|EXECUTIVE SUMMARY |
Intermediate sanctions impose a penalty tax on key employees of certain tax-exempt organizations who receive unreasonable compensation, and on managers who approve it knowingly.
Intermediate sanction regulations provide a framework of appropriate policies and procedures regarding compensation for tax-exempt organizations.
Intermediate sanction rules require organizations to publicly disclose on Form 990 that intermediate sanctions have been imposed.
The amount of required disclosure continues to grow. Changes to Form 990 in recent years have generated additional reporting requirements and a redesigned form has been proposed by the IRS that it expects to use for the 2008 tax year.
Related-party transactions must be disclosed on Form 990 and explain existing relationships between officers, directors, trustees, key employees, highest-paid employees, and highest-paid professional or other independent contractors of certain tax-exempt organizations.
A recent IRS study of Form 990 compliance resulted in the proposal of millions of dollars in intermediate sanctions. Gwen Spencer, CPA, J.D., LL.M., is a director in the Exempt Organizations Tax Services practice of PricewaterhouseCoopers’ Washington National Tax Services. Her e-mail is firstname.lastname@example.org.
I n recent years public companies became subject to rules requiring a heightened level of disclosure on executive compensation and related-party transactions. The tax-exempt sector, on the other hand, has had extensive experience with similar reporting requirements for many years, and the disclosure requirements are still evolving. Compliance in this area became important for certain tax-exempt organizations in the mid-1990s when intermediate sanctions were introduced to impose penalty taxes on key employees who receive unreasonable compensation and managers who knowingly approve it.
This article discusses the intermediate sanctions framework in relation to tax-exempt organizations, disclosure requirements for compensation and related-party transactions, and best practices on processes and procedures for compensation, expense reporting and related-party transactions.
INTERMEDIATE SANCTIONS AND FORM 990 Internal Revenue Code § 4958 and accompanying Treasury Regulations are the foundation for intermediate sanctions.
Intermediate sanction regulations provide a blueprint of appropriate policies and procedures regarding compensation for certain tax-exempt organizations as described in IRC § 501(c)(3) or social welfare organizations described in section 501(c)(4). Intermediate sanctions do not apply to private foundations because they are subject to a different excise tax regime for similar transactions.
For tax-exempt organizations, all forms of compensation and benefits, including deferred compensation and some related-party transactions, must be disclosed annually to the IRS and the public on Form 990, Return of Organization Exempt From Income Tax. In addition to penalizing key individuals who receive unreasonable compensation and those who approve it, these rules require organizations to publicize on Form 990 that intermediate sanctions have been imposed. The public disclosure of sanctions can be embarrassing for an organization and its leadership.
Congress enacted intermediate sanctions to give the IRS more flexibility in addressing situations involving excess benefits. Before intermediate sanctions were enacted, the only action the IRS could take against a tax-exempt organization or certain employees who received unreasonable compensation was to revoke the organization’s tax-exempt status. In most cases, this sanction was considered too far-reaching.
Under the intermediate sanctions rules, if a key employee (also referred to as a disqualified person) of a tax-exempt organization receives a benefit that exceeds the fair market value of the services performed, that employee must repay the excess benefit to the organization with interest and pay a penalty tax of 25% of the excess over fair market value. Key employees include the president, CEO, COO, CFO, voting board members and managers (officer, director or trustee of an organization or any individual having similar responsibilities of an officer, director or trustee).
If the excess benefit is not repaid, the employee must also pay a penalty of 200% of the excess over fair market value. Any manager who approves the payment of an excess benefit is subject to a penalty tax of 10% of the excess over fair market value, capped at $20,000.
Intermediate sanction regulations guide tax-exempt organizations on how to support reasonable compensation through process and documentation. Organizations that choose to establish what is known as a rebuttable presumption of reasonableness can shift the burden of proving that compensation is unreasonable to the IRS by securing board approval, using comparables and retaining detailed documentation. If an organization does not establish a presumption of reasonableness and the IRS questions compensation paid to key employees, the burden is on the organization to prove that the compensation is reasonable. Although many organizations choose to establish the presumption to shift the burden to the IRS, they also establish the presumption because the procedures involved in doing so are considered good business practice.
Any value provided to key employees that is not considered when establishing
the presumption may be deemed an automatic excess benefit subject to intermediate sanctions, regardless of whether the total compensation, including personal
expenditures, is reasonable. Benefits such as child care, use of automobiles, and special tuition arrangements, where the business purpose is not documented, are considered compensation.
PUBLIC DISCLOSURE OF COMPENSATION AND RELATED-PARTY TRANSACTIONS
Compensation and Benefits. Form 990 requires the disclosure of all compensation and benefits paid to a tax-exempt organization’s current and former officers, directors and key employees. Certain organizations must also report all compensation and benefits rewarded to the top five highest-paid employees other than the individuals listed above.
