This past summer, the Internal Revenue Service announced that it will be implementing a "Tax-Exempt Compensation Enforcement Project" to identify and halt abuses by tax-exempt charitable organizations that award excessive compensation and benefits to officers and insiders. IR 2004-106 (Aug. 10, 2004). The IRS expects to contact nearly 2,000 charitable organizations to request detailed information and supporting documentation on issues gleaned by the IRS from review of the organizations' Form 990 filings, primarily with respect to compensation practices and procedures. The project is also expected to scrutinize transactions with insiders, such as loans or sales, exchanges, or leases of property to or from officers or others involved with an organization.
The project will also focus on other Form 990 reporting issues, including whether and how organizations answered question 89(b) (the question about "excess benefit transactions") and other compensation information. The project will begin shortly and is expected to continue into 2005.
Steven T. Miller, the Tax Exempt/Government Entities Commissioner, has stated that some organizations will receive letters designed to give the IRS a picture of current practices, while others will get more specific letters, making inquiries based on information reported in the organization's Form 990. Marvin Friedlander, Chief of Technical Branch 1, more recently stated that there will be three types of letters: educational (with no response required); compliance check (requesting missing Form 990 information); and exam (comprising a desk audit, usually of limited scope). Some letters are expected to inquire about compensation with respect to specifically named individuals, asking how those individuals' compensation was set and reported. Organizations may also be asked for details concerning the independence of the governing body that approves compensation, the duties and responsibilities of specific managers, and how they are reporting compensation on Form 990.
The process, sometimes referred to as a "soft audit" (because no agent is sent to the organization), can be expanded into a full examination, depending on the organization's response. (The IRS expects to have roughly 500 on-site audits as a result of this initiative.) Results could range from a "thank you," to penalties for incorrect or incomplete filings, to revocation of exemption. Mr. Miller has stated that "particular organizations that we contact may or may not have problems * * *, but specific aspects of their operations have raised questions."
The IRS has shifted personnel to staff this project and other soft-audit initiatives by creating a special new compliance unit staffed by 72 examining agents in Dallas, Texas. To support that unit, the IRS has also formed a new Data Mining Unit, staffed by economists, statisticians, and research analysts.
An illustrative example of the kind of work that can be accomplished by the Data Mining Unit can be seen in The Chronicle of Philanthropy article entitled "Big Nonprofit Salaries Face Government Scrutiny" (June 24, 2004). In that article, The Chronicle of Philanthropy named 52 charity executives who earned compensation of more than $1 million in 2002. The information was prepared by reviewing Form 990 information published at the GuideStar site (www.guidestar.org). Of those named, 42 were chief executives of hospitals or medical centers.
Section 4958 of the tax code imposes restitution requirements and excise taxes on "excess-benefit transactions." The excise tax imposed on a recipient of an excess benefit can be as much as 225 percent of the amount of the excess benefit. An excess-benefit transaction is a transaction in which an economic benefit is provided by an applicable exempt organization to or for the use of a disqualified person (one who is related to the organization), and the value of the economic benefit exceeds the value of the consideration (including the performance of services) received by the organization. In the employment and independent consulting areas, the excess-benefit rules apply to most compensation arrangements in which an executive of the organization receives more than "reasonable compensation." In the words of the IRS, reasonable compensation is the value that would ordinarily be paid for like services by like enterprises under like circumstances.
Charitable organizations should be certain that they are including the full economic value of all benefits when reporting the amount of compensation paid to disqualified persons on Forms 990, 1099, and W-2. These amounts should include the value of all economic benefits provided (excluding only nontaxable fringe benefits and reimbursements under an "accountable plan"). The value of items such as meals, travel for spouses, gift certificates, season tickets to sporting or theatrical events, automobile use, club memberships, insurance benefits, deferred compensation, and similar items that are often not tracked as compensation is included for purposes of Section 4958, regardless of the federal income tax treatment. Furthermore, regulations provide that an "automatic excess benefit transaction" can result simply by making such economic benefits available to a disqualified person and failing to treat them as compensation. Treas Reg § 53.4958-4(c). This rule applies even if, including the value of the unreported benefits, total compensation received is reasonable.
Charitable organizations can create a rebuttable presumption of reasonableness in compensation matters by following procedures outlined in the applicable regulations. Treas Reg § 53.4958-6. Organizations should strongly consider engaging professionals to assist them to implement the procedures and obtain the documentation required to properly establish the rebuttable presumption. We anticipate that many of the IRS soft-audit inquiries will request copies of such documentation, including applicable board minutes and comparability data utilized to establish reasonableness.
Question 89(b) on Form 990 requires organizations to report whether they have been engaged in, or become aware of, any excess-benefit transactions. If the answer is "yes," Form 990 also requires an attachment describing the transaction and the persons involved, and informing the IRS whether the transaction has been corrected (generally by restitution). The IRS has advised that more than 4,000 organizations left the box unchecked in their Form 990 filings.
Charitable organizations should establish procedures now to identify soft-audit inquiries when received and to ensure that such inquiries are routed to an appropriate individual within the organization for a prompt and careful response. Many soft-audit inquiries will have no further follow-up if the recipient provides a timely and complete response.
Charitable organizations should seek professional advice in the preparation and review of their Form 990 filings, and before responding to soft-audit inquiry, even if the inquiry asks for seemingly routine or uncontroversial information. Organizations encountering difficulty applying Form 990 instructions to specific benefits or perks should consider adding a footnote to that schedule and disclosing specifics of the arrangement in an attachment.
It should also be remembered that most information provided on Form 990 is readily available to the public.
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