National Public Radio’s All Things Considered (November 23, 2009) highlighted the impact of business wage cuts, and the importance of having a vision for the future. The story featured Lawrence Associates’ client Michael Casper, founder and CEO of UltraSource, a ceramic microchip manufacturer in Hollis, N.H. Recognizing that every crisis contains an opportunity, Michael asked Lawrence Associates to help design and communicate a plan that would increase compensation based on profitability. By markedly reducing breakage during the company’s sensitive production process, these engaged employees are earning back even more than the 10% pay cut, and they are committed to the company’s success. Read or listen to the story here.

The Freedom From Religion Foundation has filed a lawsuit in Federal court in California, challenging the Internal Revenue Code and corresponding California law provisions which exempt ministers from tax on the rental value of a home provided as part of compensation, and on amounts paid as a rental allowance.  The challenged sections also allow the minister to deduct mortgage interest and taxes paid with a rental allowance.  The FFRF suit is found here.

We attended a presentation last Friday at the 2009 MNN/AGM Fall Conference, by David Spackman, Chief of the Non-Profit Organizations/Public Charities Division of the Massachusetts Office of the Attorney General.  Mr. Spackman expressed some views that should be noted by nonprofits.  In line with positions taken by some key IRS figures recently (see our earlier posts on this subject), he said he was convinced that the Intermediate Sanctions rules are causing escalation of executive compensation in nonprofits.  Essentially, everyone knows what everyone else is being paid, and most boards consider their executives to be above average; thus the average continually rises and actual compensation with it.  Saying this another way, he said the IRS rebuttable presumption process has set a floor.  Spackman went on to say that for some organizations, meeting the requirements for the IRS Rebuttable Presumption won’t be enough to demonstrate that compensation is reasonable.

 Spackman seemed to indicate that the AG would be affirmatively seeking out and examining only the largest nonprofits in the state, starting with the recently-announced review of some major healthcare organizations.  But boards that want to be well-positioned in case of a review by the AG, which can occur even for smaller organizations in particular circumstances, should take note of his statement that his office wants to see boards and compensation committees get more deeply into decision-making about compensation; in particular, not simply sign off on survey-based numbers, but consider, for example, why an executive’s performance is “above average” and why numbers submitted by a compensation consultant are comparable to the executive’s position.

 See our earlier posts in this blog for a series of discussions on the operation of the IRS Rebuttable Presumption rules and the examination of large Massachusetts healthcare organizations by the Attorney General.

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.

The press coverage continues from the recently-released Chronicle of Higher Education study of college presidents’ compensation, also discussed in our November 2 posts.  This morning’s Boston Globe again concentrated on the compensation of the Suffolk University President.  In the same issue, Globe columnist Derrick Jackson cited the compensation reported for the presidents of a number of major universities, and suggested a cap of $200,000 – 4 times the approximate maximum tuition.  (Why one relates to the other, he did not really support.)  As we’ve noted in earlier posts on press coverage of CEO compensation at nonprofits, important factors for a true understanding of the figures are often left for late in the story, if they are covered at all.  For example, in this instance, the fact that Form 990 rules appear to have resulted in some amounts of deferred compensation being reported in two successive years was mentioned but not explained in depth.

Check out the NewsFeed section at our website for continuing coverage of compensation in higher education.

Compensation packages for senior officials of nonprofits are rarely limited to salary alone and the value of fringe benefits must be looked at in determining whether total compensation is reasonable.  It is also important to note that failure to correctly document and report a benefit may convert it to an “excess benefit transaction”, subject to excise tax penalties, even if the overall compensation package is “reasonable.”  Fringe benefits are an audit focus as noted in the IRS Audit Techniques Guides:

Because the tax treatment of fringe benefits can vary depending on the facts and circumstances under which they are provided, it may be helpful to follow a 3-Step analysis when examining a particular item an employer gives or makes available to an executive.

First, identify the particular fringe benefit and start with the assumption that its value will be taxable as compensation to the employee.

Second, check to see if there are any statutory provisions that exclude the fringe benefit from the executive’s gross income.

