NONPROFIT QUICKTIPSSM
An electronic publication of Pfau Englund Nonprofit Law, P.C.
Disclaimer: This publication is designed to provide accurate information in regard to the subject matter covered. However, it is not intended to provide legal or other professional advice. If legal advice is required, the services of a competent professional should be sought.
Protecting Highly Compensated Employees from the Tax on "Excess Benefits"
Although the regulations are not yet finalized, highly compensated nonprofit executives and the governing boards that approve their salaries should take steps to avoid the new excise tax on "excess benefits". The new tax came as part of the Taxpayer Bill of Rights 2 (TBOR2), passed in the summer of 1996. Under IRS Section 4958, highly compensated officers, directors, operating officers, and others who implement the decisions of governing bodies of 501(c)(3) and 501(c)(4) tax-exempt organizations may be subject to an excise tax equal to 25% of the amount of any "excess benefit" they receive. In addition, the excess benefits, plus interest, must be repaid to the nonprofit organization or a tax of 200% of the excess benefit may be imposed. A second excise tax, equal to 10% of the excess benefit, may be imposed on "organizational managers" who knowingly, willfully, and without reasonable cause approve the excess benefit transaction.
To protect your organization’s employees and officers from having to pay excise taxes on excess economic benefits, it may be a good idea to use the 3-step "safe harbor" provided in the proposed regulations:
Be certain that the governing body and/or committee approving the compensation is made up of individuals who do not have a conflict of interest with respect to the compensation arrangements being approved;
Base compensation on appropriate comparability data, including compensation paid by similarly situated tax-exempt and taxable organizations. (The proposed regulations note that customized compensation surveys using an appropriate sample and compiled by an independent firm that specializes in executive compensation are sufficient. Non-customized national surveys that do not stratify the data by size of institution or any other criteria are generally unacceptable.); and
Document the basis for the compensation decision including (a) the terms of what is approved and the date it is approved, (b) the individuals who made up the governing body making the decision and who were present during the debate and who voted on the compensation arrangement, (c) the comparability data employed and how the data was obtained, (d) whether any member(s) of the governing body had a conflict of interest and if so what actions, if any, that member(s) took with respect to the compensation decision.
A second "safe harbor" is provided for decisions made by managers who rely on the advice of legal counsel. If the full facts of the situation are disclosed to the attorney and the attorney provides a reasoned written opinion that the matter in question is not an excess benefit transaction—based on the facts and applicable law—the "organizational managers" will not be considered knowing or willful. Finally, IRS Section 4958 does not forbid "disqualified" individuals from being provided with bonuses and other benefits. Based on the proposed regulations, it appears that such bonuses should be included in and reviewed along with the total compensation package using the 3-step safe harbor approach.
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