Compensation for executives of tax-exempt charitable organizations is subject to strict rules and limitations under federal and state law. I note the key considerations in advising charitable organizations and their boards.
Total compensation must be reasonable under federal law such that the organization complies with the private inurement doctrine.
A 501(c)(3) organization must be organized and operated so that no part of its net earnings inures to the benefit of any private shareholder or individual. It has long been held by the federal courts that “the payment of reasonable salaries by an allegedly tax-exempt organization does not result in the inurement of net earnings to the benefit of private individuals.”[1]
Assessing the reasonableness of compensation is largely a market driven analysis.
An executive’s compensation is properly compared to individuals in similar positions at organizations of a similar size, in the same or a comparable geographical area, performing similar services. The experience, expertise, and accomplishments of the individual are also taken into consideration. It is appropriate to hire a qualified independent consultant to conduct a market analysis to ensure that compensation is reasonable.
The total compensation of an executive, and not merely the base salary or cash compensation, must be considered in determining whether compensation is reasonable.
All compensation and benefits, including bonuses, deferred compensation, pension payments, and other perks not provided for legitimate business purposes are to be considered in calculating the total compensation at issue.
In the event that an executive is paid severance upon termination, any severance payments must be reasonable to assure compliance with applicable laws.
The payment of excessive severance can itself be deemed excess compensation in violation of state and federal laws. An exception, for example, might be in connection with the reasonable settlement of a claim against the organization for improper termination.
Entering into a formal written contract with a senior executive can be advantageous for both the organization and the executive to ensure compliance with the laws governing executive compensation.
Such a contract should set forth the duties and responsibilities of the executive, and thereby set standards for evaluating the executive. It should also establish appropriate severance in the event of termination without cause.
Board members of charitable organizations in the various states have a fiduciary duty to preserve the organizations’ charitable assets, to supervise and oversee the administration of the organization’s’ assets, and to establish mechanisms designed to protect against the squandering or misuse of such assets.
This includes the authorization and payment of reasonable compensation and benefits to executives, and establishing mechanisms and internal controls to protect the organization’s expenditures. Some states have specific laws requiring that compensation be reasonable.
The federal “intermediate sanctions” law, enacted by Congress in 1996, permits the IRS to impose excise tax penalties on charities executives who receive excess compensation (an “excess benefit transaction”) and on an organization manager or other person who is in a position to exercise substantial influence over the affairs of the organization.[2]
In addition to paying a 25% excise tax on any excess compensation received, the executive must also make a correction and return the excess amount to the organization or face a confiscatory second tier tax. The executive can be assessed the tax even if he or she acted in good faith and without knowledge that the compensation was excessive.
An organization manager can be assessed an excise tax only when he or she participated in an excess benefit transaction “knowing that it is such a transaction, … unless such participation is not willful and is due to reasonable cause.”
If a board member or other organization manager has relied in good faith on professional advice that the compensation paid is reasonable, this would provide a strong defense against any IRS claim that excise taxes should be imposed.
It is significant to note that, under formal IRS rules, an executive is entitled to a rebuttable presumption that his or her compensation is reasonable if a three-step test has been satisfied.
First Requirement: Compensation Fixed by An Independent Board
Board members must act independently and at arm’s length, and relatives and business associates of an executive should be excluded from any participation in fixing such individual’s compensation and benefits.
Second Requirement: Reliance on Appropriate Data as to Comparability
The IRS Regulations specify that the relevant information upon which the authorized body may rely “includes, but is not limited to, 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.”
Third Requirement: Adequately Document Basis for Determination of Compensation
The board of a charity should, through formal board minutes, a written employment contract, an independent compensation survey, and/or other relevant documentation demonstrate the basis for the compensation paid.
Improper excess benefits can be quite varied.
Areas which might be scrutinized by government regulators could include: purchases or leases of automobiles; payments of country-club dues; use of apartments, interest-free loans; travel expenses; use of charity credit cards without documentation; and blanket amounts to spend on expenses.
Summary: General Considerations in Fixing Compensation
- Decisions should be made by an independent board of directors at arm’s length.
- There should be Board minutes and/or other documents reflecting the criteria and basis for fixing compensation.
- Total compensation should reflect the fair market value of the executive’s services.
- Where appropriate, there should be reliance on an independent compensation survey.
