Executive compensation at not-for-profit organizations is a hot topic at the IRS these days. Executive compensation that is deemed unreasonable at tax-exempt organizations can result in excise taxes being levied against the executive. Officers, directors, trustees or any individual having similar powers and responsibilities within the organization may also be liable for excise taxes if the compensation is deemed unreasonable.
So, what is reasonable compensation? The IRS has no set formula, rule of thumb or table that you can hang your hat on. However, the IRS has established a process to provide a rebuttable presumption of reasonableness. In other words, the burden of proof then shifts to the IRS.
This safe harbor covers certain employees of tax-exempt entities organized under Section 501(c)(3). The process, set forth under the Internal Revenue Code §4958 and Treasury Regulation 53.4958-6, has three requirements:
The compensation arrangement is approved in advance by an authorized body composed entirely of individuals who do not have a conflict of interest with respect to the arrangement;
The authorized body obtained and relied upon appropriate data regarding comparability prior to making its determination; and
The authorized body adequately documented the basis for its determination concurrently with making the determination.
The documentation should include:
The terms of the transaction and the date of its approval;
The members of the authorized body present during the debate and record of its vote;
The comparability data obtained and relied upon;
The actions of any members of the authorized body who had a conflict of interest; and
Documentation of the basis for the decision.
If a not-for-profit organization follows this safe harbor process, the IRS may contest the presumption of reasonableness only if it obtains contrary evidence to rebut the value of the comparability data used.
Further, the IRS is more likely to determine that an organization is in compliance with the requirements for tax exemption if it has this process in place.
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