Executive compensation is one of the most important issues that a public charity must address. Organizations often are pulled in many directions when dealing with executive compensation. Charities need to balance their overall tax-exempt objectives with their need to hire and retain skilled management to accomplish those objectives, their future growth with their financial constraints, and their desire to compensate exceptional service with the public perception of corporate greed. Dealing with executive compensation is a difficult task for all organizations, exempt and taxable alike. For public charities, however, the disclosure requirements and their reliance on goodwill mean executive compensation is not only a difficult issue, it is also a public issue.
The need to address executive compensation has grown significantly over the past few years, as this is an issue that recently has been at the forefront of the Service's attention. The redesign of the Form 990, the extensive discussion of executive compensation in the Interim Report for the College and University Compliance Project, and the Service's rediscovery of Section 4958 all result in a need for charities to evaluate the amount of compensation provided to their executives, assess their risk, and address any potential issues or areas of concern.
In the author's experience, when dealing with executive compensation, charities generally go through three very common and distinct phases—denial, fear, and acceptance.
In the first phase, organization executives simply say that compensation is not a problem for their organization. As such, a major hurdle in this phase tends to be the assumptions and privacy issues of the organization's executives. During this phase, many executives refuse to believe that the amount of their compensation is a significant issue to anyone other than themselves. When it comes to compensation, executives tend to believe two things above all else: (1) they are compensated fairly and, if anything, are under-compensated; and (2) if anyone does care to question their compensation, "it's none of their business." Unlike executives, governing boards do not have such a personal or visceral response to executive compensation; rather, questions from the board tend to focus on risk, both to the organization and to themselves.
During the denial phase, the typical questions asked by organizations include:
- Who cares?
- Does it really matter how much we pay our executives or how we determine executive compensation?
- What are the risks of overcompensation?
Once an organization recognizes that the amount of executive compensation can have serious consequences to the organization's tax-exempt status and could result in significant tax penalties, the organization tends to enter into the fear phase. This phase is often spearheaded by the board of directors. Initially, during this phase, the governing board may view the organization's executives as adversaries in the compensation approval process. Board members may even blame certain executives for placing the organization at risk of revocation and potentially placing the board members at risk of personal liability. During the fear phase, the questions asked by the organization's governing board tend to include:
- How much compensation is reasonable compensation?
- Can we pay executives above the fiftieth percentile?
Eventually, every organization reaches the acceptance phase. This will happen once the organization's executives recognize the need to address the potential issue of overcompensation and the organization's board recognizes that, in order to attract the level of talent necessary to accomplish the its mission, the organization will need to provide reasonable and competitive compensation. Once an organization reaches this point, it is able to rationally analyze its executive compensation and the process used to approve such compensation. The questions then become more appropriately issue-focused, including:
- What can the organization do to protect itself from a finding of excess compensation?
- What are the potential red flags that inform the Service about potential executive compensation issues?
With the Service's recent emphasis on executive compensation and its rediscovery of Section 4958, it is important that exempt organizations and their advisors be well aware of the issues relating to executive compensation and the risks of providing excessive compensation, both to the organization and its management.
DENIAL
Many executives consider the amount of their compensation to be a private matter and do not like to discuss or to be questioned about the appropriateness of their salary. When the issue of executive compensation is discussed, executives frequently blow off the issue, saying that no one cares about their compensation and, even if people did care, it is none of their business. This assumption about personal privacy is unfounded and dangerous, however. The list of individuals and entities who care about the types and amount of compensation provided to executives of nonprofit organizations is long. It includes the IRS, state regulators, the media, competing organizations, executives of other exempt organizations, and the organization's own employees. Further, while a particular individual's compensation may be nothing more than a curiosity even to these stakeholders, as a matter of law it is the business of state and federal regulators and of potential donors. Moreover, with the substantial amount of information that tax-exempt organizations must make available to the public, these interested persons have ample information to satisfy their curiosity, irrespective of whether they have a justifiable need or purpose for obtaining the information. It is this mix of public curiosity and the widespread availability of information about executive compensation that makes the potential risks of excessive compensation so great.
Once an executive acknowledges that people may care about the amount of their compensation, they often fail to recognize the significance of executive compensation. This is largely due to a failure to recognize that, for most organizations, the very premise for the Service's recognition of tax-exempt status is that neither the organization's earnings nor assets inure them to the benefit of a private individual and that the organization's activities do not confer a greater than necessary private benefit. Moreover, many executives of organizations exempt under Section 501(c)(3) or (c)(4) are almost completely unaware of the substantial penalties that the Code imposes on excessive compensation though Section 4958.
