"Reasonable Compensation" Reviews
Are Very Important
By Michael Siebenhaar, JD,
Gone are the days of nonprofit organizations operating under the radar.
Whether it's from the board of directors, donors, various legislative
bodies or the IRS, nonprofits today are facing greater operational
scrutiny. One of the areas most commonly under the microscope at
nonprofits is executive compensation.
Not surprisingly, the call for increased transparency and
accountability of nonprofits is mirroring the trend in for-profit
companies. And as with public companies, the government has been
leading the charge. The Senate Finance Committee is calling for
increased oversight of nonprofits and the Internal Revenue Service
(IRS) has stepped up its auditing of compensation of top executives. In
fact, the IRS announced that it would audit 2,000 nonprofits during
2005, including foundations, healthcare organizations, and others. This
audit is based in part on Internal Revenue Code (IRC) of 1986, as
amended, IRC Section 4958, which imposes fines for unreasonable
compensation paid to a "disqualified person."
In part to limit their own personal liability, nonprofit management and
board of directors are requesting studies to benchmark compensation and
document the processes in place to determine pay. As a result,
nonprofits are undertaking significantly more reasonable compensation
studies than they have in previous years.
To help nonprofits navigate this new terrain, here's an outline of what
non-profit executives and board members need to know about the IRS and
Section 4958, and reasonable compensation reviews.
Complying with IRC 4958
IRC Section 4958 outlines a process that a board of directors for a
nonprofit described in section 501(c)(3) or section 501(c)(4) can
follow to reduce its exposure to penalties relating to unreasonable
compensation. By following these three steps, a nonprofit can position
itself to create a rebuttable presumption that the compensation is
Independent approval: An independent governing body (or a
acting on behalf of the governing body) must approve the compensation
arrangement. Usually this is a board of directors, or a compensation
committee of the board of directors
Comparable comparisons: The board or committee must have
relied upon appropriate comparability data prior to approving the
Documentation: The board or committee must adequately
basis for its determination concurrently with making that determination.
To satisfy the independent governing body requirement, the compensation
arrangement must be approved by the organization's governing body or an
appropriately authorized committee, composed entirely of individuals
who do not have a conflict of interest with respect to the arrangement
or transaction. If the committee's decision is subject to ratification
by the entire board, then both the committee and the board must satisfy
the requirement of not having a conflict of interest.
The independence requirement is met for a board or committee member if
that person (a) is not the disqualified person whose compensation is
being decided (or related to that person); (b) is not in an employment
relationship subject to the direction or control of such disqualified
person; (c) is not receiving compensation or other payments subject to
approval by such disqualified person; (d) has no material financial
interest affected by the compensation arrangement; and (e) does not
approve a compensation arrangement for such disqualified person who, in
turn, approved or will approve a transaction with that person.
Second, to satisfy the requirement relating to appropriate
comparability data, the governing body or committee must obtain and
rely on relevant data such as: compensation levels paid by similar
organizations (taxable and tax-exempt) for functionally comparable
positions; the availability of similar services in the geographic area
of the organization; current compensation surveys compiled by
independent firms; or actual written offers from similar organizations
for the services of the disqualified person. Smaller charities (with
annual gross receipts of less than $1 million) are required to obtain
Finally, to satisfy the documentation requirement, the governing body
or committee must maintain written or electronic records describing:
the terms of the compensation arrangement; the date approved; the names
of the persons on the governing body who were present during the
discussion and who voted on it; the data relied upon in making the
decision; and the actions taken by anyone with a conflict of interest
with respect to the arrangement.
These records must be prepared before the later of the next meeting of
the body or 60 days after the decision. The governing body or committee
must then review these records within a reasonable time thereafter.
If these three criteria are met, the compensation will be presumed
reasonable for purposes of IRC Section 4958, unless the IRS can rebut
this presumption by showing that the compensation is unreasonable.
If compensation to a "disqualified person" (defined as any member of an
organization exercising "substantial influence") is determined to be
unreasonable, and therefore an "excess benefit transaction" under
Section 4958, then the disqualified person will have to return the
excess compensation to the organization and pay an excise tax equal to
25 percent of the excess benefit. An additional excise tax equal to 200
percent of the excess benefit is imposed if the transaction is not
corrected within the required period. Correction generally is
accomplished by repaying the excess amount plus a payment for the loss
of use of the money (reasonable interest rate).
Boards of directors also have more at stake than their personal
reputation. A 10 percent excise tax is imposed on any "organization
manager" who participates in an excess benefit transaction knowingly,
willfully and without reasonable cause. An organization manager is
defined as any officer, director, or trustee of the organization,
including any person who regularly exercises authority to make
administrative or policy decisions on behalf of the organization.
The excise taxes on disqualified persons and organization managers can
be avoided if the excess benefit is corrected in a timely fashion and
if it is established to the satisfaction of the IRS that the excess
benefit was due to reasonable cause and not to willful neglect.
Michael Siebenhaar, JD, CPA, MBA (email@example.com) is a senior
executive compensation advisor in KPMG LLP's Compensation and Benefits
Practice. The views and opinions expressed in the column are those of
the author and do not necessarily represent the views and opinions of
KPMG LLP in the United States. The information contained in this
article is general in nature and based on authorities that are subject
to change. Applicability to specific situations is to be determined
through consultation with your tax adviser.