“Reasonable Compensation”: Lessons From IRS’ 2013 College and University Report

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Last week, the IRS released its final 37-page compensation report (“Report”), based on its five-year compliance review of 400 randomly selected colleges and universities.   The Report reflects the IRS’ increasing willingness to scrutinize public charities, particularly their comparability data used to set executive compensation.  Consequently, even though colleges and hospitals generally represent the largest and most complex of tax-exempt organizations under IRC Section 501(c)(3), the legal compliance concerns raised are worth a careful review by all tax-exempt public charities with employees.

IRC Section 4958 requires public charities to pay no more than reasonable compensation to their officers, directors, trustees, and key employees.  In the event an organization provides unreasonable compensation, significant excise taxes can be imposed on the recipients of the compensation and potentially on the board members and others who approved it.

What is reasonable or unreasonable compensation? Section 4958 provides a “safe harbor” margin for organizations that follow a three-step process:

  1. Use an independent body to review and determine the compensation
  2. Rely on appropriate comparability data to set compensation; and
  3. Contemporaneously document this compensation analysis and determination.

While Steps 1 and 3 of this process are fairly easy to satisfy, finding and relying on “appropriate comparability data” now appears to make this safe harbor elusive in actual practice. 

As the Report demonstrates, if the IRS’ technicians determine that the comparability data used is not sufficiently “appropriate,” a public charity will face an uphill battle to prove otherwise.   More specifically, the IRS Report (on page 22) strongly implies that having just one “non-comparable” factor out of several may render the entire comparability conclusion questionable.  These factors are location, endowment size, revenues, total net assets, number of students, and selectivity.  The IRS’ conclusion seems illogical, however, since it is generally unlikely - if not impossible - to make exact comparability matches for many organizations. Click here for a copy of the IRS’ Report.

So what’s a responsible nonprofit to do?  Here are some take-aways from the Report:

  1. The more modest the wages, the less a nonprofit’s leaders need to be concerned.
  2. If the reasonableness of compensation is at all in question, then a responsible nonprofit should undertake due diligence on market rates.  This can be accomplished through contacting similar organizations informally as well as researching compensation through www.guidestar.org, which is a website that provides compensation data from publicly available IRS Form 990 information returns.  Make sure to document not only the comparable institutions and positions were used, but also why they were selected as “appropriate.”
  3. It may be prudent to hire a specialist as part of a nonprofit’s due diligence.  Get one with a strong reputation who actually does a good job.  Don’t be fooled into believing that simply hiring an outside company will satisfy the IRS test.
  4. Make sure to follow the other steps of the safe harbor process, carefully avoiding conflictsof interest and documenting the compensation analysis and decision.

What’s the bottom line?  Follow the safe harbor process scrupulously, going above and beyond to obtain excellent comparability data just in case of IRS scrutiny.