Nonprofit Accounting Basics

IRS Compensation Findings for 501(c)(3) and 501(c)(4) Organizations

Note: Articles published before January 1, 2017 may be out of date. We are in the process of updating this content.

Once a scandal erupts, there’s very little chance any other initiative that has been undertaken by a group will receive much attention. That’s exactly what happened shortly after the final report for the Colleges and Universities Compliance Project was issued by the Internal Revenue Service (IRS). However, the report contains findings that will potentially have a large impact on the entire exempt organizations sector.

There are two major areas of concern outlined in the final report: compensation and unrelated business income. This article will discuss how the project was conducted and its compensation findings. The unrelated business income findings will be discussed in a future article.

The project started the same way as many other exempt organization projects have. A questionnaire was sent by the IRS to 400 randomly selected colleges and universities in 2008, of varying sizes, both public and private. Based upon the responses to the questionnaire, and prior Form 990 reporting, the IRS selected 34 organizations for examination. The final report provides an analysis based upon the questionnaire and examination results.

The compensation study focused on compliance with IRC Section 4958 as it pertains to public charities as defined in IRC Section 501(c)(3). The guidance also applies to Section 501(c)(4) organizations, but colleges and universities do not typically fall under this code section.

Section 4958 imposes an excise tax on compensation that constitutes an excess benefit transaction. Such transactions occur when a disqualified person receives more than reasonable compensation for the services she/he rendered to the organization. A disqualified person for this purpose is one who is able to exercise significant influence over the affairs of an exempt organization. Examples are officers, directors, trustees, and key employees.

Reasonable compensation is “understood to be the amount that would ordinarily be paid for like services by a like enterprise in like circumstances.” Compensation includes wages and all benefits.

During examination, the IRS may determine the compensation for disqualified persons is not reasonable, thereby forcing the exempt organization to prove the assertion is incorrect.

The burden of proof may be shifted to the IRS if three steps are taken under the “rebuttable presumption” rules as defined in the Section 4958 Regulations:

  • an independent body must review and approve the amount of compensation,
  • reliance should be placed on appropriate comparability data when setting the compensation amount, and
  • contemporaneous documentation relating to the compensation setting process must be kept.

In the case of the Colleges and Universities Compliance Project study, most of the organizations examined attempted to meet the rebuttable presumption criteria. However, approximately 20% of those organizations failed to do so because the comparability data used was not sufficient. Areas of concern were:

  • the comparability data relied on institutions that were not similar to the organization using the information due to location, endowment size, revenues, total assets, number of students, and selectivity;
  • when compensation studies were used, documentation was not available detailing the selection criteria for the schools included in the study (further, no explanation was provided for why these particular schools were considered comparable); and
  • Section 4958 requires the amounts reported include an explanation of the composition of the compensation. Compensation surveys did not always indicate whether only salaries were used in the analysis, or total compensation was used.

Failure to address these issues when developing comparability data could lead to a finding that the organization failed to meet the standards of the rebuttable presumption process, and create a situation where compensation is not deemed to be reasonable. As noted earlier, excise taxes could result.

Part VI, Line 15 of the Form 990 currently requests information relating to the three steps of the rebuttal presumption process from all filers, regardless of the code section under which the organization qualified as exempt. For filers other than those exempt under code sections 501(c)(3) and 501(c)(4), these questions are meant to convey best practices in the compensation setting process for those who would be considered disqualified persons.