The IRS has recently stepped up scrutiny of the compensation paid to key employees and insiders of tax-exempt organizations and has the authority to levy significant excise tax penalties if it finds that an organization pays excessive compensation. As a result, it is critical that boards of directors fully comply with the complex set of rules under Section 4958 of the Internal Revenue Code (the “Code”) to avoid these penalties. One of the most challenging aspects of these rules is to identify and value the total compensation paid to the organization’s key employees and determine that such compensation is reasonable and appropriate. The employee benefits provided to such individuals can be an important part of this compensation analysis and should not be overlooked.
During the early 1990s, Congress was concerned that there was potential for key employees to receive unreasonable amounts of compensation from tax-exempt organizations. At that time, the only sanction available was for the IRS to revoke the organization’s tax-exempt status. In 1996, Congress significantly changed the laws with respect to tax-exempt organizations by adding Section 4958 to the Code. Under these new rules, the IRS could penalize key employees and boards of directors of a tax-exempt organization rather than penalizing the tax-exempt organization itself. Specifically, when a tax-exempt organization fails to comply with Code Section 4958, the IRS may levy a 10% excise tax on the board members of the tax-exempt organization and a 25% excise tax on the key employee receiving the excess benefits (increasing to a 200% excise tax if a correction of the transaction is not made within a specified period of time).
In January 2002, final regulations to Section 4958 were issued. The regulations permit a tax-exempt organization to establish a presumption that the compensation to be paid to a disqualified individual is reasonable. Disqualified individuals are the key employees or individuals who were, at any time during the past five years, or are currently “in a position to exercise substantial influence” over the affairs of the tax-exempt organization. Reasonable compensation is defined as the value that would ordinarily be paid for like services by like enterprises under like circumstances. To determine the reasonableness of compensation, all forms and items of compensation must be taken into account, including: (i) all forms of cash and non-cash compensation, including salary, fees, bonuses, severance payments and deferred compensation; and (ii) all taxable and nontaxable employee benefits (excluding working condition fringe benefits under Code Section 132).
The regulations permit a tax-exempt organization that is subject to Section 4958 to establish a presumption that the compensation to be paid to the disqualified individual is reasonable. To establish the presumption, the board of directors of the tax-exempt organization must obtain comparable market data regarding key employee compensation and come to the conclusion that in light of the comparable market data and the duties and responsibilities of disqualified person, the proposed total compensation that is to be paid to the key employee is reasonable.
While it is relatively easy for purposes of this analysis to identify and value items of cash compensation, it is a little more complex and difficult to identify and value non-cash or employee benefits. The following is a brief summary of non-cash or employee benefits that should be included in this analysis for determining whether the compensation is reasonable.
- 403(b) Retirement Plans. Most tax-exempt organizations allow their employees, including key employees, to participate in a 403(b) retirement plan. For purposes of the analysis, the organization should determine the amount of matching contributions and/or employer contributions that are made on behalf of the key employee. In general, the yearly amount of these contributions can range from zero to 10% of the key employee’s W-2 compensation.
- Supplemental Retirement Plans. Many tax-exempt organizations provide their key employees with some form of supplemental retirement or deferred compensation plan. These plans are governed by Code Sections 409A and 457(f) and are fully taxable when the amounts vest under the plan. In general, these plans are designed as a form of “golden handcuff” arrangement where the key employee receives payment upon continued employment for a set number of years. The amounts payable under these plans can range anywhere from $10,000 to $300,000 depending the tax-exempt organization. The present value of the amounts payable under any supplemental plan should be included in the compensation analysis.
- Incentive Bonuses. Most tax-exempt organizations provide key employees with some type of incentive bonus compensation that is paid out in the event certain incentive targets are met. For example, the payouts may be triggered upon reaching the NCAA basketball tournament (for coaches), meeting alumni donations goals (for university presidents) or for overseeing the successful completion of a new hospital wing (for hospital key employees). Similar to the supplemental retirement plans, these arrangements are considered deferred compensation and are governed by the rules of Code Sections 409A and 457(f). The amounts payable under these arrangements are taxed at the time they vest. The present value of these amounts should be included in the compensation analysis. However, the present value should take into consideration the likelihood of the amounts actually being paid to the key employee.
- Whole Life Insurance. Many tax-exempt organizations provide key employees with whole life insurance. The level of whole life insurance provided to key employees generally exceeds the levels of whole life insurance provided to rank and file employees. The value of the whole life insurance, as well as the additional value for the additional incremental insurance, should be included in the compensation analysis.
- Health and Welfare Benefits. Health and welfare benefits are generally provided to all employees of a tax-exempt organization. However, some tax-exempt entities provide additional health benefits to their key employees. The value of the health and welfare benefits and the incremental value of the additional benefits should be included in the compensation analysis.
- Vacation. Most key employees receive vacation or leave over and above what the organization pays to its rank and file employees. Some tax-exempt universities provide key employees with paid sabbaticals. Any vacation or leave available to the key employee should be valued and included in the compensation analysis.
- Automobile Expenses. Many tax-exempt organizations provide key employees with automobiles and reimbursement for automobile expenses such as parking, maintenance, DMV expenses, insurance costs and/or garage expenses. These costs should all be factored into the compensation analysis.
- Housing. Some tax-exempt entities offer housing to their key employees. Usually, the tax-exempt entity pays for all of the associated utility expenses. For example, many tax exempt universities require that their university presidents reside in housing chosen by the university. In connection with the housing benefit, tax-exempt entities may also provide a stipend for redecorating and reimbursement for the expenses associated with moving into the house. All housing and related expenses should be factored into the compensation analysis.
- Club/Society Dues. Many tax-exempt entities reimburse their key employees for the expenses associated with professional society dues and membership to at least one social club. The social club expenses are generally deemed appropriate and necessary for fundraising and networking purposes.
- Spousal Travel. Some tax-exempt employers reimburse key employees for spousal travel expenses. While extremely difficult to value, an attempt should be made to include these costs in the compensation analysis.
The enactment of Code Section 4958 was one of the most important changes in the federal income tax law relating to tax-exempt organizations in the last 40 years. The purpose of Code Section 4958 is to impose sanctions on the influential persons in charities and social welfare organizations who receive excessive economic benefits from the organization, rather than to punish the exempt organization itself. With the heighted IRS scrutiny in this area, it is very important that tax-exempt organizations comply with these rules and determine that the total compensation, including benefits and non-cash compensation, paid to disqualified persons is reasonable to avoid any excise tax penalties.