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Why Does a Nonprofit Need to Document its Executive Compensation Policy?

By: Robert Moreland, CPA,Tax Manager and Kara Clark, CPA, Staff Accountant

In 2004, the Internal Revenue Service, through the Exempt Organizations Office of the Tax Exempt and Government Entities Division, commenced the Executive Compensation Compliance Initiative. This project was divided into three parts. In the first part, compliance check letters were sent to 1,223 organizations whose Forms 990 and 990-PF failed to provide adequate information detailing executive compensation. Part two of the project involved determining if compensation of disqualified individuals was considered reasonable under the tax code. This phase of the Initiative involved 782 organizations that had reported significant compensation for at least one officer on their Form 990 or 990-PF. The third part of the Initiative was to be based upon the findings from part two. In 2007, the IRS issued a report of their findings from the first two parts of the Initiative and indicated that, as of the report date, part three was ongoing and that the IRS would continue to look at executive compensation.

Some of the more significant findings in the report included1:

  • Examinations completed to date do not evidence widespread concerns other than reporting. However, as this was not a statistical sample, no definitive statement can yet be made concerning the compliance level in this area. Continued work in the area of executive compensation is warranted.
  • Additional education and guidance, as well as training for agents, are needed in the areas of reporting requirements, and the “rebuttable presumption” procedure that may be relied upon by public charities to establish appropriate compensation.
  • Changes in the Form 990 series are necessary to reduce errors in reporting and provide sufficient information to enable the IRS to identify compensation issues.

As evidenced by the 2007 report, nonprofit organizations continue to be under scrutiny by the IRS, a host of state legislatures, governors, attorneys general and even county governments regarding their executive compensation packages. For this reason, every nonprofit board has a fiduciary responsibility to the organization for determining and approving reasonable compensation of the executive director and other key employees.

Revisions to Form 990

As a result of the Initiative and in an effort to create more transparency, the recently updated version of Form 990 has placed a greater emphasis on disclosure of how compensation is being determined and approved. Question 15, in part VI of the core Form 990 asks if “the process for determining compensation of the following persons (executive directors, officers, and or other key employees are listed or other) includes a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision?” The process must then be described on Schedule O. When completing this narrative, organizations need to keep in mind that it should be clear and concise and use language to meet the prongs of IRS’s rebuttable presumption rule.

Executive Compensation Packages

Given the changes to Form 990 and the continued vigilance of the IRS to monitor executive compensation, it is important that the organization keep in mind the three factors when creating an executive compensation package that provides a “rebuttable presumption” that the compensation is reasonable and places the burden of proof on the IRS should executive compensation come under examination.

To ensure that the nonprofit executive compensation package can withstand the scrutiny of the IRS, the following three elements must be included in the determination process:

  • The executive compensation must be reviewed by independent persons. This could be a compensation committee or the executive committee.
  • There must be the use of “comparability data”. This may include surveys or studies from an outside consultant. It should be noted however that for data to be comparable, the information should be compiled from organizations situated in a similar geographical area, budget size, sector, etc.
  • The amounts/policy must be documented. Most commonly this occurs through meeting minutes, detailing the board’s consideration and approval.

Once established, the executive compensation package should be reviewed annually, using the three elements described above. By continuing to monitor and evaluate the executive compensation packages maintained by an organization, a layer of protection for the organization and its board members is created in the event of an IRS examination.

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