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Excise Taxes For Unreasonable Compensation At Charities

By: Stephen D. Kirkland, CPA, CMC
Tel: 803-477-5973
Email Stephen D. Kirkland

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The Internal Revenue Service (IRS) now keeps a close eye on charities and social welfare organizations to ensure that their tax-exempt status is not abused. One of the primary factors the IRS now examines is the amounts of compensation and benefits provided by charities to their key employees.

The IRS believes that some of these key employees may be taking advantage of their influential positions by setting their own compensation packages at above-market levels.

In the past, the IRS did little about overpaid executives at charities. They could revoke the tax-exempt status of a charity, but the IRS rarely chose to take such an extreme step. The IRS also had Internal Revenue Code section 4958, which allowed them to impose penalties, in the form of excise taxes, on the excessive portion of compensation paid to an employee. But the Pension Protection Act of 2006 increased the limit on section 4958 excise taxes, and the IRS has increased its efforts to find overpaid executives.

Under Code section 4958, the IRS can impose a 25% excise tax on the unreasonable portion of an individual�s compensation. (This excise tax is in addition to federal and state income tax, and FICA tax the employee has to pay on that compensation.)

Primary targets include officers who also sit on the charity�s Board of Trustees, relatives of major donors, long-term employees who have cut back their hours, those who receive performance bonuses, and anyone who has a hand in setting his or her own compensation level. Certain industries are also of special interest to the IRS. For example, hospitals are a target because market conditions have pushed their officers� compensation to such high levels.

Employees are not the only ones subject to the 25% excise tax. Over-paid independent contractors are subject to the tax also. This could include financial advisors.

In addition, section 4958 allows the IRS to impose an excise tax on an officer or board member who permits the unreasonable compensation. This tax is 10% of the unreasonable portion of the compensation. It was limited to $10,000 per transaction until the 2006 tax act raised that limit to $20,000. Officers and board members who knowingly allow the excessive compensation are jointly and severally liable for this excise tax.

Both the 25% and the 10% excise tax are imposed upon the individuals, not the charity. The IRS recently imposed $21 million in Section 4958 excise taxes on forty individuals at various charities.

In addition to the monetary impact, the publicity resulting from these penalties can be disastrous for a charity.

The Code refers to the unreasonable portion of compensation as an �excess benefit transaction� because the employee is getting a benefit (compensation) in excess of the value of services he or she provides in exchange.

Setting levels of compensation for key employees is difficult for charitable Boards of Trustees since most board members are not familiar with the complexities of compensation analysis. In fact, determining appropriate cash compensation levels for key employees at a charity may be more challenging than doing so at for-profit companies since charities cannot offer stock options, profit-sharing plans and some of the other incentives rewarded to executives at for-profit entities.

Yet pay levels and benefits at charitable organizations must keep up with the market to prevent turnover, since turnover among key employees is costly, interruptive, and damaging to donor relations.

Many charities are turning to compensation professionals for guidance on pay levels due to their complex facts, the subjective nature of determining reasonable compensation, and the desire to avoid IRS scrutiny.

The last thing you or any other volunteer board member wants is to be personally exposed to a penalty excise tax. An opinion letter from an independent consultant can give officers and board members comfort that pay levels are in line, help reduce turnover and avoid the excise tax. To protect officers and directors from the 10% tax, the opinion letter must state that the consultant believes that if the compensation amount is challenged by the IRS, it will "more likely than not" be upheld in court. Although this is not a guarantee, having such an opinion letter on file does protect the officers and board members from personal exposure to the 10% excise tax.

In preparing opinion letters, we consider the individual employee�s qualifications, responsibilities, and the results he or she achieves. Other important factors include the size of the organization, the geographic area it serves, and compensation levels at similar-sized entities in the same industry.

We are now in an environment where emphasis on corporate governance is at an all-time high. And this includes charitable organizations. As part of that governance, each charity�s advisors and board members should monitor compensation and benefits of employees and contractors.

Stephen D. Kirkland, CPA, CMC, CFC is a compensation consultant with Atlantic Executive Consulting Group, LLC in Columbia, SC. He also serves as an expert witness in U.S. Tax Court cases involving the reasonableness of executive compensation.

See Mr. Kirkland's Profile on

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