The IRS is expected to soon release a second, more in-depth report on executive compensation practices by tax-exempt hospitals as a follow-up to its interim report released in July 2007. The new report is expected to highlight two key areas: (1) high compensation paid by hospitals, and (2) a reliance on the “rebuttable presumption” standard to avoid penalties for “excess benefit transactions.”
Section 4958 of the Internal Revenue Code generally provides that that an excess benefit transaction occurs when a tax-exempt organization pays a disqualified person more than what is considered reasonable compensation. In general, a “disqualified person” is an individual who can exercise substantial influence over the affairs of the tax-exempt entity, such as key executive officers. The IRS can assess the disqualified person with an excise tax equal to 25 percent of the amount of excess benefit, and if not corrected within the taxable period, an additional excise tax of 200 percent of the excess benefit. Additionally, managers within the organization who knowingly participate in the excess benefit transaction are subject to an excise tax equal to 10 percent of the excess benefit, unless their participation was not willful and was due to reasonable cause.
A tax-exempt entity may create a rebuttable presumption that the amount of compensation it pays is reasonable, and therefore not considered an excess benefit, when three conditions are met:
- The compensation arrangement is reviewed and approved by the organization’s disinterested and authorized governing body;
- The authorized body determines the reasonableness of compensation using and relying upon appropriate comparability data, such as similarly situated tax-exempt and for-profit organizations, functionally comparable positions, and compensation surveys compiled by independent firms; and
- The authorized body adequately and concurrently documents the basis for its determination.
While the IRS does not have any current plans for changing these requirements, the study will likely lead to additional scrutiny and questions regarding the adequacy of existing guidelines for tax-exempt compensation practices. The upcoming report is part of an ongoing focus on governance practices of tax-exempt organizations, including the revised Form 990 and questionnaire sent to over 400 colleges and universities to further study executive compensation.