United States: IRS And Congress Target Exempt Organizations’ Executive Compensation Practices

Executive compensation practices of tax-exempt organizations continue to draw U.S. media attention and government scrutiny. The Internal Revenue Service recently announced its plans to contact hundreds of tax-exempt organizations (EOs) this summer regarding the compensation paid to their highest paid employees. The IRS has also announced that it will be reviewing transactions reported on the Form 990 by Section 501(c)(3) and 501(c)(4) tax-exempt organizations as "excess benefit transactions," as well as any failure of an EO to indicate on the Form 990 whether it has had any excess benefit transactions.

These IRS enforcement initiatives follow in the wake of a near daily barrage of compensation scandals in the not-for-profit world. The most recent of these scandals involves a jury verdict against two former executives of the King Foundation ordering the repayment of $7.5 million in compensation and the payment of $14 million in punitive damages.

The IRS initiatives will be proceeding on a parallel course with two other significant developments focused in part on exempt health care organizations’ use of charitable assets and other business practices. The first development is the congressional hearings held on June 22, 2004, by the Senate Finance Committee and a subcommittee of the House Ways and Means Committee. The hearings concern the oversight of tax-exempt public charities and the consideration of possible reforms that would address abuses involving EOs. In his testimony before the Senate Finance Committee, IRS Commissioner Mark Everson expressed the concern that EO governing boards are not exercising sufficient diligence as they set executive compensation, and he labeled the IRS audit initiative as an "aggressive program."

The second development is the series of class action lawsuits filed on June 16, 2004, against 13 exempt health care organizations across the United States (and expanded on June 22 to include five additional health systems). Among other things, these class actions challenge the pricing and collection practices used for uninsured patients, as well as the uses of funds in favor of persons of influence that otherwise could be used to underwrite care for the uninsured. These developments together highlight the need for Eos to conduct a federal tax-exemption compliance review of their executive compensation decisions as well as the corresponding executive compensation philosophies, plans, policies and procedures.

The IRS will select hundreds of EOs to include in the soft contact reviews on the basis of the information reported on their Form 990 annual information returns. The IRS will request that selected EOs provide detailed support for the compensation and benefits provided to highly paid employees reported on the Form 990. The IRS likely will be looking for information to address the following issues:

• Did the board, or a board committee, review and approve all forms of compensation and benefits?

• Are the board members who approved compensation truly independent?

• Did the board, or a board committee, rely on data showing the total compensation and benefits provided to similar positions at similarly situated organizations?

• Did the board, or a board committee, go through all the steps necessary to qualify for the "rebuttable presumption of reasonableness" under the intermediate sanctions rules if applicable?

• Did the EO properly report all forms of compensation and benefits on its Form 990 (Annual Information Return)?

• Did the EO fail to check either "yes" or "no" in line 89b on the Form 990, indicating whether the organization has had or discovered an excess benefit transaction?

As Commissioner Everson testified before the Senate Finance Committee on June 22, this "comprehensive enforcement project" is designed to help the IRS learn two things in particular: the practices that EOs are using to set compensation, and how EOs are reporting compensation to the IRS and to the public. The information gleaned by the IRS will go far in determining IRS enforcement priorities and legislative proposals for the next several years. Those EOs that are unable to demonstrate both sufficient support for their compensation decisions and the proper reporting of compensation will set the stage for the enforcement and legislative initiatives that follow.

It is important for EOs providing significant compensation and benefits packages to prepare for this level of scrutiny, particularly those EOs that may be possible targets of these IRS investigations and private class-action lawsuits. To the extent that they have not already done so, the best preparation would be to conduct an internal review of their compensation programs. The internal review should address both the substance of the compensation and benefits arrangements, as well as the policies and procedures by which compensation and benefits are designed, reviewed, approved and implemented. Properly designing and scrupulously following such policies and procedures is critical to achieve compliance.

One of the most important aspects of an internal review will be to assess whether the organization has appropriate comparability data in place–that is, detailed data showing that the total compensation and benefits an EO provides to its executives is comparable to those provided by similarly situated organizations for similar positions. If an organization intends to qualify for the rebuttable presumption of reasonableness under the intermediate sanctions rules, the comparability data must be sufficient to stand up to IRS scrutiny. This will require close consideration of how the EOs comparability data comports with the guidance on developing comparability that the IRS has provided in the intermediate sanction regulations. Having comparability data that meets IRS standards is critical in preparing for an IRS "soft contact." Also, for purposes of potential exposure to the organization manager intermediate sanction excise tax, the EO should determine whether it obtained legal advice concerning compliance under the intermediate sanctions provisions, including qualification for the rebuttable presumption of reasonableness.

EOs should also address the following legal questions before the IRS knocks on the door:

• If an IRS "soft contact" were to occur, exactly what documentation must, or should, be disclosed?

• What information is protected from disclosure by the attorney-client privilege, and will turning over a privileged document be considered a waiver of the privilege as to other compensation-related information that the organization would prefer not to disclose? In other words, as the result of turning over what the organization would like to disclose, what other (perhaps less favorable) information will have to be turned over?

• How strong is the organization’s argument that it has satisfied the IRS criteria for rebuttable presumption protection?

• Has all compensation and benefits information (for officers and key employees) been properly reported on the Form 990? If not, is a corrected filing appropriate before an IRS "soft contact" occurs? Could a correction cause the application of the IRS’s position concerning automatic excess benefits?

• What is the most appropriate way to value deferred compensation arrangements, and how is this information best reported on the Form 990?

• If any compensation and benefits arrangements are not adequately supported by appropriate documentation, is it prudent now to conduct a review and approval of future payments before an IRS "soft contact" occurs? In other words, if the process by which compensation and benefits have been reviewed and approved is lacking, should the substance of the arrangements be reviewed now to assess whether compensation and benefits would be considered reasonable?

After completing the internal compliance review, the EO will have to determine how to address weaknesses identified in the structure, amount and corresponding support for compensation and benefits arrangements. Depending on the nature and extent of the weakness, options to consider in such cases range from prospective correction to voluntary disclosure to the IRS. Certainly, one significant issue will be how to answer line 89b of the Form 990, which requires the EO (and the attesting officer who signs the Form 990 under penalties of perjury) to state whether the organization in that year either engaged in an excess benefit transaction (such as the payment of unreasonable compensation or benefits to a senior executive) or became aware of an excess benefit transaction that occurred in a prior year. Answering "yes" to this question requires full disclosure of the transaction, which, as part of the Form 990, is open to the public. In addition, answering "yes" to this question will likely trigger IRS review of the transaction. Before making a required Form 990 disclosure of an excess benefit transaction, an EO should conduct a thorough analysis of the transaction and should prepare and implement a complete plan of correction.

When undertaking prospective correction of current arrangements and establishing new arrangements, the EO should strive to qualify for the intermediate sanction rebuttable presumption of reasonableness and to prepare appropriate documentation to that effect, including a written legal opinion. Obtaining a legal opinion will require close coordination of the legal analysis with those responsible for developing the appropriate comparability data.

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