Charitable organizations are often caught off-guard by the compensation rules for tax-exempt organizations. Implementing proper protocols before compensating directors, officers, trustees and key employees is necessary to help meet Internal Revenue Service requirements and avoid excise taxes.
PFs and PCs
Private foundations (PFs)1 and public charities (PCs)2 are tax-exempt charitable organizations under Internal Revenue Code Section 501(c)(3) to which contributions are generally tax deductible.3 Both PFs and PCs are subject to various excise tax rules and must avoid providing impermissible private benefits and inurement or risk losing their IRC Section 501(c)(3) status.4
When a PF or PC considers its expenses, including compensation, it should confirm the expenses are reasonable, necessary and not excessive. This analysis helps affirm the deductibility of expenses on a charity’s annual return.5 These annual returns are available to the public, and some donors closely scrutinize the charity’s expenses. Excessive expenditures, including compensation, could deter current and potential donors.6
In addition, non-profit managers have fiduciary duties under most states’ laws. Failure to comply with these duties could jeopardize a charity’s exempt status, preclude board members from using statutory protections and bring excise taxes against the charity and, in some cases, the managers personally. Unreasonable or unnecessary expenses could also subject a PF to the self-dealing excise tax or a tax on taxable expenditures and a PC to intermediate sanctions.
PF Considerations
Often, PFs are run by a family or small group of related individuals, and many compensate individuals who are related to PF managers or donors. PFs may also rely on affiliated family offices to provide significant services, and the family office may seek reimbursement for the PF’s share of those services. Developing policies and procedures for determining compensation can help PFs steer clear of self-dealing issues and avoid awkward compensation conversations between related parties.
The self-dealing rules of IRC Section 4941 generally prohibit certain financial transactions between a PF and its “disqualified persons” (DPs).7 When addressing the self-dealing rules, the threshold question to ask is whether the PF is compensating a DP. See “Disqualified Persons in a Nutshell,” p. 40, for DP definitions. DPs include entities related to the PF, such as a family office controlled by the same individuals who control the PF. Compensating any DP can be considered a prohibited act of self-dealing if not administered properly.
Self-dealing doesn’t include reasonable and necessary compensation provided to a DP for personal services that carry out the exempt purpose of the PF, if the compensation isn’t excessive.8
Directors and trustees can receive reasonable fees for board or management services, officers can receive reasonable compensation for executive and administrative work and employees can receive reasonable compensation for services provided to the PF. Whether the compensation paid by a PF is considered reasonable, necessary and not excessive is based on facts and circumstances.
Personal Services
Personal services include legal, accounting, investment management and certain banking services.9 They also generally include services related to grant programs10 and property management.11
Secretarial services, mail processing and similar services are considered administrative and don’t fit the personal services definition. Maintenance, janitorial and security services also are generally excluded.12
If the PF employs an individual or entity that’s not a DP to provide services to the PF, then the PF may compensate the individual or entity for the services provided, regardless of whether they’re considered “personal services.” However, if the PF instead will compensate a DP such as a family office or the child of a director for providing services to the PF, those services should be “personal services;” otherwise, the PF should generally avoid the transaction.
PF Reasonable Compensation
When determining reasonable compensation, the PF should consider the services provided, the time required to perform the services, the experience, training or education required to adequately perform the services and what would be paid in the marketplace for comparable services. PF managers can review compensation reports that highlight what others are paid serving in similar roles to determine what’s considered reasonable.
PF managers should document the process for determining compensation, including how the managers determined the compensation is reasonable. This may include compiling a job description, anticipated hours and a resume as well as compensation data points from other similarly situated PFs.
The PF should acknowledge any conflict of interest with respect to a PF manager—such as being related to the family member employee—and follow proper conflict-of-interest procedures. This might include recusal of the conflicted director from voting on the compensation amount and documenting the conflict in the meeting minutes.
Once employed, a PF may review this record and employee’s performance and compensation annually.
Self-Dealing Penalties
Some PFs may find the process too grueling and decide to take a shortcut when setting compensation, but the self-dealing penalties are harsh and generally require the PF to unwind the self-dealing transaction, which can be difficult.
