the irs targets ttos: hot spots for tax compliance and audit avoidance strategies september 15, 2009...

The IRS Targets TTOs: Hot Spots for Tax Compliance and Audit Avoidance Strategies

September 15, 2009

Lorraine A. SciarraSenior University Counsel

Princeton University

Introduction

Compensation has been a significant issue for tax-exempt organizations at least since the mid-1990’s.

In 2006, the IRS completed an executive compensation compliance project of all exempt organizations.

It concluded that “significant reporting issues exist”:• Over 30% of compliance check recipients amended

their Forms 990. • 15% of the compliance check recipients were selected

for further examination.

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Introduction

Last year, the IRS sent questionnaires to 400 colleges and universities. Over 34 of the 94 questions posed dealt with compensation.

Slide 3

Introduction

The IRS is not the only one focused on executive compensation.

As opined by Senator Grassley in a letter to then Secretary of the Treasury Henry M. Paulson:

It can be easier to understand how much a Fortune 500 executive is paid than how much a charity is compensating [its] executives due to the shell games that go on in some cases.

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Private Benefit

A basic principle of not-for-profit law is that a section 501(c)(3) organization cannot benefit private interests or individuals.

No part of the organization’s net earnings may inure to the benefit of a private shareholder or individual. Section 501(c)(3).

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Private Benefit

The government is concerned with public dollars benefitting private individuals and with individuals who have the power to control or manipulate public institutions using public charities for their own good.

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Private Benefit

Prior to 1996, the IRS had a single enforcement tool it could use when it discovered that a person had used influence to extract unwarranted benefits from a public charity.

The sanction was revocation of the charity’s tax-exempt status.

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Intermediate Sanctions

In 1996, the so called intermediate sanction rules were introduced into the Internal Revenue Code.

The Code and implementing regulations clarified the rules about not-for-profit executive compensation.

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Under the intermediate sanctions rules of Code Section 4958, an excise tax is imposed in situations where a tax-exempt organization provides an “excess benefit” to an insider, called a “disqualified person”.

These excise taxes may be imposed on the insider as well as on officers, trustees and other managers who knowingly agree to provide the excess benefit.

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The purpose of IRC 4958 is to impose sanctions on the influential persons in charities who receive excessive economic benefits from the organization, rather than to punish the exempt organization itself.

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An “excess benefit transaction” is defined as a transaction in which a disqualified person receives a direct or indirect economic benefit from a tax-exempt organization that is greater than the value of what the disqualified person provided to the tax-exempt organization in return.

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A “disqualified person” is defined to include an individual who, at any time during the previous five years, is (or was) in a position to exercise substantial influence over the organization’s affairs.

An organization’s trustees and its officers and their family members and controlled entities are considered, by definition, to be disqualified individuals.

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The clearest example of an excess benefit transaction is when unreasonable compensation is paid to a disqualified person for services rendered to the organization.

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Automatic Excess Benefit Transaction

An excess benefit transaction may also occur in any of the following transactions between a 501(c)(3) organization and a disqualified person:

−reimbursement of personal expenses

−use of a vehicle owned by the organization for personal reasons

−use of real property owned by the organization for personal reasons

−lease of property to or from the organization

−sale of property to or from the organization

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− loans received from or made to the organization

− reimbursement of expenses of family members

− payments made to for-profit corporations owned by the disqualified person

− royalties received but not as compensation

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Rebuttable Presumption

The best way to avoid these issues is to take advantage of the rebuttable presumption offered by the regulations.

By following certain prescribed procedures, a presumption arises that the decision-making process with respect to a compensation arrangement is reasonable.

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There are three requirements for establishing the rebuttable presumption.

1.The compensation arrangement must be approved in advance by an authorized body of the applicable tax-exempt organization, which is composed of individuals who do not have a conflict of interest concerning the transaction.

2.The authorized body must obtain and rely upon appropriate data as to comparability prior to making its determination.

