In our previous posts, we’ve discussed the basics of the IRS Intermediate Sanctions rules governing compensation for senior management of nonprofits – the key definitions and the applicable penalties.  Now it’s time to consider how to stay out of trouble.

The essence of the IRS rules is that any money, property or services provided to an individual by a nonprofit must be compensation, of a reasonable amount, and documented as such.  While the regulations are extensive, the IRS sets out steps by which an organization can create a “rebuttable presumption” (that is, a presumption in favor of the organization) that the compensation for the person in question is reasonable. 

To establish the presumption requires what the IRS lists as 3 steps, although the “steps” have multiple pieces:

1.  The compensation arrangement, or the terms of the property transfer, must be approved in advance by an authorized body of the organization.  The members of the authorized body must not have any conflicts of interest with respect to the arrangement being approved.

Note: Many organizations miss the “in advance” requirement because the compensation committee doesn’t approve the compensation package until after the time period (usually a year, but longer in the case of multi-year employment contracts) has started.  We are frequently involved with providing our clients with model timetables so that all the steps for setting and reviewing compensation can be scheduled to conform to the regulations.

2.  The authorized body obtains and relies on appropriate data for comparability before making its determination.  This requires a determination that the compensation is reasonable.  Organizations frequently utilize the services of compensation consultants to provide analyses utilizing underlying data from compensation surveys.  The consultants in turn are generally looking at compensation paid by similarly-situated organizations for functionally comparable jobs.  Many factors enter into this analysis; among other things, there are significant compensation differences for similar jobs among geographic regions of the US and even between relatively nearby locations (such as a city center and outlying suburbs). 

3.  The authorized body adequately documents the basis for its determination concurrently with making that determination.

“Adequate documentation” is defined in the IRS regulations and includes, among other things the terms of the transaction approved, and, if a decision is made to pay outside the range established by the comparable data, the basis for that determination.

Note:  Many organizations miss the timing requirements for the documentation.  The IRS spells out that to meet the “concurrently” requirement, records must be prepared by the next meeting or 60 days after final action by the authorized body is taken, whichever occurs later.  Then, there’s a second step – the records must be reviewed and approved by the authorized body as “reasonable, accurate and complete.”

While failing to meet every element of establishing the rebuttable presumption is not necessarily fatal and does not, by itself, mean that the compensation will be subject to penalties, the difference between “mostly” complying and actually meeting the rebuttable presumption requirements is often one of planning.  By setting a schedule in advance, the organization can help ensure that it will gather the necessary data, obtain the necessary advice from its attorneys, accountants and compensation consultants, and take the necessary actions in a timely manner.