Stopping Excessive Benefits

IRS unveils proposed rules to crack down on high pay

The Internal Revenue Service has released proposed regulations to explain how it will enforce a law designed to punish top executives and board members who receive overly generous financial benefits through their involvement with non-profit groups.

The law, which was enacted two years ago, says charity officials who receive inappropriately high salaries or perquisites will be fined, as will trustees who approve them. Sweetheart deals involving charity trustees and officers could also lead to financial penalties, as could some charity relationships with donors.

The law generally applies to transactions that occurred after September 13, 1995.

The statute’s penalties are often referred to as “intermediate sanctions” because until the law was passed, the I.R.S. had only one way to punish abuses: Revoke a charity’s tax exemption. Because that penalized an entire organization and the people who benefited from its services, the agency rarely took that step.

The new rules apply to people involved with charities as well as with advocacy groups classified under Section 501(c)(4) of the Internal Revenue Code.

Under the statute’s provisions, the I.R.S. is allowed to force charity officials to pay fines equal to 25 per cent of the portion of the compensation or other benefits found to be excessive. If such officials failed to pay the penalties or return the portion of the compensation considered excessive, they could face fines of up to 200 per cent of the money they received improperly. Board members who approved excessive benefits could be subject to a 10-per-cent tax, up to $10,000.

The I.R.S.’s proposed regulations define the terms used in the law, provide examples of how the rules would be applied, and explain the detailed steps charities may take to head off trouble.

Charity leaders gave the I.R.S.’s proposal some early positive reviews, although they cautioned that they were still studying the rules and expected to find fault with certain provisions. Many officials were hopeful that the law and regulations will help both government and charities put a lid on abuses.

“It’s going to give the I.R.S. some more maneuverability,” said Daniel Borochoff, president of the American Institute of Philanthropy, a watchdog group. “Given the I.R.S.’s small staff in relation to the giant size of the non-profit field, they can’t look at everybody and they may only be able to look at the worst abuses.” So, Mr. Borochoff said, “the greatest good of this will be providing an education to non-profits on prudent operating practices.”

Said Matthew Hamill, vice-president for government relations at Independent Sector, a coalition of major charities and grant makers: “The rules are relatively easy to understand. They are not something that only lawyers and accountant-types can understand and apply. Non-profit executives can incorporate them into their management practices.” Mr. Hamill added: “For most charities, the issue is knowing how to do this right so they can avoid a problem later.”

Substantial Influence

The law passed in 1996 allows the I.R.S. to fine employees and officers who have a substantial influence over the affairs of a charity, such as top executives and board members, who are called “insiders” by lawyers. Also covered by the statute are an insider’s family members and any businesses in which an insider has control of at least 35 per cent of the assets.

The I.R.S.’s proposed regulations spell out what other kinds of people are — and are not — considered to have substantial influence over organizations.

Those that are include voting members of governing bodies; presidents, chief executive officers, or chief operating officers; and treasurers and chief financial officers.

Others could also be considered insiders, the I.R.S. said, depending on relevant “facts and circumstances.” A person who tends to have “substantial influence” includes someone who:

• Founded an organization.
• Is a major donor to a group. (That means that he or she provided more than $5,000 and that amount was more than 2 percent of the organization’s total gifts.)
• Received compensation based on revenue stemming from activities of the organization that the person controlled.
• Has authority to control or determine a significant portion of the organization’s capital expenditures, operating budget, or compensation for employees.
• Has managerial authority or serves as a key adviser to a person with that authority.

On the other hand, the I.R.S. said that it tends not to consider the following people as insiders: an employee who took a vow of poverty; an independent contractor, such as a lawyer, accountant, or investment manager (with some exceptions); and donors who gave significant sums and received preferential treatment from a charity — as long as the organization offered the same treatment to anyone who made a similar gift during a fund-raising campaign.

Net ‘Cast Very Broadly’

James J. McGovern, former top charity regulator at the Internal Revenue Service, said that charities should be pleased that the proposed rules clarify who is an insider. “The bad news is the definitional net has been cast very broadly,” especially for large groups like universities and health-care organizations, said Mr. McGovern, who now works for the accounting firm KPMG Peat Marwick. Insider status, he said, “is likely to reach far beyond the corporate officer and senior vice-president ranks to positions such as department chair or medical director.”

The I.R.S., in a hypothetical example, said that a company that manages bingo games for a charity is an insider because it provides all of the staff members and equipment to run the games, pays the charity a percentage of the revenues, which make up more than half of the charity’s annual income, and has “full managerial authority” over the charity’s principal source of money. The company, according to the revenue service, “is in a position to exercise substantial influence over the affairs” of the charity.

But, the I.R.S. said, a major donor to a repertory theater company is not considered to be an insider even though he got “preferential treatment” for making a large gift, including an invitation to a special opening production and party and the right to reserve tickets for performances. A key reason: The charity provided similar treatment to all others who made the same gift.

