The IRS released its final report of audit results relating to its study of colleges and universities in April 2013. The report focuses on two primary areas – one of which is compensation. More specifically, the IRS provides some guidance for determining appropriate comparable data used in benchmarking studies and discusses employment tax and retirement plan issues that arise from misclassifying employees and/or income. The IRS's findings may indicate its expectations not only for higher educational institutions, but for all entities, regardless of whether they are for-profit or not-for-profit.

So, here's what can your company can take away from the report.

Review comparable data used to benchmark executive compensation

In approximately 20% of the organizations examined, the IRS found issues with the comparable data used to set executive compensation. To help make sure your comparable data is indeed comparable, take the following measures:

  • Document the selection criteria for determining comparable entities: All companies should establish selection criteria for determining appropriate peers so that the decision-makers use a consistent approach in setting executive compensation each year. Selection criteria can include the typical attributes such as total revenues, industry, location and employee size but can be broadened. Considering the subjective information most entities disclose to comply with current legislation (for example, proxy disclosures and Form 990 reporting), organizations can identify more attributes, such as strategy and growth goals, for their selection criteria. Whatever criteria you deem appropriate, make sure to document it.
  • Explain why peers and surveys are appropriate bases of comparison: Once you've established selection criteria, use those criteria to document why each peer and survey source used is appropriate, especially in niche markets where comparables are hard to identify. Understanding why certain organizations were included and excluded can help your organization improve your selection criteria every year.
  • Specify which elements of compensation (base salary, bonus, health and welfare benefits, perquisites, etc.) are being analyzed from compensation sources: While setting compensation levels across all levels of an organization, decision-makers should be confident they are making apples-to-apples comparisons. Understanding which compensation elements are included in survey data and from peers is a critical step and should be documented.

Bring all parties to the compensation table

While organizations may or may not be subject to federal income tax, most are subject to various employee-related payroll taxes. Additionally, most sponsor some type of qualified and/or nonqualified retirement plan. If an employee is incorrectly categorized as an independent contractor or if certain types of income are improperly included in or excluded from an employee's gross income, the mistake can result in not only payroll tax exposure but also noncompliance with the organization's retirement plans. The IRS found employment tax issues in all of the cases it examined and found issues with retirement plans in approximately a quarter of cases.

Regarding employment tax, the IRS identified that common errors in payroll filings resulted from the failure to include certain types of income (personal use of automobiles, housing and other perquisites); failure to classify independent contractors as employees; and withholding errors for nonresident aliens. Properly communicating various forms of compensation with the payroll department is critical to reducing exposure in this area.

Regarding retirement plans, the IRS found that certain organizations did not meet the requirements under §457(f)(3)(B) to establish a "substantial risk of forfeiture" for contributions under §457(f) plans. Additionally, the IRS found issues with organizations' compliance with the rules regarding loans, annual deferrals and annual additions for their §403(b) plans. For organizations that have either qualified or nonqualified plans, the board must understand how its decisions affect plan administration. Before finalizing compensation decisions, the board should consult the plan administrator to reduce plan errors.

To help manage exposure in these areas, companies should ensure there are clear lines of communication among those making compensation decisions (i.e., the board), the payroll department, plan administrators and whoever handles independent contractors. These parties should meet at least annually to discuss the types of compensation paid to various people, to ensure the compensation is properly taxed and considered for retirement plan purposes.

It's easy for most companies to ignore the IRS's findings on colleges and universities, but it's prudent to take time to focus on relevant issues the agency has identified. Compensation remains a heavily debated topic among all organizations, and understanding the IRS's stance is critical to reducing your exposure.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.