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
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