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IRS Probes Non-Profit Executive Pay

A new IRS memorandum on excessive pay packages squelches one executive's tax break and sends a signal to other high-paid bosses.
Lisa YoonJanuary 21, 2003

Just when it seems like executive pay policies have taken all the heat they can handle, the Internal Revenue Service aims to fan the fire by stepping up its scrutiny of non-profit executive pay plans.

The IRS recently released a Technical Advice Memoranda (TAM) regarding Section 4958 taxes on excess-benefit transactions at non-profits, and it seems that the agency is playing hardball with overpaid executives.

Excess-benefit transactions are deals in which a non-profit organization pays an executive more than the fair value of his services. (Think of the pre-bust riches of Tammy Faye and Jim Bakker.)

According to a Watson Wyatt review of Section 4958, excess-benefit transactions at 501(c)(3) and 501(c)(4) organizations are subject to exorbitant excise taxes. Specifically, a “disqualified person” (anyone with enough power to influence an organization, such as an insider like the CEO, CFO, or treasurer) who benefits from an inflated compensation agreement must pay a 25 percent tax on the excess benefit. That figure could jump to 200 percent if the non-profit doesn’t pay back the difference in fair-value compensation before the IRS assesses the excise tax.

In addition, executives of the tax-exempt organization who approved the compensation deal pay a 10-percent excise tax.

Not all big-package deals warrant such heavy taxation, however. Under what’s called rebuttable presumption, such contracts are acceptable under three conditions:

  • The deal gets the approval stamp of a responsible committee. The compensation arrangement must be approved in advance by the organization’s compensation committee, which should be composed entirely of disinterested people, such as persons with no conflict of interest as to the compensation arrangement or property transfer.
  • The compensation committee did its homework. The committee must base its approval of the contract on appropriate data—such as surveys and research reports—as to comparability.
  • The committee keeps records. The compensation committee must adequately document the basis for its decision.
  • Given that all three conditions are met, the onus falls on the IRS to prove that the compensation deal was an excess-benefit transaction.

    Apparently, however, the compensation committee of the non-profit hospital addressed in TAM 200244028 satisfied only the first and third rebuttable presumption conditions, failing to show any industry benchmarks or other meaningful data for determining the pay level for the hospital CEO to be reasonable.

    What data the committee was able to produce was late (obtained nine months after the effective date of the executive contract). What’s more, the committee was still relying on the by-then stale data five years later, when the contract was renewed.

    The moral: Like in the corporate arena, executive pay must be justified, muses a Watson Wyatt compensation executive, who points out that “the past years’ focus on corporate governance in the for-profit sector is now encompassing tax-exempt organizations as well.”