The PF never owes the excise tax but rather an excise tax is imposed on the self-dealer and PF managers who knowingly participate in the self-dealing transaction.13 The excise taxes are high and increase if the acts aren’t corrected within a specific period.14
PC Considerations
Instead of the PF self-dealing rules, PCs are subject to the intermediate sanctions rules, which prohibit a PC from entering into any arrangement or transaction that generates an “excess benefit” for a DP.15 To avoid providing an excess benefit to a DP, it’s important for a PC to identify its DPs,16 regardless of actual job title, and track and analyze the compensation provided through the PC or indirectly through an affiliated entity.
Generally, a PC may enter a compensation arrangement with a DP as long as the compensation provided is reasonable and the PC doesn’t pay more than fair market value for the received services. Particularly for key employees and officers, it’s important for a PC to retain valid information on competitive pay levels and practices for similarly qualified individuals in comparable positions at similar organizations.
PC Reasonable Compensation
The IRS provides a safe harbor protection that, if followed, will create a rebuttable presumption of “reasonableness.”17 To fall within this regulatory safe harbor, it’s crucial that:
- A PC’s board or compensation committee (excluding any interested parties) approves, in advance, compensation arrangements for its DPs.
- A PC collects data to substantiate the reasonableness of the compensation provided to its DPs. When analyzing compensation, PCs should consider:
- Data from similar organizations, including those with a comparable number of employees, revenue, assets or endowment size, operating budget and similar services
- Data on comparable roles at similar organizations
- Availability of similar services in the geographic area
- Current compensation surveys compiled by independent firms or collected by reviewing publicly available documents, such as
- Form 990s, of similarly situated organizations
- Where available, actual written offers for the services of the DP.
When determining the reasonableness of the compensation, outsourcing to a third-party consultant may provide some liability protection. The intermediate sanctions regulations say an organization manager’s participation in a transaction later determined to be an excess benefit transaction won’t be considered “knowing” if the manager relies on a “reasoned written opinion” of an appropriate valuation professional, which generally includes attorneys, CPAs and “independent valuation experts.”18
A PC sufficiently documents the reasonableness of the compensation and the approval of the compensation by the appropriate governing body. A PC’s board or compensation committee should approve all compensation arrangements for DPs. The board or committee should document the procedures and decisions regarding compensation, including whether a conflict of interest existed that precluded a board or committee member from voting on a particular compensation decision. The board or committee may also choose to outline general policies for approving compensation arrangements.
Penalties
The penalties for violating the excess benefit transaction rules are high.19 Correcting an excess benefit transaction requires unwinding the transaction and taking additional steps to return the organization to a financial position no worse than if the DP were dealing with the highest fiduciary standards.
In addition to these onerous taxes, an organization could lose its tax-exempt status and open itself to additional federal and state scrutiny. Given the high cost of failing to comply with these rules, PCs often implement procedures to comply with the regulatory safe harbor.
Compensation Over $1 Million
In addition to the self-dealing and intermediate sanction rules that PFs and PCs, respectively, must navigate, a 21% excise tax is imposed on compensation of more than $1 million paid by a tax-exempt organization (or its related organizations) to a “covered employee” and on certain parachute payments.20 A “covered employee” is any employee (or former employee) of a PF or PC if the individual is one of the five highest compensated employees for any year or was a covered employee in any preceding year.21
What often comes as a surprise is that for the purpose of determining the five highest compensated individuals, the organization must aggregate all compensation that it pays to an individual with all compensation paid by a related entity to the same individual. A “related” entity includes one that controls the charity, is controlled by the charity or is controlled by the same individuals who control the charity.22 With PFs, this commonly creates concerns in the corporate foundation context or when the PF works with a related family office.
The Takeaway
Developing robust compensation practices can be a challenge, but it can assist in stewardship efforts with donors, help managers fulfill their fiduciary duties and support the organization in the event of state or federal scrutiny or audit.
Endnotes
1. Private foundations (PFs) are typically funded and controlled by an individual, family, corporation or other small group and are generally used to make grants to public charities (PCs), qualified individuals and government entities for charitable purposes. They’re described in Internal Revenue Code Section 509(a).
