EXECUTIVE COMPENSATION
INTERMEDIATE SANCTIONS COMPENSATION CONSULTING
WAGE & SALARY ADMINISTRATION
PERFORMANCE APPRAISAL PROGRAMS
EMPLOYEE BENEFIT ANALYSIS
ORGANIZATION DEVELOPMENT
TRAINING & DEVELOPMENT

On September 8, 2005, the IRS released a set of Proposed Regulations that established the standards the IRS proposes to use to determine whether to revoke the 501(c)(3) status of an organization that has engaged in a transaction that constitutes both private inurement and an excess benefit transaction. Under these Proposed Regulations, organizations that attempt in good faith to follow corporate governance and compliance practices both before and after a private enurement problem occurs, will be able to maintain their tax-exempt status.

Internal Revenue Code 501(c)(3) provides for a tax exemption only if “no part of the net earnings of the organization inure to the benefit of any disqualified person.” An “excess benefit transaction” may include any transaction with a disqualified person where the value of the economic benefit provided to the disqualified person exceeds the value provided (including the performance of services) received from the disqualified person. Further, in many cases, the provision will apply to payments of unreasonable compensation.

The term “disqualified person” includes those persons who were (within a period of five years ending on the date of a given transaction) “in a position to exercise substantial influence over the affairs of the organization.” Such persons would include presidents, chief executive officers, or chief operating officers, as well as any person who, regardless of title, has ultimate responsibility for implementing the decisions of the governing body or for supervising the management, administration, or operation of the organization.

The Internal Revenue Service issued final regulations under Section 4958 of the Internal Revenue Code referred to as the “Intermediate Sanctions” provisions. These regulations are potentially applicable to organizations that must make annual determinations regarding the “reasonableness” of compensation paid to the organization’s managers and administrators. Perhaps the best feature of the final regulations involves the possibility of an organization to create a “rebuttable presumption” that a compensation arrangement is, in fact, reasonable. Thus, if an organization can demonstrate that it exercised care and prudence in the decision making process relating to a transaction with a disqualified person, then the IRS bears the burden of showing that the transaction is unreasonable. The final regulations created a rebuttable presumption that compensation is reasonable (and not an excess benefit transaction) where:

• The compensation arrangement or the terms of the property transfer are provided in advance by an authorized body (usually the Board of Directors, or a designated Committee thereof) of the applicable tax-exempt organization. The authorized body, must be composed entirely of individuals who do not have a conflict of interest with respect to the compensation;

• The authorized body obtained and relied upon “appropriate data” as to comparability prior to making its final decisions. Such data may include compensation levels paid by similar types of organizations providing similar types of services, current compensation surveys by independent firms, and written offers from similar institutions competing for the services of the disqualified person. “Small” organizations (defined as those with annual gross receipts of less than $1 million) will be considered to have appropriate data if it has data on compensation paid by three comparable organizations in the same or similar communities for similar types of services; and 

• The authorized body adequately documented the basis for its decision concurrently with making the decision.

The documentation by the authorized body must contain:

• The terms of any approved transaction and the date of approval;

• The names of the members of the decision making body who were present during discussions and/or debate on the transaction that was approved and the name of those who voted on the transaction;

• The comparability data that was relied on by the authorized body; and a description of how the data was obtained; and

• A description of any actions by a member of the authorized body having a conflict of interest.

The documentation must be prepared before the later of the next meeting of the authorized body, or 60 days after the final actions of the authorized body. Further, the authorized body must approve the documentation within a reasonable time after preparation.

A disqualified person’s compensation may change annually. If so, and an organization wants to establish a rebuttable presumption for those years, it needs to follow the above procedures annually. For disqualified persons with fixed multi-year contracts, the procedures would only have to be adhered to again when there is a material change or a new contract. Annual cost-of-living increases, based on government cost-of-living figures, would not necessitate a new procedure.

If an organization follows the types of procedures identified above, with respect to each disqualified person, then the organization would be entitled to a rebuttable presumption that the compensation provided is reasonable. The Internal Revenue Service would not ordinarily challenge apparently appropriate and relevant compensation data with its own data and may only rebut the presumption if it develops sufficient contrary evidence to rebut the probative value of an organization’s supporting compensation data.

Dean Group Consulting is not a law firm and thus cannot provide legal advice. For such legal advice on this written paper and on Section 4958 of the Internal Revenue Code or other legal matters, Dean Group Consulting recommends that organizations consult with their respective legal counsel.

Dean Group Consulting can however, provide compensation consulting services and can work with the Board of Directors or a designated Committee thereof to gather appropriate comparable compensation data to help ensure the proper balance and reasonableness of executive compensation for nonprofit organizations. The types of deliverables we can provide include:

• Preparing a comprehensive executive compensation report focusing on all elements of executive compensation including: base salary, short-term incentives, executive perquisites, supplemental executive benefits, and long-term incentives;

• Working with members of the Board of Directors or a designated Committee thereof to develop a statement of executive compensation philosophy;

• Working with members of the Board of Directors or a designated Committee to develop an Executive Compensation Policy Guide outlining Board and/or Committee responsibilities and procedures.