If you were on the board of directors of Enron,
would you have approved Kenneth Lay's compensation package? What if
the law said that you could personally be fined if the package were
too generous? What would you have done then?
"That's not a realistic scenario," you might
say. But if Enron were a nonprofit, it would absolutely be the case.
Newly finalized IRS guidelines provide for exactly that type of
result. Under the regulations, penalties are assessed against
managers and directors who approve any transaction in which an
economic benefit is provided a "disqualified person" that is
"excessive."
The regulations also provide a safe harbor
and guidelines board members and managers can use to protect
themselves from these penalties. Prudence dictates that all of us
who sit on nonprofit boards be aware of these choices.
Background
What has this year become an enforcement priority
became so, in good part, because of one man, William Aramony.
Aramony, then head of the United Way, hit the national spotlight
when it was exposed that his salary as president of that large
nonprofit was $390,000. He also had the charity pay for work on his
house and had a penchant for flying to Europe via the Concorde on
United Way's nickel. Technically, this arrangement may not have been
illegal, but the media-led umbrage and ensuing scandal almost
destroyed the United Way. (Aramony later was convicted of fraud and
went to jail.)
An outraged Congress reacted by adding a
provision to the Internal Revenue Code (section 4958, part of the
"Taxpayer Bill of Rights 2") imposing penalty excise taxes - so
called "intermediate sanctions" - on "excess benefits transactions"
such as those afforded Aramony. In addition to fining the
beneficiary of such largesse, penalties are also imposed on
directors and managers who approved these compensation arrangements.
After five years on the books the IRS has just published final rules
implementing this law. (26 C.F.R. 53.4958-0 et seq.) And it
is wasting no time enforcing them.
Late last year the IRS announced that it
would make enforcement of excess benefits transactions penalties an
enforcement priority by the start of 2002. What makes this threat
palpable is that the information needed by the IRS to make an
initial assessment as to whether compensation is excess is found on
every nonprofit's annual informational tax return. Those returns are
also publicly available. Already individuals have informed the IRS
of situations they think implicate the new rules.
Take note that the regulations do not just
cover compensation arrangements. They apply to any transaction in
which an economic benefit is bestowed on a disqualified person.
These include vendor contracts, sales of corporate assets, and
purchases by the nonprofit, among others.
Who Is Targeted and What Are the
Penalties?
Section 4958 applies specifically (and only) to
entities which are tax exempt under sections 501(c)(3) and 501(c)(4)
of the Internal Revenue Code. These include virtually all
charitable, religious, and other public benefit and mutual benefit
organizations, and all private foundations. Not included are
nonprofits such as trade organizations, condominium associations,
and labor unions. Sanctions can be imposed on the excessively
compensated party as well as managers and directors who approved the
transaction in question.
The excess benefits rules apply to economic
benefits provided to so-called "disqualified persons." A
disqualified person is anyone who was, at any time during the five
years preceding the transaction, in a position to exercise
substantial influence over the affairs of the organization, a member
of that person's family, or a 35 percent controlled entity. This
definition includes directors, officers, and key managers. It can
also include independent contractors and other vendors with
substantial influence over the organization's activities. The
initial penalty imposed on a party whom the IRS has found to have
been excessively compensated is disgorgement of the excess plus 25%
of the excess. If that amount is not timely paid, an additional 200%
penalty is imposed.
Managers, directors and officers who
participated in the decision approving the excess benefits
transaction are assessed a penalty of 10% of the excess to a maximum
of $10,000 per excess benefit transaction. The liability is joint
and several if more than one person is involved. If the excessively
benefitted disqualified person participated in the consideration or
decision regarding that benefit and did not vote against it, he or
she have to pay the 10% penalty in addition to the other penalties.
Thus acquiescence by passive conduct may lead to liability.
Excess Benefits and the Safe
Harbor
Section 4958 defines an excess benefit as a transaction
in which the "value of the economic benefit provided . . . any
disqualified person exceeds the value of the consideration . . .
received for providing such benefit." As stated above, the
regulations look at all financial transactions. Included are
compensation arrangements (including all payments whether direct or
indirect, taxable - but not most nontaxable - fringe benefits,
housing allowances, contributions to retirement plans, insurance,
etc.), vendor and consultant payments and contracts, asset sales and
purchases, among others.
The definition of an excess benefit
transaction does not seem to be a very helpful, at least insofar is
it begs the question, How does one determine the value of the
consideration received? The IRS's new regulations do not explain.
They do, however, provide a safe harbor that offers directors a
margin of safety. A board that follows the safe harbor rules obtains
a rebuttable presumption that its decision was reasonable and the
approved transaction not excessive. The rebuttable presumption does
not preclude the IRS from claiming that the benefits were excessive,
as so amply demonstrated in the first Tax Court decision invoking §
4958 (Caracci v. Comm'r, 118 T.C. No. 25 (May 22, 2002),
upholding an $11.6 million penalty on the transfer of home health
agencies' charitable assets to some of the agencies' directs at less
than fair market value). But if it does, it must satisfy a high
burden of proof before a judge will approve the penalties.
These protections apply when a board (or a
committee of the board, as the case may be) takes the
below-enumerated steps with regard to the total compensation package
or other economic benefits provided a disqualified person. Note
that, whenever a disqualified person's benefits arrangement changes,
this analysis must be undertaken anew.
- The compensation or other financial
arrangement must be approved in advance of any payment.
