December 3, 2015
Determining the amount to compensate top leaders in a tax-exempt organization can be a daunting task, considering that tax-exempt and for-profit organizations compete in the talent pool.
Although there are measures of a tax-exempt leader’s effectiveness, a commonly used measure on the profit side is not available in a tax-exempt situation. That measure, of course, is profitability, or increase in shareholder wealth.
Pay too little and the top talent will not be attracted to the organization. Pay too much and the organization may receive bad publicity, lose focus on the purpose of the organization or incur the attention of the Internal Revenue Service.
Despite the fact that a tax-exempt organization does not pay taxes to the IRS, it must nevertheless file an annual tax return, Form 990. This return is informational in nature, revealing information about the income and expenditures of the organization, in addition to providing information about aspects of the operations of the organization.
One informational section included on the return is compensation paid to current officers, trustees and directors, regardless of the amount of compensation, and the five highest compensated employees (other than officers, trustees and directors) receiving compensation in excess of $100,000 from the organization and related organizations. In addition, the organization must disclose the compensation of all former officers, key employees and highest compensated employees receiving more than $100,000 of compensation in the current year and any former officers and directors receiving more than $10,000 in compensation.
Federal law prohibits tax-exempt organizations from paying excessive compensation. It defines compensation by addressing reasonableness of salary plus all benefits, whether taxable or not. Furthermore, reasonable compensation is defined as the amount that would ordinarily be paid for like services by like organizations (taxable or tax-exempt) under like circumstances.
If a leader receives excessive compensation, the leader must repay the excessive compensation to the organization with interest. Failure to repay any portion of the excess will result in a penalty of 200 percent of the amount not repaid. The IRS also may levy a fine of 25 percent of the overpayment.
But federal law goes further than requiring repayment by the executive receiving the excess compensation. It may require each board member approving the excess compensation to pay a fine of 10 percent of the excessive compensation, not to exceed a $20,000 fine. In extreme cases, the organization may lose its tax-exempt status.
So, how does an organization take steps to help assure that it can support a presumption of reasonableness? After all, reasonableness is often in the eye of the beholder.
Four principles have been enumerated that may help support reasonableness in compensation.
1. Select members who are independent of the organization for the governing body or committee setting compensation.
2. Obtain valid comparable data. Be able to cite similar organizations and the compensation paid to their leaders.
3. Create and maintain contemporaneous documentation of the process involved in setting the compensation for leaders.
4. Have an official compensation policy. The Evangelical Council on Financial Accountability (ECFA) has issued its Statement 6, which can be used to craft a valid compensation policy.
Unreasonable compensation is currently an area of IRS focus. Therefore, it is imperative that the organization not just have reasonable compensation for its leaders but be certain that the compensation and benefits are completely and accurately reported on Form 990 and Forms W-2, as applicable.
Recall that the definition of compensation in these instances includes not just salary and taxable benefits but nontaxable benefits as well. Part VII of Form 990 asks for reportable compensation from the organization (W-2 or 1099-MISC), reportable compensation from related organizations and an “estimated amount of other compensation from the organization and related organizations.”
Do not let the word “estimated” lull you into a false sense of security because the IRS will not accept just a random number entered into this column. There must be some justification for the number shown.
Setting proper compensation is a balancing act, riddled with consequences from paying leaders too little or from overcompensating them. To maintain an effective organization, leaders should be well-compensated but not to the extent that there is a risk of overcompensation. A deliberate, documented process following recommended guidelines will help an organization avoid such pitfalls.
This article was originally posted on December 3, 2015 and the information may no longer be current. For questions, please contact GRF CPAs & Advisors at firstname.lastname@example.org.