By Jesse D. Delanoy, Esq.
Compensation of senior executives of tax exempt, nonprofit organizations has come under intense scrutiny by the IRS in recent years. Obviously, the potential for abuse exists wherever the compensation payable to a senior executive is decided upon by the executive himself, or persons who may be subject to his influence.
An organization, even though charitable in nature, does not qualify for tax exemption under Section 501(c)(3) of the Internal Revenue Code if its net earnings inure in whole or part to the benefit of private shareholders or individuals. Under the Treasury Regulations, “private shareholders or individuals” refers to individuals having a personal and private interest in the organization’s activities, as opposed to members of the public generally. Without over-complicating the issue, senior executives of an exempt organization are generally included in the class of individuals referred to in the statute, known as “disqualified persons”. Compensation to these executives which is unreasonably high in relation to the value of the services they provide will result in a finding of private inurement to the benefit of the over-compensated employee(s).
If there is a finding that an exempt organization has paid unreasonably high compensation to a senior executive (or other disqualified person under the statute), the law provides for penalty excise taxes upon the employee receiving the excess benefit, as well as upon the members of the organization’s governing body who approved or voted in favor of the unreasonably high compensation.
However, reasonable compensation to employees, including senior executives, allowable under the “ordinary and necessary” business expense standard, is not private inurement.
The best way to avoid the intermediate sanctions and possible loss of tax-exempt status is to observe the formula set out by Congress, that a rebuttable presumption exists that compensation paid to a disqualified person is reasonable, if approved by a board of directors, or a committee of a board, if the board or committee:
- is composed entirely of individuals who do not have a conflict of interest with respect to the compensation arrangement. For this purpose, an individual is deemed not to have a conflict of interest only if the individual:
- is neither a disqualified person participating in, or economically benefiting from, the compensation arrangement, nor a member of the family of the disqualified person;
- is not in an employment relationship subject to the direction or control of any disqualified person participating in, or economically benefiting from, the compensation arrangement;
- does not receive compensation or other payments subject to approval by any disqualified person participating in, or economically benefiting from, the compensation arrangement;
- has no material financial interest affected by the compensation arrangement; and
- does not approve a transaction providing economic benefits to any disqualified person participating in the compensation arrangement, where that disqualified person in turn has approved or will approve a transaction providing economic benefits to the member.
- in setting the compensation, obtains and relies on appropriate data as to comparability of compensation. Appropriate data includes but is not limited to (i) compensation levels of similar taxable and tax-exempt organizations for functionally comparable positions; (ii) the organization’s location and the availability of similar specialties in the geographic area; (iii) independent compensation surveys by nationally recognized independent firms; and (iv) offers from similar institutions competing for the services of the disqualified person.
- adequately documents the basis for its determination. In this regard, written or electronic records of the authorized body approving the compensation must note all of the following:
- the terms of the transaction that was approved and the date it was approved;
- the members of the authorized body who were present during debate on the transaction that was approved and those who voted on it;
- the comparability data obtained and relied upon by the authorized body and how the data was obtained; and
- any actions taken with respect to consideration of the transaction by anyone who is otherwise a member of the authorized body but who had a conflict of interest.
If the rebuttable presumption is established by the organization, then the IRS may only overcome it, and thereby establish that compensation paid was nevertheless unreasonably high, by developing evidence sufficient to overcome the comparability data relied upon by the organization. This requires a higher standard of proof for the IRS to satisfy, and makes it much more unlikely that the IRS, in an audit, will arrive at a result unfavorable to the exempt organization, its governing body and its executive employees.
Jesse D. Delanoy is a Principal in the firm’s Business & Real Estate Group. Mr. Delanoy serves as outside general counsel to both nonprofit and privately-owned businesses and concentrates his practice primarily in the areas of corporations and partnerships, mergers and acquisitions, family and non-family business ownership transitions, commercial contracts, business planning, employee agreements, and real estate. He can be reached by phone at 301.575.0301 and by email at jdelanoy@offitkurman.com
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