BE AWARE OF REASONABLENESS OF COMPENSATION RULES
The Internal Revenue Service has specific rules for compliance under the Intermediate Sanctions ruling (IRC Section 4958) regarding reasonableness of compensation. These rules apply to nonprofits that take donations in all sectors of the economy. These organizations should periodically review the compensation levels for their most senior executives (“disqualified persons” as specified in IRC Section 4958). The IRS acknowledges broad compliance with the Intermediate Sanctions regulations. However, all nonprofits should be aware of these rules and how to comply with them.
REASONABLENESS OF COMPENSATION FOR SENIOR EXECUTIVES
For purposes of determining the reasonableness of compensation of senior executives who have a material impact on the nonprofit institution, the Internal Revenue Service has determined that, in the absence of a formal audit, an organization may achieve a “rebuttable presumption of reasonableness” if it meets three pre-established criteria:
- The organization must have an independent committee of the Board of Directors comprised of “disinterested” individuals approve the actual pay levels of the executives;
- The organization must rely on comparability data (compensation and benefits) applicable to the executives; and
- The organization must document, the results of the comparability study, any inference regarding adjustment of pay for executives and the decision of the Board of Directors to approve any adjustment of the executives’ compensation levels.
A more tailored methodology
IRC Section 4958 establishes a general approach in the three steps above. However, the comparability study requires a more tailored methodology for determining the reasonableness of compensation including:
- A compilation of data from actual peer organizations that meet specific criteria
- Comparable industry types of nonprofit organizations;
- Similarly sized nonprofit organizations;
- Organizations in the same geographic location; and
- Organizations in related industries that compete for executive talent.
- A review of the role of each disqualified senior executive in the nonprofit including an assessment of the duties and responsibilities of the executive.
- A report on the comparability of the following compensation elements:
- Base Salary,
- Incentive pay (short-term bonuses),
- Benefits plans, and
The Board of Directors, through its Compensation Committee, determines the appropriate compensation levels for these positions based on this review of the competitive labor market as well as executive performance.
When this procedure is applied, tax exempt organizations can use the three steps above to justify their total remuneration policies and help avoid assertions of excessive compensation and benefits for the nonprofit’s senior executives.
Third party objectivity
A third-party, objective consulting group can assist the Board of Directors of a nonprofit by completing a comparability study from a totally independent perspective. The approach that this third party can offer includes:
- Using a comprehensive survey or surveys of the nonprofit’s industry group to determine competitive levels of salary, bonus or incentives, benefits, and perquisites for the senior executives; and
- Using a comprehensive analysis on specific peer organizations (similar industry, size and scope of operations) to establish a rebuttable presumption of reasonableness for the nonprofit organization and its most senior executives.
For a complete copy of the recent IRS reports concerning this ruling, please visit:
https://www.irs.gov/pub/irs-tege/exec._comp._final.pdf or https://www.irs.gov/charities/charitable/article/0,,id=123301,00.html