Being market competitive for leadership talent is important across every type of business. FGMK has previously highlighted how the Tax Cuts and Jobs Act of 2017 (the “TCJA” or “Act”) has impacted executive compensation in public and private for-profit companies. We now turn to the Act’s potential impact on executive compensation in certain tax‐exempt organizations.
As you likely know by now, the Act added new pay limit for executives in certain tax‐exempt organizations. We have briefly summarized the regulations on executive compensation for tax-exempt organizations that existed prior to the Act under section 4958 of the Internal Revenue Code, as well as the new requirements.
Intermediate Sanctions Regulations
Intermediate Sanctions regulations were originally created by Congress on July 30, 1996. These regulations were enacted to apply when there is an "excess benefit" transaction with a "disqualified person" within a tax‐exempt organization, with the obvious goal of limiting executive compensation.
As defined by section 4958, an "excess benefit" occurs when the value of the economic benefit provided is greater than the value of the consideration received by the tax-exempt organization. A "disqualified person" is any person having the ability to exercise substantial influence over the affairs of the organization during the five-year period ending on the date of such transaction. This would include the organization’s senior executives, although it can include family members, Board members, and those managing the organization’s financial assets.
The regulations allow the Internal Revenue Service (“IRS”) to penalize both the organization and the individual (both those who benefit from, as well as those who knowingly authorize the transaction). Intermediate sanctions may be imposed either in addition to or instead of revocation of the tax-exempt status of the organization. If a violation occurs, the disqualified person must "correct," or pay back the excess amount to the organization, plus a penalty that ranges from 25 to 200 percent of the excess amount (the maximum penalty is assessed if the transaction is not corrected in a timely manner). The “organization manager” (i.e., any officer, director, trustee, or other person having the authority to make administrative or policy decisions) who knowingly approved of the payment also pays a penalty equal to 10 percent of the excess benefit amount (not to exceed $10,000 per transaction).
Over the years, examples of potential violations have included executive benefits and perquisites such as, spousal travel, tax preparation services, compensation disguised as loans, and deferred compensation.
A primary impact of the Intermediate Sanctions regulations has been the use of what is called the “rebuttable presumption of reasonableness,” whereby the organization shifts the burden of proof to the IRS. This is not required but recommended to ensure that your organization satisfies any inquiry about the reasonableness of compensation paid. The following exemplify its application.
- The transaction was approved in advance by an independent and authorized body of the organization.
- The decision to pay the benefit was based on appropriate comparability data.
- The decision to pay the benefit was adequately documented, in writing, in a timely manner.
As illustrated, the rebuttable presumption arises as a result of formalized meetings of the Board or the Compensation Committee where market compensation studies completed by independent third parties are reviewed in order to support decisions regarding executive salaries, bonuses and deferred compensation plans.
Tax Cuts and Jobs Act – New Pay Limits
The controls on executive compensation sought by the Intermediate Sanctions regulations was deemed insufficient by Congress. The Act added new limits on executive pay for tax-exempt organization as follows:
- Imposed a new 20 percent tax on any compensation over $1 million paid to a “covered employee.”
- The definition of a “covered employee” encompasses the organization’s five highest‐paid current or former employees.
- Employees retain that status for as long as they receive compensation from the organization (or any successor organization).
- Imposes excise tax penalties on excess severance pay (similar to the section 280G tax penalties for excessive parachute payments in for-profit corporations).
The tax‐exempt organization would have responsibility for paying this new tax.
Action Steps to Consider
The new rules establish an arbitrary “bright line” of reasonableness not found in section 4958, which extend a pay limit to tax-exempt organizations that public companies faced for years with section 162(m). This will slow executive compensation growth levels for many tax-exempt organizations and limit the use of severance plans. The new rules will likely also impact deferred compensation plans that provide for lump sum payments, as payments post-employment would count towards the $1 million annual cap.
To address the regulatory constraints discussed above, FGMK offers some actionable steps organizations can take:
- The Board should continue with (or commission, if not a current practice) a market compensation study covering at least the top five executive positions to be completed by a qualified independent third party (typically a compensation advisory firm that conducts such studies). The study should ideally include a summary analysis of Form 990 information collected on other tax-exempt organizations determined to be reasonable peers (size, type of entity) of the organization. In addition to the rebuttal presumption benefit, such a study provides the organization with other insights regarding how top executives of comparable organizations are paid (e.g. prevalence and magnitude of bonus and deferred compensation plans) and may provide structuring ideas for further consideration.
- Review existing deferred compensation and severance plans to assess whether or not they might trigger compensation in excess of $1 million in a future year post-employment of the executive with the organization. If so, revise as necessary.
- Explore enhancing qualified benefit plans and section 457 plans, as compensation paid from these plans would not count towards the $1 million annual limit.
Planning and budget cycles are starting for many tax-exempt organizations. Being cognizant of these regulations and proactively addressing them will allow the organization to attract and retain the leadership talent it needs, while at the same time mitigate the risk of inadvertently running afoul of tax guidance that can negatively impact the reputation and financial well-being of the organization and the Board of Directors.
If you have additional inquiries about executive compensation in tax exempt organizations, please contact:
Compensation Advisory Services
The summary information in this document is being provided for education purposes only. Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.