Using the Initial Contract Exemption in Setting Executive Compensation

July 8, 2009

In response to questions from Congress, the Internal Revenue Service is taking a closer look at tax-exempt organizations’ use of the initial contract exception to set compensation levels for their senior executives. Under current regulations, tax-exempt organizations often use compensation information from comparable nonprofit and for-profit organizations to establish a rebuttable presumption that compensation to their executive employees is reasonable.

This presumption allows tax-exempt organizations to avoid penalties if the IRS later determines that the compensation paid to their top executives is excessive. However, the initial contract exception generally allows tax-exempt organizations to avoid the application of these rules and the related potential penalties in the case of a first contract with a prospective hire.

In order for the IRS to consider third-party salary information comparable, so that tax-exempt organizations can establish the reasonableness of compensation paid to their executives, tax-exempt organizations must use information from similar organizations whose executives have similar duties. However, the IRS is concerned that tax-exempt organizations are using comparable information from third-party organizations that set their executive salaries using the initial contract exception to avoid the rules requiring compensation to be reasonable.

The IRS believes that when tax-exempt organizations do so, the salaries based on the initial contract exception improperly skew the comparable information. The IRS also questions the propriety of tax-exempt organizations using comparable salary information from for-profit organizations, rather than only comparable salary information from nonprofit organizations, when determining the reasonability of executive compensation.

The IRS initially raised these concerns in the context of hospitals when it released its tax-exempt hospital study in February 2009. The report’s discussion of executive compensation indicated that although hospital executive salaries were high, they were nonetheless based on the procedures allowed by the current regulations. Recent Congressional inquiries led the IRS to announce this new look at the initial contract exception.

In addition, IRS Director of Exempt Organizations Lois Lerner has indicated that she expects that the IRS will obtain additional information about compensation levels and whether they are reasonable as a result of new questions on the redesigned Form 990, which includes questions relating to the initial contract exception.

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