2. In broad terms, a PC is an institution (such as a church, university or hospital), an organization that has broad public support or an organization that functions in a supporting relationship to such institutions or publicly supported organizations. IRC Section 170(b)(1)(A).
3. The deduction depends on the identity of the donor (individual or corporation), the recipient charity (whether it’s a PC, a PF, a private operating foundation, etc.), the type of property that’s contributed (cash, ordinary income property or capital gains property), the adjusted gross income of the individual donor or taxable income of the corporate donor and other charitable gifts the donor made in the same year. See Conrad Teitell, Stefania L. Bartlett and Cara Howe Santoro, “Charitable Deductions for Gifts by Individuals, Partnerships and Corporations,” Trusts & Estates (October 2018).
4. IRC Section 501(c)(3) prohibits private inurement. In addition, if a charity provides a private benefit that’s substantial in nature, it can destroy its tax exemption, even if the charity conducts other charitable activities.
5. Form 990 Series.
6. Salary information for certain highly compensated employees, officers, directors and trustees is available to the general public on a charity’s Form 990.
7. See“Disqualified Persons in a Nutshell,” p. 40, for definition of “disqualified person” (DP).
8. IRC Section 4941(d)(2)(E) and Treasury Regulations Section 53.4941(d)-3(c).
9. Treas. Regs. Section 53.4941(d)-3(c)(2).
10. Private Letter Ruling 201937003 (Sept. 13, 2019).
11. PLR 9226067 (March 31, 1992).
12. Madden v. Commissioner, 74 T.C. Memo. 1997.
13. PF managers are jointly and severally liable. Section 4941(c)(1).
14. Specifically, an excise tax of 10% of the amount involved is imposed on the self-dealer (regardless of whether the self-dealer knew the act was self-dealing at the time) and a 5% tax on the manager (if the manager knowingly participates in the transaction) with a $20,000 cap per act. Section 4941(a) and 4941(c)(2). If the self-dealing act isn’t corrected within a specific time period, there’s a second level of tax of 200% of the amount involved that’s imposed on the self-dealer and a 50% excise on the PF managers who knowingly participated (again, with a $20,000 cap per act). Sections 4941(b) and 4941(c)(2).
15. IRC Section 4958.
16. See“Disqualified Persons in a Nutshell,” p. 40, for definition of a DP for purposes of the intermediate sanction rules.
17. Treas. Regs. Section 53.4958-6.
18. Treas. Regs. Section 53.4958-1(d)(4)(iii).
19. There’s a 25% excise tax imposed on excess benefit transactions. Section 4958(a)(1). In addition, there’s a tax equal to 10% of the excess benefit (with a maximum of $20,000) imposed on any manager who knowingly participates in an excess benefit transaction. Section 4958(a)(2) and 4958(d)(2). There’s an exception if participation wasn’t willful and was due to reasonable cause. After an initial tax is imposed, a tax equal to 200% of the excess benefit is imposed on any DP who participates in an excess benefit transaction unless it’s corrected within the taxable period as defined in Section 4958(f)(5). Section 4958(b). If multiple individuals are liable for the tax, their liability is joint and several. Section 4958(d)(1).
20. IRC Section 4960.
21. Section 4960(c)(2). An “employee” is defined to include certain officers of a non-profit corporation (but not directors (trustees) serving in their capacity as such). Ibid. There’s an exception to this excise tax for licensed health care providers—remuneration paid for the performance of medical services doesn’t count toward the $1 million threshold; however, if the professional also receives compensation for other services (including administrative or management services associated with the performance of medical services), then amounts paid for those services count for purposes of calculating whether an excise tax applies. Section 4960(c)(3)(B).
22. Section 4960(c)(4)(B). Control is determined by a “more than 50%” ownership threshold, or in the case of a non-profit entity, by the power to remove and replace more than 50% of the directors or trustees, or by more than 50% of the directors or trustees of the entity also being trustees, directors, officers, agents, or employees of the related entity. Ibid.