Does Your Institution Utilize the Proper Process for Determining Executive Compensation?

Situation

Troas Bible College (TBC) is a private university.  TBC has a procedure for determining executive compensation each year.  The finance committee of the board of trustees (all members of the committee are free from a “conflict of interest” as described in the instructions for Form 990, Part VI, Section B, Line 15) reviews and approves compensation for the college president and other officers and/or key employees.  Each year, this “qualified” committee utilizes salary and benefit data from compensation studies that are done every three years and then documents the process in a contemporaneous, written manner in the committee minutes.  Can TBC answer “Yes” to Form 990, Part VI, Section B, Lines 15a and 15b?  Yes.

Rules

Although a murky area, I would suggest that a compensation study is not required each year in order to be considered “comparable data”.  Certainly, annual compensation studies would be a good practice, but the data likely has some reasonable “shelf life”.  I am not sure where the line is, but it would appear that – for many organizations – a reasonable case could be made for a compensation study being valid for three years.  However, raises and other changes to compensation and/or changes to tax laws could affect this position and governing boards should be intelligent about this process.

The Form 990 instructions state…

Form 990, Part VI –

Line 15. Answer “Yes” on line 15a if, during the tax year, the organization (not a related organization or other third party) used a process for determining compensation (reported in Part VII or Schedule J (Form 990)) of the CEO, executive director, or other person who is the top management official, that included all of the following elements.

Review and approval by a governing body or compensation committee, provided that persons with a conflict of interest regarding the compensation arrangement at issue were not involved. For purposes of this question, a member of the governing body or compensation committee has a conflict of interest regarding a compensation arrangement if any of the following circumstances apply.

  1. The member (or a family member of the member) is participating in or economically benefiting from the compensation arrangement.
  2. The member is in an employment relationship subject to the direction or control of any person participating in or economically benefiting from the compensation arrangement.
  3. The member receives compensation or other payments subject to approval by any person participating in or economically benefiting from the compensation arrangement.
  4. The member has a material financial interest affected by the compensation arrangement.
  5. The member approves a transaction providing economic benefits to any person participating in the compensation arrangement, who in turn has approved or will approve a transaction providing economic benefits to the member. See Regulations section 53.4958-6(c)(1)(iii).

Use of data as to comparable compensation for similarly qualified persons in functionally comparable positions at similarly situated organizations.

Contemporaneous documentation and recordkeeping for deliberations and decisions regarding the compensation arrangement. Answer “Yes” on line 15b if the process for determining compensation of one or more officers or key employees other than the top management official included all of the elements listed above.

If the answer was “Yes” on line 15a or 15b, describe the process on Schedule O (Form 990 or 990-EZ), identify the offices or positions for which the process was used to establish compensation of the persons who served in those offices or positions, and enter the year in which this process was last undertaken for each such person.

*If the organization did not compensate its CEO, executive director, or top management official during the tax year, answer “No” to line 15a. If the organization did not compensate any of its other officers or key employees during the tax year, even if such employees were compensated by a related organization, answer “No” to line 15b. (In this situation, it might be good to explain on Schedule O.)

This is an important concept because “unreasonable” or “excess” compensation may result in substantial penalties under Internal Revenue Code section 4958.  If the “unreasonable” compensation is deemed to be an “excess benefit transaction”, the executive would be required to 1) pay back the “excess” amount with interest, 2) pay the IRS a 25% “Tier 1” penalty, and/or 3) may be subject to an additional 200% “Tier 2” penalty.

For Our Canadian Friends

Canada’s Income Tax Act (ITA) in s. 188.1(4) contains similar penalties for “Undue benefits” as follows:

A registered charity that, at a particular time in a taxation year, confers on a person an undue benefit is liable to a penalty under this Part for the taxation year equal to

(a) 105% of the amount of the benefit, except if the charity is liable under paragraph (b) for a penalty in respect of the benefit; or

(b) if the Minister has, less than five years before the particular time, assessed a liability under paragraph (a) or this paragraph for a preceding taxation year of the charity and the undue benefit was conferred after that assessment, 110% of the amount of the benefit.

Note that (again similarly) ITA s. 188.1(5) excludes payments of “reasonable” compensation as follows:

[The penalty for undue benefits] does not include a disbursement or benefit to the extent that it is
(a) an amount that is reasonable consideration or remuneration for property acquired by or services rendered to the charity;

Bottom Line

Be watchful, prayerful, and careful when it comes to reporting executive compensation. Your school should endeavor to follow the “rebuttable presumption” guidelines set forth in Treasury Regulation 53.4958-6. Note, however, that the 2014 House Ways & Means Committee Tax Reform proposal sets forth changes to these accepted rules.

Specific questions? Email Dave Moja

The information provided herein presents general information and should not be relied on as accounting, tax, or legal advice when analyzing and resolving a specific tax issue. If you have specific questions regarding a particular fact situation, please consult with competent accounting, tax, and/or legal counsel about the facts and laws that apply.