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Excessive Compensation: Can You Satisfy the Rebuttable Presumption?

A recent New York Times article put the spotlight on the generous compensation enjoyed by two executives at the nonprofit Young Adult Institute—totaling nearly $2 million a year. Their behavior lit a firestorm, prompting the state government to seek compensation data at other New York–based nonprofits.

Exempt organizations across the country should be sensitive to the issue. When a nonprofit executive receives excessive compensation, the IRS can impose excise taxes on the executive and the organization will suffer reputational damage. But who is the arbiter of excess? Are the organization and its executives left to the capricious nature of subjective determination? The answer is “yes,” initially, but the IRS has made a “safe harbor” available to alleviate some of the uncertainty.  Under the safe harbor, an organization may shift the burden of proof from the organization to the IRS. Once the burden has shifted, it is incumbent upon the IRS to rebut the presumed “reasonableness.”  This places the organization in a much better position.

The Law on Compensation
Internal Revenue Code Section 4958 prohibits 501(c)(3) and 501(c)(4) organizations from engaging in an “excess benefit transaction” with a “disqualified person.” Disqualified persons generally include anyone in a position to exercise substantial influence over the organization’s affairs at any time in the five-year period preceding the transaction, such as officers and directors.

An excess benefit transaction takes place when a disqualified person receives a benefit that exceeds the value of the benefit the organization receives in exchange—for example, when an executive director is paid a salary that far exceeds the salary of executive directors at similar organizations. Violations of Sec. 4958 can lead the IRS to impose excise taxes (intermediate sanctions) on the disqualified person who benefited from the transaction as well as the nonprofit’s managers (for instance, board members) who approved it.

Invoking the Rebuttable Presumption
Federal tax regulations provide a rebuttable presumption of reasonableness for compensation arrangements that satisfy three requirements. If all of the following are met, it’s up to the IRS to show that compensation was unreasonable.

1. The compensation arrangement was approved in advance by an authorized body of the organization. Compensation generally must be set by the board of directors or a subcommittee composed of board members. It’s critical that none of the participants have a conflict of interest regarding the arrangement. For example, neither the executive nor a subordinate of the executive can participate in the compensation decision.

2. The authorized body relied upon appropriate comparability data prior to making its determination. That entity can rely on data derived from industry surveys, documented compensation of individuals in similar positions in similar organizations, expert compensation studies or other comparable data about reasonable compensation for the position. If your organization’s gross annual receipts are less than $1 million, you only need compensation data for three similar positions in similar communities. The regulations don’t specify the requisite number of comparables for larger organizations. Remember that similar job titles don’t necessarily mean similar jobs. When evaluating comparability data, the positions must have comparable duties, not just titles.

It’s important to identify what level of detail you need to meet federal tax regulations.  In some instances, a survey may suffice, however, the data provided in a survey is solely dependent on solicited participation, and it’s not always clear if the information provides a strong enough sampling of similar titles, duties, organization size and focus, geographic location, industry issues, etc.  Unless your organization has determined the survey sampling and information provides sufficient information, you should invest in a study that will give you specific compensation data based your organization’s size, location, purpose, age, history, growth projections, industry trends, and other business factors.

3. The authorized body adequately documented the basis for its determination while making that determination. This requirement is often overlooked. Documentation must include terms of the arrangement and the date it was approved, members of the body who were present during debate on the arrangement and those who voted on it, comparability data that was relied on and how it was obtained, and any actions by a member with a conflict of interest.

You must prepare the documentation before the later of the next meeting of the authorized body or 60 days after the body’s final actions. The body also must approve the documentation within a reasonable time after preparation.

Key Takeaway
If you’re not already abiding by the rebuttable presumption requirements when setting compensation for disqualified persons, start now. Otherwise, you risk incurring costly excise taxes and long-lasting reputational damage.

Defining a Conflict of Interest
A member of the authorized body (see “Excessive Compensation” article) charged with approving a compensation arrangement has a conflict of interest with respect to the arrangement if he or she:

  • Is a disqualified person participating in or economically benefiting from the compensation arrangement or is a family member of any such disqualified person,
  • Is in an employment relationship subject to the direction or control of any disqualified person participating in or economically benefiting from the compensation arrangement,
  • Receives compensation or other payments subject to approval by any disqualified person participating in or economically benefiting from the compensation arrangement,
  • Has a material financial interest affected by the compensation arrangement, or
  • Approves a transaction providing economic benefits to any disqualified person participating in the compensation arrangement, who in turn has approved — or will approve — a transaction providing economic benefits to the member.


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