3.The authorized body must adequately and timely document the basis for its determination concurrently with making that determination.

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In meeting the rebuttable presumption, an organization should establish an independent trustee committee that reviews the compensation of all disqualified individuals.

Any trustee who has an economic, financial, family or employment relationship with the transaction being reviewed must recuse himself or herself from participating in the decision about the proposed transaction.

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Rebuttable Presumption - Comparable Data

The IRS has indicated that it considers reasonable compensation to be an amount ordinarily paid for:

−like services,

−by like enterprises (whether taxable or tax-exempt),

−under like circumstances.

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In assessing “like services”, the IRS looks at:

−the type of work performed,

−the number of employees managed,

−the budget or assets managed,

−whether multiple functions, departments, facilities or entities are managed, and

−whether two or more related organizations are involved.

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The IRS also looks at whether the work is:

−full-time or part-time,

−hands-on or general,

−national or local in scope, and

−covers the entire or only part of a year.

Compensation for service in multiple capacities for the same organization or group of related organizations must be aggregated.

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In assessing “like enterprises”, the IRS looks at the organization's:

−business type (pre-school vs. university, nursing home vs. hospital), and

−size, by budget, revenue, number of employees, and persons served.

The IRS has indicated that entities can be a mix of non-profit and for-profit, but they must be competing for the same pool of talent.

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In assessing “like circumstances”, comparables must:

−consist of a similar mix of compensation items,

−include all compensation items, whether taxable or not, and

−involve similar geography (urban vs. rural, size of area, cost of living).

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In assessing where in the “range of comparables” an executive should fall, the IRS wants the organization to consider:

−the ratio of revenues to proposed compensation,

−the ratio of expenses to proposed compensation,

−the executive’s track record,

−written offers from unrelated enterprises,

−competitive market pressures, and

−any special circumstances.

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The IRS cautions that:

“Surveys are not a “magic bullet”.

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Rebuttable Presumption - Minutes

As to the third factor, minutes, the organization should thoroughly document its deliberations and record in minutes the following information:

−description of the terms of the compensation arrangement;

− list of trustees who were present for the discussion and the names of those who voted;

− detailed description of the discussion about comparability data the trustees relied upon and how these comparability data were obtained;

− description of any action taken by a member of the board who had a conflict of interest with respect to the proposed action; and

− if the board determines that the compensation being paid is outside the range of comparability data it has reviewed, then the basis for its determination of reasonableness.

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Rebuttable Presumption - Minutes

The minutes must be prepared before the later of the next meeting or 60 days after final action is taken.

The minutes must be approved as

−reasonable,

−accurate, and

−complete

by the board or board committee that reviewed the proposed investment.

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The rebuttable presumption shifts the burden of reasonableness to the IRS. The IRS may refute the presumption of reasonableness only if it develops sufficient contrary evidence to rebut the probative value of the comparability data relied upon by the authorized body.

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The IRS has emphasized the importance of the rebuttable presumption:

Meeting the rebuttable presumption of reasonableness is not a prerequisite for having reasonable compensation but it will minimize the likelihood of future IRS scrutiny of the organization’s compensation arrangements.

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Under the statute and regulations, an organization must clearly indicate its intent to treat an economic benefit as compensation or the economic benefit will automatically be an excess benefit transaction under section 4958.

Slide 30


An organization indicates its intent to treat a benefit as compensation,

−by reporting the benefit on Form W-2 or 1099,

−by reporting the benefit on Form 990, or

−by the executive reporting the benefit on his or her Form 1040.

If the benefit is not reported, then it will be considered an automatic excess benefit transaction, with an automatic 25% tax on the amount of the benefit.

Slide 31

Form 990

The IRS is obtaining its information about college and university not-for-profit executive compensation from several sources:

− The college and university questionnaire sent out last year.

− Form 990, the annual information return filed by public charities exempt from income taxation under Section 501(c)(1) and Section 501(c)(3) of the Internal Revenue Code.

