IRS Renewed Interest in Compensation and Benefits Paid by Nonprofits: A Visit to the Private Inurement and Excess Benefit Transaction Topic in Today’s Environment

December 21, 2009

The new and expanded Federal Form 990 (return for exempt organizations) is an indication that the Internal Revenue Service (IRS) is scrutinizing the policies and procedures of exempt organizations more closely.  The instructions to the new form include a discussion that while certain policies and procedures are not required by the Internal Revenue Code (IRC) for organizations to adopt, the IRS considers them important to generally provide good tax compliance.  It goes on to discuss how the size and structure of each organization is a factor in considering exactly which policies and procedures should be adopted, but the point is the IRS is making it clear that they expect tax exempt organizations to have enough and appropriate policies and procedures in place to provide assurance that tax compliance, in all its meaning, is complied with. The form 990, Part VI, is a page of questions in regard to “Governance, Management and Disclosure”.

The instructions to the 990 also state “The absence of appropriate policies and procedures may lead to opportunities for excess benefit transactions, inurement, operation for non-exempt purposes, or other activities inconsistent with exempt status” (instructions to 990, page 15).  The assumption currently is that the IRS will have a helpful tool with the new form 990 in identifying organizations at risk of having excess benefit transactions, and possibly organization they will want to look more closely at.

The IRS has recently increased the number of its exempt organization tax enforcement specialists.  Over 100 new tax exempt tax specialists, and additional exempt organization appeals officers and tax law specialists have been hired just this past fall, in part aided by the availability of talent due to the current economic downturn.  The increased scrutiny by the IRS could be stemming partly from increased pressure from Congress and Senator Chuck Grassley (R-Iowa) who is the Senate Finance Committee ranking minority member.

The premise that at a nonprofit organization no individual can “inure” privately or benefit from the organization is not a new one.  It is a basic tenet of tax exempt status and is required in order to be granted that status from the IRS.  Excessive compensation to officers, key employees, or any other “disqualified persons” is considered to be private inurement, and the IRC has a special code section, 4958, which imposes penalties for excessive compensation of disqualified persons, and penalties for unreported taxable compensation to disqualified persons. The form 990, Part VI question 15-15b inquires about the process for determining compensation for the organization’s top management official and other officers or key employees, and requires a narrative describing the process.  In regards to compensation and benefits paid to organization officers and key employees, the rebuttable presumption test, a three-pronged procedure for establishing reasonable compensation, is commonly regarded as a safe harbor for documentation in case of an IRS audit.  However, there was a recent case with the IRS last summer whereby a tax exempt healthcare organization had fulfilled the rebuttable presumption test, but the IRS was questioning the actual dollar amount paid as a result of the organization’s process.  It may not be enough anymore to merely have gone through documented processes of comparison, discussion and approval, but it may be necessary to fully substantiate the reasoning behind the amount arrived at as being reasonable and acceptable in regards to  the size, type, services provided, and  geographic location of the organization.

A “disqualified person” for purposes of section 4958 (and the disclosure required in Schedule L, Transactions with Interested Persons) is rather broad.  The definition is “any person who was in a position to exercise substantial influence over the affairs of the applicable tax-exempt organization at any time during a 5-year period ending on the date of the transaction.”  The IRS can always designate these persons for you, whether you have self identified this group as extending to certain persons or not, should the IRS disagree with who you on who is covered by this definition. For this reason, an organization wants to take a broad view itself when identifying disqualified persons for the purpose of tax compliance.  The following persons are specifically identified as disqualified persons: the voting members of the board of directors, CEO and CFO, a family member of a disqualified person, and a donor or donor advisor to a donor advised fund.  The IRS has been suggesting for many years that all tax exempt organizations have written conflict of interest policies, annually updated by all applicable persons, to disclose relationships and transactions that involve the organization.  The new form 990 now has three questions and a requested narrative (see the form 990 Part VI questions 12a-c).

Situations where a tax exempt organization has a controlled 501(c)(3) or (4) subsidiary, the parent is considered a disqualified person to the subsidiary under the disqualified persons definition.  This means any reimbursements paid by the subsidiary to the parent needs to meet the reasonable compensation standard or risk being identified as excess benefits subject to the sanctions under section 4958.  Frequently, a “management fee” agreement will exist between parent and subsidiary, so in these cases the substantiation of the amount of the fee should be in good order and be put to the “rebuttable presumption of reasonableness” test if the amount reimbursed is going to stand up under IRS scrutiny.  In defending the amount reimbursed to a parent organization, an entity does not want to be in a position of dusting off a ten year old “agreement” that the current board of directors is not even aware of.

The IRC has provisions that consider all personal payments to be compensation, and the scope of that definition may surprise many finance officers.  The first items that come to mind as compensation and benefits is the usual salary and fringe benefit package available from the organization.  Unreported taxable compensation in the eyes of the IRS could be a number of other items, though.  Sometimes surprisingly, examples include the use of corporate credit cards that lack appropriate business purpose documentation and invoice backup, which are therefore required to be reported on the W-2 as personal compensation.  Also personal travel expenses, travel paid for spouses or family members of employees or disqualified persons, etc are considered personal compensation and should be included in W-2 wages.  When the organization is justifying the compensation and benefits package paid its officers, top management and key employees, it needs to be sure it is including all compensation under the definition of the IRC.

In organizations where there are board directors, committees, consultants, and numerous top management individuals, it is conceivable that transactions with disqualified persons are occurring that the finance department, who has traditional responsibility for the preparation of the complete and accurate form 990, is not aware of.  The IRS recommends that all those charged with governance complete an annual written conflict of interest policy, in addition to the organization conducting a discovery process to identify all disqualified persons and any possible transactions occurring with them.

Part IV of the form 990, questions 25a through 28c, and further on Schedule L, requires disclosure of excess benefit transactions with disqualified persons and other transactions and relationships that exist involving the organization.  Part VI, question 2 requires disclosure of family relationships or business relationships.  Couple these questions with the requirement that the form be signed under penalty of perjury by an officer of the organization, and further that it be completed fully in order to be considered filed at all (non filing penalties apply if a full and complete return is deemed to have not been filed), and one understands why there is so much angst over the new form 990.

In this time of increased transparency and open disclosure of business dealings and relationships, a nonprofit organization wants to be in the camp where all the required and recommended good governance practices are being conducted, updated timely, evaluated, approved, and documented to best combat any IRS audits or inquiries.  It seems that increased scrutiny from the IRS, with Congress’ pressure behind it, is coming down the pipeline soon if not already here.  If your organization has not heightened its due diligence and evaluated disqualified persons’ transactions, now is a great time to get started.  It is easy to see how the governance policies discussed above do have a direct relationship with the complete and accurate reporting of the transactions and relationships required to be disclosed in the federal form 990.

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