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Congress and the IRS continue to examine the issue of excess compensation of executives of charitable organizations. An executive is entitled to receive reasonable compensation for an executive's services to a charity. If, however, an executive's compensation is excessive, the executive may be subject to the taxes on excess benefit transactions under §4958. The taxes are applied against the excess benefit, i.e., the amount by which the excessive compensation exceeds a reasonable compensation. The executive is subject to a tax of 25% of the amount of the excess benefit and, if the excess benefit is not repaid, to a tax of 200% of the excess benefit. A charity's managers are subject to a tax of 10% of the excess benefit under certain circumstances.

If an executive's compensation is grossly unreasonable, then the organization may lose its tax-exempt status due to the private benefit incurred by the executive.

Section 4958

The regulations under §4958 provide a safe harbor rule under which executive compensation is presumed to be reasonable. If the safe harbor rule is satisfied, the burden is on the IRS to show that the compensation is unreasonable.

To rely on the safe harbor rule, the following criteria must be present:

1. The arrangement was approved by a board or committee comprised entirely of individuals who had no conflict regarding the arrangement;

2. The board or committee used appropriate comparability data based on similarly situated organizations; and

3. The basis for the board or committee's decision was adequately documented.

Proposed Amendment

A recent IRS study of public charities and exempt hospitals reported that executives were receiving very high salaries, even though they were relying on the safe harbor presumption. Moreover, the Senate Finance Committee staff reported abuse of the presumption by exempt hospitals, foundations, supporting organizations, and some ministries. For example, some organizations used comparables from for-profit companies that were completely different from the organization.

In response, ranking minority member Senator Chuck Grassley has offered an amendment to the health care bill that would abolish the safe harbor rule and require charitable organizations to disclose their comparability data in their annual returns. If adopted, this amendment would shift the burden to the charity to prove that an executive's compensation is reasonable.

Conclusion

The general public has become increasingly sensitive to government support of extravagant expenditures, such as the payment of exorbitant salaries and bonuses by financial institutions which receive government bail-out funds. Even if Senator Grassley's amendment does not pass, executive compensation by charitable organizations will continue to be under IRS scrutiny.

If some charitable organizations are, like some of their for-profit counterparts, paying excessive compensation to their executives, then the funds for accomplishing the purposes for which they receive tax-exemption are reduced by the amount of the excess compensation. The charity's effectiveness is compromised. Moreover, such a private benefit is prohibited. Even so, whether the extent of abuse of the rebuttable presumption requires it to be eliminated seems to be somewhat anecdotal.

A preferable solution may be to retain the rebuttable presumption and add Regulations or other guidance to clarify the meaning of the terms “appropriate comparability data” and “similarly-situated organizations.” When weighed against the importance of eliminating excessive executive compensation, it does not seem overly burdensome to require charitable organizations to disclose the names of the organizations used as comparables and to summarize why such organizations are in fact comparable. With that information in hand, the IRS should be in a better position to stop abusive executive compensation arrangements.

Practice Note: Attorneys, accountants, and other tax professionals should advise their tax-exempt charitable clients carefully to review their compensation arrangements with the highest-paid directors or executives. Especially when an executive's salary is justified by comparing it to salaries paid by taxable or exempt organizations which are much larger or completely different, a charity should take another look for truly comparable non-profit or for-profit entities.

This commentary also will appear in the November 2009, issue of the Tax Management Estates, Gifts and Trusts Journal. For more information, in the Tax Management Portfolios, see Roady, 884 T.M., Intermediate Sanctions, and in Tax Practice Series, see ¶6510, Charitable Organizations.