Slide 32

Form 990

The new Form 990, which received a major overhaul in 2008, requires not-for-profits to disclose much more information in much greater detail reflecting the IRS’s view that the Form 990 serves increasingly as a means of ensuring not-for-profit tax compliance, in addition to the form’s traditional role of providing public information.

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Form 990

The new Form 990 digs deeply into compensation practices.

The new form addresses compensation in at least four locations:

− Part VI - Governance, Management, and Disclosure

− Part VII - Compensation of Officers, Directors, Trustees, Key Employees, Highest Compensated Employees, and Independent Contractors

− Schedule J - Compensation Information

− Schedule L - Transactions with Interested Persons

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Form 990

A new series of questions require the organization to report information about certain compensation processes. These questions essentially incorporate the information necessary to satisfy the rebuttable presumption with respect to excess benefit transactions under IRC Section 4958.

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Form 990

As in the past, the new Form 990 requires that compensation of officers, directors, trustees, key employees, and highly compensated individuals be reported.

However, certain specific rules have changed and/or been clarified including the definition of “key employee”, which has been expanded.

Organizations have to disclose compensation information about a greater number of individuals than in the past as well as more information about these individuals.

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Form 990

Organizations must report for these identified individuals:

− compensation received from related entities,

− severance arrangements,

− W-2 and 1099 compensation broken out by base pay, bonus, and incentive compensation,

− deferred compensation and non-taxable benefits separately broken out,

− deferred compensation previously reported,

− supplemental nonqualified retirement plan benefits, and

− equity-based compensation arrangements.

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Form 990

Organizations must also report compensation paid to former officers, directors and trustees as well as severance payments made to them.

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Form 990

A new Schedule J requires an organization to report whether it provides the following categories of benefits to officers, directors, trustees, highly compensated and key employees:

−first-class or charter travel; travel for companions,

−tax indemnification and gross-up payments,

−discretionary spending accounts,

−housing allowances or residences for personal use,

−payments for business use of personal residence,

−health or social club dues or initiation fees, and

−personal services (e.g., maid, chauffeur, chef).

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Form 990

If the organization provides any of these benefits, then it must provide:

− whether it has a written policy regarding provision of these benefits, and

− whether it requires substantiation before the expense is paid or reimbursed.

The instructions make clear that the above information must be disclosed even if not considered “reportable” compensation.

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Conclusion

It is worth spending the time and resources to fill out Form 990 carefully, completely and accurately. For example,

• Complete the information for each listed officer, trustee, or key employee, even if they are not compensated.

• Make sure to report all economic benefits to officers, directors, and key employees - taxable or not - to avoid excess benefit transactions.

• Follow the form’s lead and use IRS rebuttable presumption procedures.

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Conclusion

Consider appointing a Form 990 task force.

The task force should focus on:• New data necessary to complete the form and how this

information is being/will be obtained (e.g. trustee questionnaires).

• Information gaps and how the institution intends to close them.

• Thorny issues that may arise from in-depth disclosure of compensation and non-taxable benefits and how the institution plans to address potential media reporting of any high-profile benefits or prerequisites.

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Conclusion

Consider the IRS position that the new form 990 allows institutions to “tell their story”.

At minimum, institutions need to be aware that much new information will be in the hands of the IRS and available on the web.

Be proactive.

Use the new Form 990 to your advantage: some of the questions may lead to positive governance reforms.

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Conclusion

To avoid problems with executive compensation, the IRS advises nonprofits to:• Set compensation in advance using appropriate comparability

data.• Make sure that no one involved in setting salaries has a

conflict of interest.• Document all decisions on compensation.

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Conclusion

Remember:

The most important thing an institution can do with respect to executive compensation is to have good compensation practices, policies and procedures.

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the irs targets ttos: hot spots for tax compliance and audit avoidance strategies september 15, 2009...

Documents

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taxexempt organizations

intermediate sanctionsunder

intermediate sanction

intermediate sanctionsin

section 501c3 organization

private interests

private shareholder