Don’t Run Afoul of IRS Regulations

Executive compensation at nonprofits is a hot-button issue right now as the IRS has begun ramping up oversight and enforcement. This is partly in response to some high-profile instances where executives working at nonprofit organizations received excessive salaries in relation to the size of the organization or the region of the country.

Now is a good time to take a look at your organization’s executive compensation policies. If the IRS determines that your executive compensation is excessive, you could be subject to fines or even loss of your tax-exempt status. Also, executives must repay excess compensation with interest and may also have to pay an excise tax of 25% of the excess amount.

The Excess Nonprofit Compensation Tax

Section 4960 of the Tax Cuts and Jobs Act added an excise tax on excess compensation paid to certain executives of nonprofit organizations. The tax is imposed at the corporate tax rate of 21% on remuneration paid to a covered employee that exceeds $1 million, as well as excess parachute payments to covered executives.

This makes it critical to closely monitor whether your organization employs any executives whose compensation may be subject to excise tax. Section 4960 defines covered employees as any nonprofit employees who:

• • Are among the five highest-compensated employees in the organization for the tax year.
• • Were covered employees for any preceding tax year beginning after December 31, 2016.

Remuneration and wages are considered interchangeable as defined in Sec. 3401(a). This includes any amount required to be included in gross income under Sec. 457(f), but it excludes designated Roth contributions. It also includes any remuneration paid with respect to employment by a related person or government entity.

Each common-law employer, whether this is the nonprofit organization or a related entity, must pay its share of excise tax based on its proportional share of remuneration paid to the covered employee. 

Is Your Executive Compensation Reasonable?

The key question to ask is whether your executive compensation package is “reasonable.” The IRS defines reasonable compensation as “the value that would ordinarily be paid for like services by like enterprises under like circumstances.”

The IRS looks at several factors when determining the reasonableness of nonprofit executives’ compensation. These factors are weighted differently, depending on specific circumstances:

• The executive’s job description and nature of duties
• The organization’s size
• How much education or experience is required for the job
• Average compensation for similar positions at other nonprofits in the same area
• How many hours the executive works
• The organization’s overall budget

When determining whether a nonprofit executive’s compensation is reasonable, the IRS will consider the reasonableness of the total compensation amount and the services for which the compensation was paid. In addition to base salary, the following are also considered part of an executive’s total compensation package:

• Pension and profit-sharing plan contributions
• Personal use of the organization’s facilities
• Unpaid deferred compensation
• Payment of personal expenses
• Rents, royalties, and fees

Be Sure to Use Arms-Length Procedures

Smaller organizations where employees wear many different hats can sometimes get tripped up here. In effect, executives should not have a say in the size of their own compensation packages.
For example, suppose the president of the board is also the salaried executive director of a nonprofit organization. In this scenario, the individual should refrain from any board discussions about his or her compensation. Also, no board member voting on the executive’s compensation should have any relation to him or her.

Not following arms-length procedures when creating compensation packages can be costly. The IRS could classify an executive compensation package as an excess benefit transaction, especially if the total package is considered unreasonable. Intermediate sanction penalties could then be levied against board members for allowing financial transactions that unfairly benefit insiders.

Similarly, it is also a good idea to adopt conflict of interest policies for nonprofit board members and executive directors. This can help prevent the payment of improper private benefits before they occur, including excessive executive compensation. Effective conflict of interest policies detail what constitutes a conflict of interest and spell out the procedures for disclosing potential conflicts.

Disclosing Executive Compensation

Nonprofit organizations disclose various types of compensation paid, including executive compensation, on Form 990, which is filed annually. Here, the organization must specify how it determined compensation—for example, by a compensation committee, independent compensation consultant, compensation survey, or board approval.

Note that if an executive’s compensation exceeds a certain amount, Schedule J must be filed with Form 990. Schedule J lists the executive’s base pay, bonus and incentive compensation, deferred compensation and non-taxable benefits such as health insurance, educational assistance, life and disability insurance, dependent care assistance, and adoption assistance. In addition, it asks questions like whether the executive flies first class.

It is smart to reexamine your compensation practices given how closely the IRS is watching this issue and the potential consequences of paying excessive compensation to executives.

Three Steps to Preventing Excess Executive Compensation

The National Council of Nonprofits advises nonprofit organizations to take the following steps to help ensure that executive compensation is not excessive:

1. Get your board of directors involved in creating executive compensation packages.

2. Compare your organization’s compensation to those of executives at similarly sized organizations in your area that perform similar types of work.

3. Document your compensation review process, including the names of everyone who participated in the compensation committee and the specific data they reviewed.

(The U.S. Bureau of Labor publishes Occupational Compensation Surveys that can give you a good idea of total compensation packages that similar nonprofits have offered in your area. Visit https://www.bls.gov/bls/blswage.htm. You can also look at online sites like Monster.com and Indeed.com, as well as local newspaper classifieds.)

We Can Help

Contact our advisors so we can help you structure executive compensation packages that don’t run afoul of regulations.

Disclaimer of Liability
Our firm provides the information in this article for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisors. Before making any decision or taking any action, you should consult a professional advisor who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this blog are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability and fitness for a particular purpose.