Compensation includes salary, fees, bonuses, severance payments, and deferred compensation both in the year promised (whether or not funded or vested) and in the year paid, as well as payments to welfare benefit plans (such as medical, dental, life insurance and disability) on behalf of the individual. Tax-exempt organizations must disclose as compensation the value associated with personal use of the organization’s property, such as housing. They must provide details of any loan arrangements with current and former officers, directors, trustees, key employees and non-key employees, vendors, suppliers and independent contractors.
Form 990 also calls for the disclosure of compensation and benefits paid to officers, directors and key employees by related organizations. This requirement is intended to prevent an organization from paying one individual from several controlled organizations without disclosure. Certain tax-exempt organizations must disclose fees paid to their top five professional service providers, such as lawyers, accountants, architects and doctors, and the five highest-paid providers of non-professional services
Expense Reporting. Expense reporting is another area of focus, both by the IRS and the public. Several prominent charities have drawn media attention in the past few years because of their executives’ spending practices. This can be a sensitive area to navigate. Nonetheless, organizations that want to avoid intermediate sanctions must fill out expense reports and other documentation properly.
Related-Party Transactions. Related-party transactions must be disclosed on Form 990 and reveal whether any officers, directors, trustees, key employees, highest-paid employees, and highest-paid professional and other independent contractors are related to each other through family or business relationships. If such a relationship exists, the organization must attach a statement that identifies the individuals and explains the relationships.
Certain organizations must disclose whether they are engaged, either directly or indirectly, in transactions with any substantial contributors (someone who has given, in aggregate, more than 2% of the total contributions an organization has received since its inception), trustees, directors, officers, key employees or their family members, or with any taxable organization with which any of these individuals are affiliated as an officer, director, trustee, majority owner or principal beneficiary. Transactions of interest include the sale, exchange or lease of property; lending of money or other extensions of credit; furnishing of goods, services or facilities; payment of compensation; and transfer of any part of the organization’s income or assets.
Changes to Form 990
The IRS recently released a proposed redesigned Form 990 for public comment. With a goal of increasing transparency, the form expands disclosures on compensation, benefits and expenses. The IRS expects to use the redesigned form for the 2008 tax year.
It is difficult to go more than a few weeks without seeing a news report or reading an article about issues associated with executive compensation or related-party transactions in the for-profit or not-for-profit world. The government and the public want transparency and an understanding of whether compensation is fair.
Below are suggested best practices for tax-exempt compensation and expense reporting matters. These practices are similar to those of public companies.
Best Practices for Compensation:
Develop a formal process to determine executive compensation.
Establish a rebuttable presumption of reasonableness and include the following in the company’s compensation review of key employees:
- Board approval. The organization’s governing board or an appropriate committee should review and approve all compensation and benefits awarded to key employees. Members of the governing board and the committees who determine compensation must not have a conflict of interest.
- Use of comparables. The governing board must rely on appropriate data in deciding whether to approve the compensation. Appropriate comparables depend on the organization’s size and complexity. Relevant compensation comparables include compensation levels paid by similarly situated organizations, both taxable and tax-exempt. Larger organizations routinely obtain compensation studies from companies that compile this data. Smaller organizations may look at Forms 990 from comparable organizations to obtain compensation data.
- Documentation. The governing board must document its actions thoroughly and contemporaneously.
Review annually the special deferred compensation arrangements of key employees to determine whether income tax reporting and disclosure are complete and accurate.
Best Practices for Expense Reporting:
Review current expense reporting policies and procedures for key employees.
Accountable plan rules. Require key employees to follow IRS “accountable plan” rules. (Use of “listed property” including automobiles and electronic devices may require additional documentation.)
Approvals. Require a sign-off and review of expense reports submitted by senior management. For example, have the CFO, rather than the president’s assistant, sign off on the president’s report and have the chairman of the board or an appropriate committee periodically review for reasonableness the overall expense level incurred by senior management.
Best Practices for Related-Party Transactions:
Procedures. Have procedures in place to ensure that transactions with related parties are approved, documented and disclosed.
Decision making. A related party should not participate in an organization’s decision to enter into the transaction. Document non-participation of a related party in the decision process in meeting records.
Conflict-of-interest rules. Circulate a conflict-of-interest statement and questionnaire to all officers, directors and key employees annually. Questionnaires should be completed, signed and returned. Organizations should review the questionnaires to identify conflicts that may require disclosure in tax filings. Key employees should review the disclosures to confirm they are complete.
Recent IRS Compliance Check Findings
In March, the IRS published the results of its 2004 compliance check of tax-exempt organizations. The project’s intent was to review compensation practices of exempt organizations and to identify areas of concern or abuse, also referred to as “excess benefit transactions.” Missing information on Forms 990 resulted in the closer examination of hundreds of tax-exempt organizations. While the overall findings have indicated general compliance, some of the cases are still being investigated. In addition, where reporting errors and omissions were discovered, millions of dollars in excise taxes, or intermediate sanctions, have been proposed.