Intermediate Sanctions. Federal tax laws impose penalties in the form of excise taxes, known as “intermediate sanctions,” if a charity pays more than reasonable compensation for services of directors, trustees, officers, key employees and others in a position to exercise substantial influence over the affairs of the charity. The excise taxes are imposed not only upon the persons of substantial influence (known as “disqualified persons” under federal tax laws) who receive such compensation, but also the governing board or managers who approve such compensation.
Safe Harbor. To provide some assurance to governing boards and managers responsible for compensation, federal tax laws create a safe harbor, or “rebuttable presumption,” that compensation is reasonable, if the following processes are followed:
- Approval Free of Conflicts of Interest. The compensation arrangement is approved in advance by an authorized body composed entirely of individuals who do not have a conflict of interest with respect to the arrangement. A director has a conflict of interest if he or she (i) participates in or economically benefits from the compensation being considered, or is a family member of someone who is so participating or benefiting, or (ii) is in an employment relationship subject to the direction or control of, or receives compensation or other payments subject to approval, by a person of influence whose compensation is being considered, or (iii) is not considering compensation of a person of influence who in turn will approve a transaction providing economic benefits to the director. The safe harbor requires that those with conflicts of interest, with any arrangement being considered by an authorized body, recuse themselves from the meeting, and not be present during debate and voting on the arrangement except to the extent invited to by the body to answer questions.
Accordingly, it is important for you to know that your compensation committee is composed of directors free of such conflicts of interest and to require recusal from discussion and vote on any compensation arrangement of those having any conflict of interest with respect to such arrangement.
- Appropriate Data of Comparable Peers. The authorized body receives appropriate data as to comparability sufficient to determine whether the compensation arrangement in its entirety is reasonable. The authorized body obtains and relies upon appropriate data as to comparability prior to making its determination. Such data may include compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions; the availability of similar services in the geographic area of the applicable tax-exempt organization; current compensation surveys compiled by independent firms; and actual written offers from similar institutions competing for the services of the disqualified person.
Accordingly, it is important to identify similarly situated organizations as peer organizations in your geographic area and obtain compensation data of functionally comparable positions of those organizations.
- Concurrent Documentation in Minutes or Reports. The authorized body adequately documented the basis for its determination concurrently with making the determination. Documentation generally means the principal terms of any compensation approved, the comparability data that was received and how it was obtained, and the extent of participation of anyone who had a conflict of interest with respect to the compensation being considered. If the authorized body determines that reasonable compensation for a specific arrangement is higher or lower than the range of comparability data obtained, the authorized body must record the basis for its determination. To be concurrent, documentation must be prepared before the next meeting of the authorized body or 60 days after the final action or actions of the authorized body are taken.
Accordingly, it is important for appropriate minutes to be maintained showing the processes followed, reports received, and decisions made by the compensation committee and for those minutes and reports to be retained on your behalf.
Total or Entire Compensation. For the safe harbor or rebuttal presumption, federal tax laws require the authorized body to determine that the amount of entire compensation of a person of influence is comparable to that “ordinarily paid for like services by like enterprises (whether taxable or tax-exempt) under like circumstances.” For this purpose, “entire compensation” includes:
- All forms of cash and noncash compensation, including salary, fees, bonuses, severance payments, and deferred and noncash compensation.
- All other compensatory benefits, whether or not included in gross income for income tax purposes, including payments to welfare benefit plans, such as plans providing medical, dental, life insurance, severance pay, and disability benefits, and both taxable and nontaxable fringe benefits (other than fringe benefits described in Code § 132). Other compensatory benefits include any of the following if not otherwise available to employees who are not management or highly compensated: employer provided housing; educational assistance; health insurance; medical reimbursements; life insurance; disability benefits; long-term care insurance; dependent care assistance; legal or tax assistance; discretionary expense or reimbursement accounts.
Reliance on Professional Advice. Similar to the right of reliance provided by state corporation laws discussed in last month’s article, intermediate sanctions allow reliance upon legal counsel and independent compensation consultants for matters within their professional expertise.
Rebutting the Safe Harbor. The Internal Revenue Service may rebut the safe harbor or rebuttable presumption only if it develops sufficient contrary evidence to rebut the probative value of the comparability data relied upon by the authorized body.
In conclusion, federal tax laws impose an excise tax on managers who approve — and employees and others who receive — excessive compensation from a tax-exempt organization. These taxes can be avoided by complying with the safe harbor described in this article, which results in creating a “rebuttable presumption” under federal tax laws that compensation approved in following the safe harbor is reasonable. Accordingly, it is important for you to know that the board or committee responsible for overseeing compensation is composed of persons free of conflicts of interest.
It is also important for you to know that the board or committee as part of its process has identified similarly situated organizations as peer organizations in your geographic area and obtains compensation data of functionally comparable positions of those organizations. Finally, it is important for you to know appropriate minutes are maintained showing the processes followed, reports received, and decisions made by the board or committee and for those minutes and reports to be retained on your behalf.