United States: IRS Sharpens Focus On Tax-Exempt Organization Compensation

On March 1, 2007, the Internal Revenue Service (IRS) issued its long-awaited report on compensation paid and benefits provided by tax-exempt organizations to their executives and directors. The report reveals that the IRS sent compliance check letters to approximately 2,000 exempt organizations in two separate projects. Significantly, 15 percent of the compliance check recipients were selected for examination, and thus far, 25 examinations have resulted in proposed excise tax assessments under chapter 42 (i.e., under the self-dealing rules for private foundations, and under the excess benefit transaction rules for public charities) aggregating in excess of $21 million against 40 disqualified persons or organization managers. Executives and board leadership of tax-exempt organizations should pay close attention to a number of the report’s conclusions, and review their organizations’ compliance levels in light of the report’s conclusions that reporting and compliance levels are much lower than expected.

The report first discusses the methodology used by the IRS. This discussion is instructive because it not only identifies the types of exempt organizations that were sent compliance check letters and that were examined but also discusses the levels of compliance within each of those levels.

The first part of the project involved sending compliance check letters to 1,023 public charities and 200 private foundations. These organizations covered a broad spectrum of exempt organizations, including those involved in health, education and grant-making. The categories identified by the IRS and the observations concerning each category’s compliance level are quite interesting. One category involved larger public charities that had reported significant total compensation but failed to provide complete detailed information regarding the compensation. Another category involved public charities that reported receivables or loans from officers, directors or trustees exceeding $100,000 or more. The third category involved public charities that either answered "yes" or failed to respond to the question of whether they had participated in an excess benefit transaction. A final category included private foundations that either did not report any officer compensation or indicated that they made loans to officers, which is an act of self-dealing.

The second part of the project involved actual examinations that initially involved 782 organizations. The IRS increased the number of examinations by 179 due to unsatisfactory responses to the compliance checks. The sample selected was similar to the organizations that were sent compliance check letters.

The compliance check results also were quite interesting. First, they revealed that many organizations had problems completing their returns to the extent that 31 percent filed amended returns or schedules as a result of compliance check contact. This is a significant percentage and suggests the omissions or incorrect disclosures were sufficiently important to warrant the filing of amended returns or schedules. Second, the compliance check responses revealed significant reporting errors and omissions relating to compensation paid to officers or other employees, including lack of necessary detail. Finally, the information elicited regarding loans generated several examinations, including examinations of several private foundations that potentially were involved in acts of self-dealing.

The examination results revealed that more than half of the examinations were closed without change to status or tax owed, while a significant number were closed with a written advisory suggesting modifications of behavior in the future. Written advisories are subject to future review by the IRS.

Most importantly, 25 examinations resulted in proposed or assessed excise taxes aggregating in excess of $21 million against 40 disqualified persons or organization managers. The $21 million does not appear to include the amounts of required correction, which could be considerably more. The issues giving rise to these assessments included excessive salary and incentive compensation, payments for vacation homes, personal legal fees or personal automobiles that were not reported as compensation, payments for personal meals and gifts to others on behalf of disqualified persons that were not reported as compensation, and payment to an officer’s for-profit corporation in excess of the value of services provided by the corporation.

The report indicates, somewhat surprisingly, that public charities experienced difficulties accurately responding to excess benefit transaction and disqualified person questions on Form 990. It is unsurprising, however, that there was no self reporting of excess benefit transactions by public charities, because section 4958 depends on fair market value determinations. In addition, only 51 percent of the organizations attempted to satisfy all three prongs of the rebuttable presumption of reasonableness and only 54 percent relied on comparability studies, notwithstanding that both are generally considered "best" practices in today’s environment. Almost all of the disqualified persons reclused themselves from the discussion and approval of their compensation, which also is considered a "best" practice.

On the private foundation side, 5 percent of the organizations examined were found to have paid excessive compensation to officers and directors, while 86 percent required the reclusal of officers and directors from the discussion and approval of their compensation. Less than half, however, commissioned a survey to establish compensation, but this may be explained by the wide availability of general surveys of private foundation board and executive compensation based on asset size. Of those foundations that commissioned surveys, 92 percent set compensation within the survey range.

The last part of the report identifies 10 lessons learned and makes an number of recommendations, many of which relate to IRS administration matters. The following are most useful to the general exempt organization community:

• The report concludes that using correspondence examinations to deal with factually sensitive and complicated issues such as self-dealing and excess benefit transactions is not effective. This undoubtedly is because of the factual nature and complexity of the valuation issues they raise. The IRS will likely use field examinations more frequently.

• The report concludes that the Form 990 needs to be revised to facilitate accurate and complete reporting. The report also recommends that the IRS revisit the issue of when penalties should be assessed for filing an incomplete Form 990 or 990-PF.

• The report observes that only a relatively small percentage of corrections were made by disqualified persons before contact from the IRS, and recommends that the IRS continue to review compensation issues in more focused projects and pursue base-lining general compliance with the compensation rules.

Reading between the lines, the IRS’s report on exempt organizations’ executive compensation clearly indicates that the IRS will continue and perhaps even step up its focus on executive compensation matters, especially loans to officers and directors. Furthermore, the report makes clear that the IRS is willing to pursue unreasonable compensation and self-dealing issues. Importantly, while the report indicates that proposed excise tax assessments aggregated in excess of $21 million, it does not indicate how many of those proposed assessments were sustained during the appeals process or the value of excessive amounts returned to the charities in order to correct the excess benefit transaction or act of self dealing.

The report also reinforces the importance of correctly reporting fringe benefits, especially cars, cell phones, credit cards and computers. It is likely that many returns were required to be amended due to under-reporting of those and similar items. Also, the report reinforces the need to ensure that employment and other returns used to report executive and board compensation and benefits need to be consistent with amounts reported on the Forms 990 and 990-PF.

Lastly, the results of this report clearly indicate that exempt organizations need to pay more attention not only to what they report as executive or board compensation and benefits, but also to how they report those items. As the 2006 instructions to the Forms 990 and 990-PF suggest, exempt organizations should seriously consider providing a more detailed narrative description of their executive and board compensation packages, processes and rationales.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.