Intermediate Sanctions and Executive Compensation – A Quick Refresher

Executive pay in the exempt organization setting has been subject to scrutiny and regulation since long before corporate bad actors and the financial crisis prompted Congress to pass laws limiting compensation and imposing process requirements for banks, public companies and other for-profit employers. The basic rules that apply to the setting of executive pay and benefits by tax-exempts haven’t changed since final regulations under Code Section 4958 (the “intermediate sanctions” rules) were published back in 2002. More recently, however, the IRS has signaled its intention to pay closer attention to the compensation and benefits paid to executives in exempt organizations, and the well publicized enhancements to the compensation disclosure requirements on Form 990 give the IRS plenty of information to work with. With this in mind, we wanted to offer a brief review of the so-called “intermediate sanctions” rules and a refresher on the simple process that tax-exempt employers should follow when setting compensation and benefits packages for executives. Over the next couple of months, as the filing deadline for Form 990 draws near, we’ll review some of the key concepts relating to the disclosure of executive pay on Form 990 (including Schedule J).

Before the development of the intermediate sanctions rules the only mechanism the IRS had to address the payment of excessive compensation for services (or an excessive purchase price for property) was to attack the exempt status of the organization under a “private benefit” theory. Among other flaws, that blunt instrument approach (which is still used in appropriate cases) effectively penalizes the organization itself rather than the individuals who participated in and/or benefited from the questionable transaction. The intermediate sanctions rules were designed to provide a more surgical approach that the IRS can take to address these types of issues without jeopardizing the exempt status of the organization. Specifically, Section 4958 of the Internal Revenue Code authorizes the IRS to impose an excise tax on any “disqualified person” who benefits from an “excess benefit transaction” with an applicable tax-exempt organization. The term “excess benefit transaction” includes the payment of excessive or unreasonable compensation to a disqualified person. The rules allow the IRS to impose a 25 percent excise tax upon a disqualified person (such as a senior executive) who receives excessive compensation or otherwise benefits from an excess benefit transaction. A 10 percent excise tax may also be imposed on organization managers who knowingly and willfully participate in the excess benefit transaction, subject to certain limits.

The Treasury Regulations under Code Section 4958 describe the procedure a tax-exempt organization may follow to create a rebuttable presumption that the compensation and benefits provided to an executive are reasonable. Specifically, payments under a compensation arrangement are presumed to be reasonable if the following conditions are satisfied: (1) the compensation arrangement is approved in advance by an authorized governing body of the organization, excluding any member of the body that has a conflict of interest in the matter; (2) the governing body obtained and relied upon appropriate data as to comparability(generally provided by an independent consultant or advisor) prior to making its determination; and (3) the governing body adequately documented the basis for its determination concurrent with making the determination. If these requirements are satisfied then the IRS may overcome the presumption of reasonableness only if it develops sufficient contrary evidence to defeat the comparability data relied upon by the governing body.

A failure to establish a rebuttable presumption does not necessarily lead to the conclusion that compensation is unreasonable. (The compensation may just turn out to be reasonable anyway.) So why incur the expense and occupy the valuable time of a Board of Directors in going through the three-step process, especially where the organization could obtain a “reasonableness letter” from compensation consulting firms as an alternative means of supporting the reasonableness of executive pay? At least three reasons. First, establishing the presumption provides a valuable first line of defense in the event of an IRS audit because it puts the burden on the IRS to show that the compensation is excessive. (A reasonableness letter obtained after the fact can help but it will not shift the burden of proof to the IRS.) Second, by going through the process the organization’s governing body demonstrates a serious commitment to sound governance practices and legal compliance. Third, the organization may (and most of our clients do) find that the process actually builds the strength, confidence and depth of involvement of the Board or Board committee with authority over compensation matters. For those reasons and others, in our experience, the Board members and the organization both benefit from this process-oriented approach and we strongly recommend it.