Recently, the IRS, state Attorney Generals, and charity watchdog groups have raised concerns regarding the payment of excessive compensation to charity executives.  For example, the redesigned Form 990 includes numerous questions regarding compensation and related practices.  The IRS has sent compensation questionnaires to thousands of hospitals and universities.  Recently, Protect the Hershey’s Children sent a letter to the IRS Commissioner, Senate Finance Committee, and Pennsylvania Department of Banking alleging board compensation abuses at the Milton Hershey Trust School and Milton Hershey School. 

I believe it is likely that charities will continue to experience heightened scrutiny of executive compensation from the public, IRS, and Attorney Generals, especially in light of the additional compensation data that is now available on the Form 990.  In addition to negative publicity, payment of excessive executive compensation may result in loss of the charity’s exempt status (private inurement), the imposition of excise taxes on the executive who received and the directors who approved the compensation (excess benefit or self-dealing rules), and other potential penalties imposed by the state Attorney General. 

So what can your charity do to protect itself against scrutiny?  The answer is simple – follow the procedures set forth in the Treasury Regulations! 

Treasury Regulation Section 53.4958-6(a) establishes a method for creating a rebuttable presumption in favor of the charity that executive compensation is reasonable.  Under this “safe harbor,” compensation is presumed to be reasonable if the following conditions are satisfied:

  1. The compensation arrangement is approved in advance by an authorized body (directors or compensation committee) composed entirely of individuals who do not have a conflict of interest with respect to the compensation arrangement;
  2. The authorized body obtains and relies upon appropriate data as to comparability prior to making a determination (e.g., compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions; the availability of similar services in the geographic area; independent compensation surveys; or actual written offers from similar institutions competing for the services); and
  3. The authorized body adequately documents the basis for its determination concurrently with making that determination.

If these requirements are satisfied, the IRS may rebut the presumption only if it develops sufficient contrary evidence to rebut the probative value of the comparability data relied upon by the authorized body.

Compliance with these requirements has become “best practices” for charities and may have significant value at the audit stage or in litigation since many cases are decided based on the burden of proof.  In addition, although it will not prevent an allegation, compliance with the IRS safe harbor may help refute allegations of excessive compensation.