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IRS Increases Enforcement Focus on Nonprofit Executive Compensation

February 2007

Note: The following discussion is provided for informational purposes only and is not intended to serve as legal or tax advice. For specific information about compensation practices for exempt organizations, consult your attorney or tax advisor.
The IRS is sending some pretty strong signals these days that it is going to be looking hard at compensation and benefit levels for nonprofit executives. And nonprofits that want to avoid unwanted scrutiny may need to be more familiar with such terms as "disqualified persons," "excess benefit transactions," and "rebuttable presumption of reasonableness."

  • New Form 990 Instructions
    The 2006 instructions require more information to be reported on compensation and who sets compensation. Legislation in 2006 required more stringent definitions of "disqualified persons"—those in a position to exercise substantial influence over an exempt organization—and increased penalties for those who participate in an "excess benefit transaction" (a financial transaction in an amount that exceeds market rate) in violation of the rules. The changes are summarized and the new instructions are available on the IRS Web site (see the links at the end of this article).

  • New IRS List of Good Governance Practices
    A draft list of "Good Governance Practices for 501(c)(3) Organizations" was released by the IRS on February 7, 2007. It stated:
    Charities should generally not compensate persons for service on the board of directors except to reimburse direct expenses of such service. ... Charities may pay reasonable compensation for services provided by officers and staff. In determining reasonable compensation, a charity may wish to rely on the rebuttable presumption test of section 4958 of the Internal Revenue Code and Treasury Regulation section of 53.4958-6.
    You can link to the full draft from the end of this article.

  • IRS Findings of 2006 Executive Compensation Initiative Project
    In 2006, the IRS concluded an Executive Compensation Initiative Project (started in February 2004). In a report just released on Parts I and II of the project, the IRS noted that "Significant reporting issues exist—Over 30% of compliance check recipients amended their Forms 990. Fifteen percent (15%) of the compliance check recipients were selected for examination." The report also states, "Where problems were found, significant dollars are being assessed (25 examinations have resulted in proposed excise tax assessments under Chapter 42, aggregating in excess of $21 million, against 40 disqualified persons or organization managers.)"

    You can link to the full report from the end of this article.

  • IRS Investigation of Nonprofit Hospital Executive Compensation
    In 2006, as part of an investigation into how nonprofit hospitals set and pay compensation to their executives, the IRS sent questionnaires to more than 500 hospitals. In 2007, the IRS plans to evaluate the responses. Next steps could include more written guidance, new examinations, and additional compliance checks. Congressional leaders have also expressed interest in hospital executive compensation, particularly as the debate over medical costs and coverage has intensified.

  • Matching Data Reported to the IRS and SSA
    The 2007 plan for the IRS Exempt Organizations Division also includes a project to ensure that nonprofit organizations report and pay employment taxes properly. Recently, the IRS developed a process to match information reported to the Social Security Administration with IRS data. The IRS will select the targets for examination using a risk-modeling program developed in 2006 that identifies high-risk compliance patterns.

What the IRS Notices on Form 990

The nonprofits that were included in the IRS compliance check were chosen because of omissions on their Forms 990. To avoid making similar mistakes, be sure to answer and include any required schedule or explanation for the following sections of the form:

  • Schedule A, Part III–List transactions between related individuals or leases of property to officers, directors, or shareholders. If there are no such transactions, note, "None."

  • Form 990, Part IV, line 50–List receivables from trustees, officers, directors, and key employees. If there are no such transactions, note, "None."

  • Form 990, Part V-A, column B–Complete for each listed officer, trustee, or key employee, even if they are not compensated.

  • Form 990, Part VI, question 89–Checkbox for "Entered into an excess benefit transaction." Be sure to check "No" if there were no excess benefit transactions.

What a Nonprofit Should Do

To avoid problems with executive compensation, the IRS advises nonprofits to:

  • Set compensation in advance using appropriate comparability data.
  • Make sure that no one involved in setting salaries has a conflict of interest.
  • Document all decisions on compensation.
  • Avoid penalties by reporting all economic benefits to officers, directors, and key employees on Form 990.
Having good compensation practices means having established policies and procedures, doing the homework of finding and assessing comparables, making decisions based upon them, and then recording the actions taken. You are not likely to get in trouble with the IRS if you develop and follow procedures for setting compensation and if you make an honest, responsible effort to determine appropriate compensation based on your size, revenues, organizational structure, and mission. Be sure to:

  • Document the policies and procedures in advance and include them in board minutes.
  • Collect comparable salaries (for like services, in like enterprises, in like circumstances). Surveys and databases of salary information as well as the Form 990 images on the Web make these data more easily available than ever before.
The IRS has actually provided a checklist for organizations that can be used to establish procedures that will help them avoid an IRS investigation. Follow the checklist, and the burden of proof that the organization is breaking the rules moves to the IRS. This checklist can be found at "Compensation Issues for Exempt Organizations," slides 13-19.

To establish a rebuttable presumption of reasonableness (meaning the burden of proof that the compensation is unreasonable is on the IRS), nonprofits should use an independent survey of comparability data. Information and software that easily provide the necessary analyses can be obtained from GuideStar; ERI Economic Research Institute; SalariesReview; Abbott, Langer Association Surveys; and other salary survey sources that specialize in the nonprofit sector.

By obtaining and using appropriate data, nonprofits can set compensation that attracts and retains talented staff and is aligned with organizational missions and values. At the same time, they can ensure that charitable dollars are spent on achieving the mission, not answering questions from the IRS, state charity regulators, and Congress.

More Information

Linda M. Lampkin, ERI Economic Research Institute
© 2007, ERI EconomicResearch Institute

Linda M. Lampkin is research director of ERI Economic Research Institute, a company that provides Form 990 compensation data for use by nonprofits, and former director of the National Center for Charitable Statistics at the Urban Institute. She can be reached at linda.lampkin@erieri.com or (877) 799-3428.