Executive Compensation Reporting and Taxation of Automatic Excess-Benefit Transactions

In recent months, charitable organizations have come under increased scrutiny by Congress, the IRS, state attorneys general and the public. The news media have publicized allegations of failures to exercise fiduciary responsibility by charity and foundation board members, misuse of charitable funds and excessive executive compensation. Partly as a result, the IRS has stepped up enforcement of existing rules on disclosure of compensation on Form 990, Annual Information Return of Organizations Exempt from Income Tax, to increase the transparency of transactions between exempt organizations and their top executives (For more details, see Anderson, Tax Clinic, Form 990: More than Just a Tax Return, TTA, April 2004).

Open for public inspection, Form 990 is commonly the first source of information for the news media, donors, grant applicants and others to learn about an exempt organizations activities and operations. Further, the IRS announced in December 2003 that the Sec. 4958 intermediate sanctions excise taxes, which penalize individuals and exempt organization managers who participate in excess benefit transactions, will apply automatically in certain situations.

Reporting Rules

Sec. 6033 requires all Sec. 501(a) tax-exempt organizations to file Form 990 annually, stating specifically the items of gross income, receipts, disbursements and such other information prescribed by the form and regulations. Regs. Sec. 1.6033-2(a)(2)(ii)(g) provides that an exempt organization has to include on Form 990 a list of its officers, directors and trustees (and any person having responsibilities or powers similar to those of such individuals, commonly referred to as key employees). Per Form 990, Sec. 501(c)(3) organizations also have to attach a schedule showing the names and addresses of the five employees (if any) who received the greatest amount of annual compensation in excess of $50,000 and who otherwise are not listed as officers, directors, trustees or key employees.

Under Regs. Sec. 1.6033-2(a) (2)(ii)(h), an organization has to show on Form 990 the compensation and other payments made during the organizations annual accounting period (or during the calendar year ending within such period) that are includible in the gross income of each individual listed. As specified in the Form 990 instructions, the types of payments requiring disclosure (in Part V and Schedule A, Part I, of Form 990) include salary, bonus and severance pay, employer contributions to pension and welfare benefit plans, all forms of deferred compensation (whether or not funded or vested and whether or not the deferred compensation plan is a Sec. 401(a) qualified plan), and taxable and nontaxable fringe benefits (except for de minimis fringe benefits described in Sec. 132(e)). Other benefits to be disclosed include the value of spousal travel expenses paid by the organization and the personal use of housing, automobiles and other assets provided by the organization without charge.

Automatic Excess-Benefit Transactions

The Sec. 4958 intermediate sanctions rules impose an excise tax on disqualified persons of a Sec. 501(c)(3) or (c)(4) organization (applicable organization) who engaged in an excess-benefit transaction with the organization, and also impose an excise tax on an organization manager who knowingly participated in such a transaction. Sec. 4958(f)(1) defines a disqualified person generally as anyone who was in a position to exercise substantial influence over an applicable organization at any time during the five-year period ending on the transaction date.

In a December 2003 Exempt Organization Continuing Professional Education article, Brauer and Henzke, Jr., Automatic Excess Benefit Transactions Under IRC 4958, the IRS stated that if an applicable organization conveys an economic benefit to a disqualified person and such benefit is not treated as compensation, the IRS will consider the economic benefit an automatic excess-benefit transaction, even if the amount of the benefit is reasonable. The Service treats an economic benefit as compensation only if the exempt organization clearly indicates such intent when the benefit is paid. Certain economic benefits, such as expense reimbursements under an accountable plan and Sec. 132 nontaxable fringe benefits, are disregarded for Sec. 4958 purposes.

The Service has directed its agents to review all agreements that provide any type of economic benefit to any disqualified person, including (1) employment, deferred compensation, bonus, retirement and severance agreements; (2) loans between the disqualified person and the organization; and (3) the purchase or sale of goods between the disqualified person and the organization. Additionally, it has also asked agents to review an organizations expense reimbursements made to disqualified persons.

In light of this IRS examination initiative, applicable organizations have to account properly for and report all components of a disqualified persons compensation to avoid automatic excess-benefit transactions. If this is not done, the disqualified person may be subject to the penalty excise tax, even if the compensation is reasonable.

Also, Form 990 requires an applicable organization to report whether it engaged in a Sec. 4958 excess-benefit transaction during the year or became aware of such a transaction from a prior year. The amount of Sec. 4958 taxes imposed on disqualified persons and organization managers has to be disclosed on Form 990. Beginning this year, the Service will review Forms 990 filed by Sec. 501(c)(3) and (c)(4) organizations and will inquire if they fail to answer or answer not applicable to the Sec. 4958 questions.

Future Assistance

As part of its increased enforcement, and as part of its customer education and outreach initiatives, the IRS will probably release new publications this year, designed to help exempt organizations avoid inappropriate financial transactions. It anticipates that these publications will contain best practices for exempt organization governance, and it is looking at provisions in the Sarbanes-Oxley Act of 2002 for direction.

From Christine Bernschein, CPA, J.D., MBA, and Travis L. Patton, CPA, Washington, DC