Third, value any portion of the benefit that is not excludable for inclusion in the executive’s gross income.  Fringe benefits are generally valued at the amount the employee would have to pay for the benefit in an arm’s length transaction.

We wanted to pass along a timely notice issued by the law firm of Seyfarth Shaw, about the IRS 409A correction program.  409A is a section of the Internal Revenue Code, enacted several years ago, that imposes limits on deferred compensation, and picks up items generally not thought of as “deferred compensation” such as severance pay and performance bonuses.  It was several years between the time Congress enacted 409A and the time it went into effect, implemented by 300+ pages of IRS regulations.  In general, December 31, 2008 was the “drop dead date” for companies to bring their deferred compensation arrangements into compliance with the law and regulations, but there are exceptions.  The Seyfarth write up is here.

We are not affiliated with Seyfarth, nor do we provide legal services.  Readers should consult their legal counsel or other tax advisers about this topic.

Key Intermediate Sanctions terms to be aware of include:

Disqualified Person – A disqualified person is “any person who was in a position to exercise substantial influence over the affairs of the applicable tax-exempt organization at any time during a 5-year period ending on the date of the transaction.”  These selected individuals typically include the Chief Executive Officer, the Chief Financial Officer, and voting members of the governing body  but the definition may extend to other members of the executive team and some physicians in a health care organization.  Family members of disqualified persons are also included.  In a healthcare organization, persons with a material financial interest in provider-sponsored organizations may be included.

Excess Benefit Transactions – In these transactions, “an economic benefit is provided by an applicable tax-exempt organization, directly or indirectly, to or for the use of any disqualified person, and the value of the economic benefit provided by the organization exceeds the value of the consideration (including the performance of services) received for providing such benefit.”  The simplest example of this is an overly high salary for a disqualified person who does not seem to warrant such a salary.

Reasonable Compensation – “Reasonable compensation,” as discussed in 3[a] below, is based on an extensive historical body of laws and cases that guide an organization in determining what is reasonable. 

Rebuttable Presumption of Reasonableness – IRS regulations offer a safe harbor process for fulfilling the requirements to avoid the imposition of Intermediate Sanctions.  We’ll discuss this in detail in an upcoming post.  We generally encourage all nonprofit organizations to comply with the “safe harbor” process afforded by these provisions.

The Internal Revenue Code (the “Code”) and IRS regulations impose penalty (“excise”) taxes on “excess benefits transactions” between tax-exempt organizations and “disqualified persons” as defined in the Code.  These taxes are referred to as “intermediate sanctions” because they allow the IRS to impose a penalty in between doing nothing and penalizing the organization by revoking its tax-exempt status.  Notably, “excess benefits transactions” include compensation for services where the value of the compensation exceeds the value of the services, and “all consideration and benefits” (with certain exceptions such as expense reimbursements and nontaxable fringe benefits) are taken into account.  

The taxes may be imposed on the person receiving the compensation and the organization’s managers.  These taxes are based on percentages of the amount involved.  The initial level of tax on the recipient is 25% of the amount involved, while the tax on organization managers is 10% with a maximum of $20,000 in the aggregate.  The tax increases significantly for failure to make timely corrections of improper payments or benefits.  In addition, excess amounts of compensation must be returned to the organization, with interest.  So the cost of noncompliance can be very substantial.  The effect of the penalty is magnified because if the excess must be returned, it may be long after the recipient has spent it – and indeed, the excess may have been received in the form of goods or services (such as use of a house or car, or health of other life insurance) that were not paid in cash originally.

Wasting no time, Sen. Chuck Grassley (R. Iowa) issued a press release about the Chronicle of Higher Education survey of college salaries discussed in our post yesterday.  The release says that Sen. Grassley “expressed concern that private college presidents’ salaries continue to go up even as tuition increases for students.”  Interestingly, the press release recounts the Senator’s 2007 investigations into “soaring endowment growth”, a problem that few colleges are left with after last Fall’s stock market retreat.

Also, look at U.S. News and World Report’s analysis of the issue, particularly the question of whether and how college presidents’ salaries affect tuition – or not.