Finally, even when they acknowledge that people do care about the amount of their compensation and that it may impact their organizations' exempt status, many executives will perform a quick calculation in their head in which they weigh the value of the benefits that they believe that they provide to the organization against the amount of their compensation. Almost without fail, the executives will determine that, if anything, they are underpaid for the vast number of important services provided to the organization. As such, they quickly dismiss the issue, believing that there is no real risk of overcompensation. This quick calculation often fails to consider all of the risks, however, including loss of exemption and the potential of personal liability for excise taxes should the IRS disagree with their conclusion. Additionally, while many positions relating to executive compensation are defensible, the lack of an appropriate approval process for such compensation may itself lead to a perception of excessive compensation that may result in unwanted public or regulatory scrutiny and perhaps even a proposed adverse determination. Thus, even a fully defensible position may cause an organization to endure significant expense and hardship if the organization's approval process does not sufficiently demonstrate the reasonableness of the amount of executive compensation.
WHO CARES?
As noted above, the list of individuals and organizations that care about the compensation of particular executives is long and the list of reasons why they care is equally long. The first, and probably the most significant, entity on this list is the IRS. Contrary to the belief in privacy held by many executives, executive compensation is the Service's business.
The IRS. In recent years, executive compensation has been a hot topic for all organizations, and charities have not been an exception. The Service's focus on executive compensation has been demonstrated by the information that it seeks from organizations in the Form 990, the Tax-Exempt/Government Entities annual work plans, public statements by IRS officials, publications by the IRS in recent years, and in the actual IRS enforcement efforts, including litigation.
The redesigned Form 990. In 2007, the Service released a redesigned Form 990 with the intention of improving organizational reporting and streamlining IRS enforcement with respect to several important issues. These included executive compensation, governance procedures for approving executive compensation, and the independence of an organization's governing board. Specifically, the Service added questions to the redesigned Form 990 requesting information that is directly relevant to determining whether the organization is providing reasonable compensation, including:
- Part VI, "Governance, Management, and Disclosure." In Part VI a tax-exempt organization must describe the composition of its board of directors, its governance and management structure, and its policies for promoting transparency and accountability to members and beneficiaries. Notwithstanding these requests, the Service has made clear that no particular policy or form of governance is compelled as a matter of law.
- Schedule J, "Compensation Information." Organizations are required to provide additional information about officers, directors, and employees who earn more than $150,000 in reportable compensation (as reflected on Forms W-2 or 1099) or $250,000 in total compensation (including nontaxable fringe benefits and expense reimbursements). Affirmative responses to this question on the main body of Form 990 will trigger more detailed reporting requirements in Schedule J. In addition to requiring the organization to break out base compensation, bonus and incentive compensation, other compensation, deferred compensation, certain nontaxable benefits (described below), and compensation reported in prior Forms 990, Schedule J specifically asks whether an organization's compensation approval process takes the steps necessary to establish the rebuttable presumption of reasonableness. Additionally, Schedule J requests information about other benefits that the organization provides to its executives in addition to compensation, including payments for first-class or charter travel, travel for companions, tax indemnification and gross-up payments, discretionary spending accounts, housing allowances and payments for the business use of a personal residence, health or social club dues or fees, and personal services (such as those of a maid, chauffeur, or chef).
- Schedule L, "Transactions with Interested Persons." Organizations are also asked whether they have engaged in an excess benefit transaction with an interested person in the past year. If this question is answered affirmatively, the organization must also complete Schedule L. In the current version of Form 990, Schedule L has been structured to incorporate all conflict of interest reporting relating to transactions with interested persons into a single location.
Due to the level of detail and reporting of executive compensation packages in years 2008 and later, substantiating the reasonableness of executive salaries and benefits must be a top priority for all organizations submitting a Form 990, and as every tax-exempt organization knows well, details reported in Form 990 become public information. An organization that pays employees what may be viewed as excessive compensation risks affecting the public perception of the organization as a whole and jeopardizing future fundraising efforts, membership support, and the like.