The I.R.S. said that charity board members, as insiders, could be fined if they have “actual knowledge” of the facts that make someone’s compensation excessive; are aware that the compensation may violate the law; and negligently fail to make reasonable attempts to find out whether the compensation is excessive.

The government would declare that board members “participated” in the decision to provide excessive compensation if they were silent or took no action when the charity set the pay. But if trustees were on record as opposing the decision, the government would let them off the hook.

“The message is clear,” said Mr. McGovern. “Silence in the boardroom can result in personal tax liability for members of the board of trustees.”

Detailing What Is Acceptable

The Internal Revenue Service’s proposal describes in detail what kinds of compensation that it considers to be acceptable and what is out-of-bounds.

Acceptable to the agency, for example, are the reasonable expenses that charities pay to trustees to attend board meetings. Also permitted: a charity’s payment of an insider’s liability insurance premium to cover any fines imposed on the person under the new law, as long as the premium is treated as compensation and the person’s total pay is reasonable.

But the I.R.S. said that an insider could sometimes get in trouble if the person’s compensation were based on a “revenue-sharing” arrangement — when an insider’s pay was based in whole or in part on the charity’s income. Problems could arise, the I.R.S. said, if the person could “receive additional compensation without providing proportional benefits that contribute to the organization’s accomplishment of its exempt purpose.”

For example, the I.R.S. said that it would not penalize a charity employee who manages the organization’s investment portfolio and receives a bonus that is based on the percentage of the increase in the value of the charity’s portfolio over a year. The reason: The bonus is “an incentive to provide the highest quality service in order to maximize benefits and minimize expenses” to the charity, the I.R.S. said.

But in another hypothetical example, the government said that it would have problems if, among other things, a company that runs a charity’s gambling operations gave the charity a percentage of net profits. In this example, the I.R.S. said, the company “controls the activities generating the revenue on which its compensation is based” as well as the amount the charity is charged for the company’s services. The deal does not provide the company “with an appropriate incentive to maximize benefits and minimize costs” to the charity, the I.R.S. said, and the company will benefit “whether expenses are high and net revenues are low or expenses are low and net revenues are high.”

Mr. McGovern said that he was disappointed with the revenue-sharing part of the text. “While the proposed regulations establish a framework for structuring such arrangements, they may raise more questions than they answer.”

Providing a Road Map

The I.R.S.’s proposal gives charities a road map they could follow to stay out of trouble when they set compensation. The government would presume such pay to be reasonable — and not an “excess benefit” — if it was approved by a charity board that:

Was composed entirely of people who did not have a conflict of interest with the person receiving the compensation or other benefits.

Collected compensation figures for similar non-profit and for-profit organizations and used them in determining salaries. Charities with gross receipts of less than $1-million annually would only have to obtain data from five other “comparable organizations in the same or similar communities.”

“Documented adequately” the steps it took. For example, if the board decides “that reasonable compensation for a specific arrangement or fair market value in a specific transaction is higher or lower than the range of comparable data obtained, the governing body or committee must record the basis for its determination.”

Lee M. Cassidy, executive director of the National Federation of Nonprofits, a Washington-based association, said he had general praise for those three requirements.

“If you do things at arm’s length, if you use some comparability data, and if you keep good records, that will tend to keep you out of trouble,” said Mr. Cassidy. “It’s a good umbrella.”

In an example provided in its proposal, the I.R.S. said that a university’s board could be penalized if it set a president’s salary by relying on a national survey of compensation for presidents that did not “divide its data by any measure of university size or other criteria,” and if the board members did not have particular expertise in higher-education compensation matters.

Revocation Still Possible

In an explanation of its proposal, the I.R.S. makes clear that it can still revoke a charity’s tax exemption if it finds that excess compensation has been paid.

Congress said that a fine on insiders will suffice when the unreasonable pay “does not rise to a level where it calls into question whether, on the whole, the organization functions as a charitable or other organization,” the revenue service said.

But the I.R.S. could move to pull an exemption if, for example, the charity grossly overpaid executives or had repeatedly gotten in trouble with pay problems.

The I.R.S. said that the public may rely on the proposed rules for guidance pending the publication of final rules. If the final regulations turn out to be more restrictive than the proposed rules, the government will apply them from the date they are published rather than retroactively.

The revenue service’s proposed regulations were published in the August 4 issue of the Federal Register, Pages 41,486-506.

The I.R.S. wants to hear from the public about changes that should be made before it issues final regulations.

Comments and requests for a hearing must be received by the government by November 2. They can be mailed to CC:DOM: CORP:R (REG-246256-96), Room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington 20044.

Comments also may be sent to the I.R.S. electronically by following the instructions on the revenue service’s World-Wide Web site at http://www.irs.ustreas.gov/prod/tax_regs/comments.html.

For more information about the proposed rules, call Phyllis D. Haney at the I.R.S. at (202) 622-4290.