applied to all disqualified persons, including family members of disqualified persons. For example, if a nonprofit’s chief financial officer’s nephew is employed as an administrative assistant at the same organization, his compensation should be approved using the procedures described above. By having these procedures in place, a nonprofit has established that its executive and disqualified person compensation determinations were reasonable; and therefore, rebut any potential IRS accusations of excessive compensation.

In addition to IRS scrutiny of nonprofit executive compensation, recent state legislation has sought to revoke a nonprofit’s property tax exemption, if the level of a nonprofit’s executive compensation surpasses a certain threshold. While 2017 bills in Connecticut and Montana have stalled, a Massachusetts bill remains active. As states continue to seek new sources of revenue, it’s likely that other states may consider similar measures.

Executive compensation presents a variety of complex legal, tax, and governance issues for nonprofits. In addition, allegations of excessive executive compensation can cause both donor and media relation problems for nonprofits. If you have questions regarding executive compensation at your organization, please contact an attorney at Bea & VandenBerk.

This article is provided for general information and is not intended to serve as legal advice for a specific situation.

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