Public statements by IRS officials, workplans, and publications. On 11/23/10, in a speech to the Practicing Law Institute conference, Lois Lerner, the IRS Director of Exempt Organizations, indicated that the Service was going to once again begin focusing on whether exempt organizations are providing their executives with excessive compensation. This announcement was consistent with anecdotal evidence that practitioners have seen while representing tax-exempt organizations in IRS examinations. Basically, the IRS has rediscovered Section 4958 and has begun using this previously forgotten enforcement tool with a new vigor.
The 11/23/10 announcement about the focus on executive compensation is consistent with other public statements made by IRS officials. For instance, at a Georgetown Law Center conference on Nonprofit Governance on 4/27/11, IRS Area Manager Peter Lorenzetti identified executive compensation as "far and away the most common risk area for nonprofits" and an issue that the Service will "look at on every audit we do."
Additionally, enforcement efforts relating to executive compensation were discussed in the Exempt Organization Implementing Guidelines for fiscal years 2006, 2007, and 2008, and in the IRS TE/GE Fiscal Year 2011 Workplan.
Finally, the Service's focus on executive compensation issues is clearly evinced by the interim report on its College and University Compliance Project ("Interim Report").1 Published on 5/7/10, the Interim Report summarized the information that the Service received in response to compliance questionnaires sent to more than 400 colleges and universities in October 2008. The Interim Report identified executive compensation as an area of focus moving forward with the Compliance Project. The information in the Interim Report is valuable for all tax-exempt organizations because it provides a roadmap of the issues to be reviewed during future IRS examinations. Two of the most prominent issues discussed in the Interim Report were executive compensation and organization governance.
In reviewing executive compensation and organizational governance, the Interim Report noted that the "questions were principally focused on issues related to excess benefit transaction under section 4958 of the Code."2 As such, the Service gathered a substantial amount of information about the total amount and type of compensation provided to the officers, directors, trustees, key employees, and highly compensated employees of each surveyed college and university. Additionally, the questions requested information about the compensation approval process used by each organization, including: whether the organization had a written compensation policy, whether the organization used outside consultants to determine the reasonableness of the amount of compensation paid, whether the organization used comparability data to determine the reasonableness of the amount paid to its executives, and whether the organization's compensation approval process was sufficient to establish the rebuttable presumption of reasonableness.
Based on the Service's public and published statements, including the Interim Report, it is clear that executive compensation is a significant issue on which the Service is focused. Thus, it would be wise for organizations to focus their own attention on identifying and addressing potential issues related to executive compensation.
IRS enforcement efforts. All of the information that the Service has publicly disclosed with respect to its review and enforcement activities regarding executive compensation comports with its actual enforcement efforts. As noted by Lois Lerner, the Service has once again started enforcing the provisions of Section 4958.
A quick review of the published rulings by the Service demonstrates that, while the Service published five technical advice memoranda imposing excise taxes under Section 4958 in 2004, it imposed or recommended the imposition of such taxes in only one published TAM or private letter ruling between 2004 and 2011. Additionally, since the Fifth Circuit found that the Service failed to meet its burden in imposing intermediate sanctions in Caracci, 98 AFTR 2d 2006-5264, 456 F3d 444, 2006-2 USTC ¶50395 (CA-5, 2006), the Service's enforcement of Section 4958 had been almost nonexistent. Since October 2008, however, the author's firm has seen 18 cases in which the Service imposed or proposed intermediate sanctions under Section 4958. Additionally, the Service recently litigated a case regarding the imposition of excise taxes under Section 4958 in the United States Tax Court ("Tax Court"). Thus, consistent with its many public statements, the Service's enforcement efforts evince its focus on executive compensation and, in particular, on the enforcement mechanisms of Section 4958.
Others. While the focus of this discussion is on IRS enforcement efforts with respect to executive compensation, to put this issue in its proper perspective, it is important to include a brief discussion on other individuals and entities that may be concerned with the amount of compensation earned by an organization's executives, as well as the motivations for such interest. Those interested include potential donors, competing organizations and interests, the media, and employees.
Potential donors. Due to the economic conditions of recent years, the pool of available donations for charities has dwindled and the competition for funding has increased. Increased competition for more limited donations is making it increasingly important for organizations to use information available to the public, such as the Form 990, to demonstrate that the organization is using its funds to the fullest extent possible to efficiently achieve their exempt missions. This is especially important when trying to attract charitable contributions from potential donors.
