This is part two of our post on the recently issued IRS final report for the Colleges and Universities Compliance Project, and the related implications for the larger tax-exempt sector. To recap, the IRS report kicked off in 2008 with the distribution of questionnaires to 400 randomly selected higher-education institutions. The IRS then selected 34 of those organizations for examination, given their responses on the questionnaires. This post will examine the IRS’ findings on executive compensation in the report.

As background, several types of tax-exempt organizations (including 501(c)(3) organizations) must comply with Section 4958 of the Internal Revenue Code in determining and paying compensation for their disqualified persons, sometimes called insiders (officers, directors, trustees and key employees). Section 4958, also known as the intermediate sanctions rules, requires that any compensation paid to disqualified persons be reasonable, and can impose penalties for compensation that is unreasonably high. Specifically, a determination of unreasonably high compensation may result in wage adjustments and individual tax penalties for the disqualified person recipients (presumably there is no reward for those being paid less than their reasonably compensated peers), and tax penalties for the person or persons who approved the compensation. Note that Section 4958 does not apply to public universities and colleges, but does apply to those in the private sector. In considering the reasonableness of compensation, the rules require inclusion of all forms of taxable gross income, and will consider whether fringe benefits and deferred compensation were properly excluded.

In general, reasonable compensation is the amount that would ordinarily be paid for like services by a like enterprise under like circumstances, which necessarily involves some subjectivity—and uncertainty. To protect itself, there are steps that organizations can take when determining compensation to raise a presumption of reasonableness:

• Using an independent body to review and determine the amount of compensation;
• Relying on appropriate comparability data to set the compensation amount; and
• Contemporaneously documenting the compensation-setting process.

If an organization conducts these three steps flawlessly, the onus is on the IRS to prove the compensation is excessive; but if the organization fails to meet these standards, it assumes the burden of proving reasonableness in an IRS examination. However, the above steps still involve a degree of subjectivity, namely the basis for determining appropriate comparability data. The IRS found that, despite best intentions, 20 percent of the universities failed to meet this specific element of rebuttable presumption, essentially failing to collect sufficient data to compare apples to apples (e.g. failure to compare to a similar-sized organization, or to a similar for-profit organization, which is allowed). It is important to note that, in choosing to attack this element, the IRS keeps the burden of proof on the organization by concluding that the organization didn’t properly follow the process.

The report also studied whether the institutions properly categorized elements of their employees’ income. Of the initial 34 organizations selected, 11 were examined for employment tax issues and all 11  resulted in increased taxable wages—which triggered increased employment taxes of about $7 million and additional related penalties. Wages were adjusted upward to include to account for the following:

• Personal use of the organization’s assets;
• Payments made to employees who were wrongfully classified as independent contractors;
• Payments to non-resident aliens that had no tax withheld; and
• Failure to include value of graduate level tuition waivers and reimbursements.

Similarly, the IRS examined eight institutions for compliance with deferred compensation payment practices and made wage adjustments to nearly half for failure to properly categorize contributions in the current year and/or not adhering to prescribed limits for retirement plan loan distributions, deferrals and additions.

The overall result? An overwhelming majority of the institutions examined were required to adjust their 990-series returns.  The Colleges and Universities Compliance Projects follows a similar 2009 Hospital Compliance Project, which examined executive compensation in 20 hospitals. Like their higher education and hospital counterparts, other nonprofit organizations should expect to have their executive compensation more closely scrutinized and should take the necessary steps to strengthen their internal rebuttable presumption process. In addition, they should take a second look at how they are categorizing certain payments or benefits. As discussed in last week’s post about unrelated business income, additional tax and penalties associated with excess or misclassified compensation will likely prove to be an economic boon for the IRS.