- Deliberation of the benefit and the vote
to accept it must be made by non-interested parties only.
- The board has procured adequate data about
the compensation of persons holding similar positions in similar
organizations (whether nonprofit or for-profit), or of the value
of similar or comparable transactions, to support a finding that
the transaction in issue is fair and reasonable based on fair
market value standards. For example, what would it cost the
organization to hire someone to do the same job if it were to go
into the marketplace to hire a person with qualifications
comparable to the person to be compensated.
As well as comparisons of similar transactions, in the case of
compensation the board may include written offers from a similar
organization competing for the services of the disqualified
person. The value of property or other benefits to be included in
the compensation package should be based on fair market value. If
upheld on appeal the Caracci case suggests that the board
use the most conservative methods of assessing fair market value.
An organization with less than $1 million in annual revenue need
only use comparisons from three similar positions in similar
communities. The boards of larger organizations must use their
best judgment as to what constitutes adequate comparative data.
- The decision must be adequately
documented. That documentation must include:
a. The terms of the approved transaction
and the date of approval;
b. Identification of the members of the
decision-making body present during deliberation of the
transaction and how each person voted;
c. The data relied on to make the decision
and how it was obtained;
d. The justification for any benefits or
payments that exceed the comparative data; and
e. Any actions by any member of the
decision-making body having a conflict of interest.
The documentation must be prepared before the
later of the next meeting of the decision-making body or 60 days,
and must be approved within a reasonable time after its preparation.
In addition to the safe harbor, the rules
provide additional (or alternative, as the case may be) protection
from the 10% penalty for decision makers - but not the excessively
compensated party. Their liability for the penalty is excused to the
extent that they relied on the reasoned written opinion of an
attorney, C.P.A. or qualified independent valuation expert, with
respect to elements of the transaction within the professional's
expertise. Of course, the professional must first be given full
disclosure of the facts regarding the transaction.
Two Examples
A couple of examples at the extreme help to illustrate
these rules. One involves a salary that on first blush may seem
excessive but, in the author's opinion, is not. The first example,
however, is of a case of compensation the author would find
difficult to justify, at least on its face. Both examples briefly
examine how application of the new IRS rules can guide the boards to
make an appropriate decision on the compensation in question. Both
examples draw on data freely available at www.guidestar.org.
In the first example, consider a Los Angeles
nonprofit that shall, for the protection of the innocent, be
referred to here pseudonymously as the Dr. John Smith Foundation.
This organization's tax exempt purpose is to undertake cardiac
research. In 1999 it had assets of just under $1 million and revenue
of under $200,000. It's tax return for that year disclosed that the
eponymous Dr. John Smith worked 20 hours per work for his foundation
as its medical director. For this half-time post he drew a
compensation of $384,000, $6,000 more than William Aramony's
infamous base salary. A survey of the compensation paid medical
directors of comparably-sized medical research organizations in the
Los Angeles area show a median of about $60,000. And these were for
full-time positions. As a board member of this nonprofit, could you
come up with a justification for the compensation paid Dr. Smith?
For our second example we will look at Los
Angeles Philharmonic. L.A.'s venerable, world class orchestra is a
501(c)(3) organization with an annual budget that approaches $50
million. Last year it was announced that the compensation of its
music director and principal conductor was being doubled to $2
million per year. Can such a salary in a nonprofit ever be
justified? Can it ever be reasonable?
As an L.A. Philharmonic board member
considering this compensation, one would need to consider the
marketplace for world class conductors and Salonen's stature in that
marketplace. Let's look at what was happening in the marketplace at
the time. In the last two years there has been a rash of retirements
of conductors among the world's top orchestras. At one point, three
top U.S. orchestras were simultaneously conducting searches for
their orchestras' leaders. With the intense competition from other
orchestras, the Berlin Philharmonic, which was also in the market
for a new conductor, secured the services of Sir Simon Rattle as its
new conductor at a salary of about $2 million.
L.A.'s Salonen is ranked at the top of all
conductors and is in constant demand around the world. He is widely
credited with raising the level of the L.A. Phil to that of the best
orchestras in the world. At the time, other orchestras were
approaching Salonen to fill their soon-to-be empty posts. The L.A.
Phil board apparently determined that in order to retain Salonen,
and thus maintain the orchestra's place at the pinnacle of classical
music, it had to compensate the maestro at a level commensurate with
his peers. The country's other leading orchestra, the San Francisco
Symphony, likewise increased the salary of its conductor to the same
level. Under the IRS's safe harbor rules, though he makes more than
many top corporate executives, Salonen's compensation should not be
deemed excessive.
Summary
Congress invoked the excess benefits transactions law
to stem perceived and real abuses in the compensation of nonprofit
executives and contractors. The onus, as it always is with
nonprofits, is on board members to ensure that the new rules are not
violated. The IRS has provided relatively straightforward guidelines
to aid board members in assessing the reasonableness of compensation
paid to disqualified persons and for assessing the reasonableness of
other, non-compensatory transactions. Directors who fail to heed the
guidelines - or do not know them - will be subject to the penalties
imposed by the law. For the rest of us, awareness of the rules and
when to invoke them will serve us if we heed them.
The excess benefits transactions rules should
not dissuade anyone from being a director or trustee of a nonprofit.
While they penalize directors who do not object to excess benefits
transactions, knowledge of the rules will ultimately result in
directors who have greater awareness of their fiduciary duty to the
organization. If this means directors who take their duties more
seriously, then it is for the better.