Overall, donors are primarily concerned with a charity's exempt mission and a significant concern when making a substantial contribution is how that contribution will be used to accomplish that mission. For many organizations, the list of donors often includes a substantial number of people who take the organization's mission personally because their lives have been affected by the issue that the organization is working to address. Such donors care less about the fairness of the organization's executive compensation than they do about accomplishing the organization's underlying mission. Due to the substantial amount of information disclosed in an organization's Form 990, any potential donor can look at page 10 of a charity's Form 990 and instantly see and compare the portion of an organization's expenses that are comprised of executive compensation with the portion of the organization's total expenses that are used on programs directly related to the organization's mission.
Given the limited pool of charitable donations and the increased competition for them, it is easy for competing organizations that expend a smaller portion of their total expenses on executive compensation to use this information to demonstrate a greater commitment to the accomplishment of the organization's exempt mission, regardless of the veracity of such claims. As such, the provision of excessive compensation, or even high but reasonable compensation, may impact the perception that donors have of the organization and the willingness of such donors to make contributions to a particular charity.
Competing organizations and interests. A recent trend in the world of tax-exempt organizations is for individuals to use information reported in the Form 990 to publicly discredit the tax-exempt status of entities. These attacks tend to focus on competing interests and seek to use media and regulatory attention to change public opinion or even cause the revocation of an organization's tax-exempt status. A recent example of this is a complaint filed with the IRS by Common Cause against the American Legislative Exchange Council (ALEC) in May 2012, in which Common Cause filed a complaint with the Service seeking a review of ALEC's activities. Another example is the Playoff PAC, an organization created for the purpose of eliminating college football's Bowl Championship Series (BCS) and replacing it with a playoff system (an effort motivated in part by perceived excessive compensation involved in the playoff system). The Playoff PAC example should be considered by all charities that engage in highly politicized or controversial activities and lack adequate compensation approval processes.
The Playoff PAC was able to garner a substantial amount of media exposure by using publicly available information to create the perception that the individual tax-exempt organizations comprising the BCS—the Fiesta Bowl, Sugar Bowl, Orange Bowl, and Rose Bowl—were using the benefits of their status as public charities to engage in prohibited activities such as the provision of excessive compensation. A large part of the Playoff PAC's success appears to be its ability to attract media and public attention to the compensation and compensation practices of the Fiesta Bowl in particular, and the compensation provided to its chief executive officer, John Junker. The perceived abuses, especially those related to executive compensation and extravagant employee benefits, were the subject of multiple media exposes, and were the subject of reports by ESPN, HBO, Sports Illustrated, and the NonProfit Times. Based, in part, on the efforts of the Playoff PAC and the negative attention it was able to attract to the compensation of the executives of the individual bowl organizations, John Junker was fired and subjected to criminal investigations, and college football's BSC system was recently replaced with a playoff system.
The Playoff PAC example is also indicative of the media attention that compensation issues attract. The success of the Playoff PAC in obtaining its goal of a college football playoff was largely attributable to the public and political pressure that the Playoff PAC was able to impose on the various entities that make up the BCS, such as the individual bowl organizations. Moreover, the general interest in the issues discussed in the media helped focus the public and political attention on the BCS.
As demonstrated by the Playoff PAC example, questions about executive compensation can have a significant impact on an organization and on the individual executives who receive it. Also, compensation that is perceived to be excessive, whether or not it actually rises to the level necessary for enforcement by the Service, is an issue that can generate a lot of attention and potentially lead to significant problems for an organization and its executives.
Employees. Another group that frequently focuses on executive compensation is an organization's employees. The payment of high compensation to an organization's executives may result in complaints or the dissatisfaction of employees who receive substantially lower salaries. While this may be expected and accepted to some degree in any organization, the disparity between executive and staff compensation is often far greater in nonprofit organizations. This can cause issues when an organization pays its chief executive at the 90th percentile while the rest of its staff and management team is paid at the 50th percentile. For the long-term success of the organization, it is important that the organization's employees be qualified and capable because a productive organization is the product of a productive workforce. When an organization clearly favors a single employee or position over others, it may lead to dissatisfaction and high turnover amongst the rest of the employees, which may lead to greater turnover and a less productive organization. Thus, it is important to keep the perceptions of employee compensation in mind when establishing executive compensation.
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Footnotes
1 Available at www.irs.gov/pub/irs-tege/cucp_interimrpt_052010.pdf.
2 Interim Report at 54.
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