Executive compensation in tax-exempt organizations

By Michelle M. Cain The Daily Record Newswire There seems to be a number of stories of executive pay practices exposed in tax-exempt organizations. Rarely is much attention given to the specifics of the organization or the qualifications required of the executive in question. The story usually focuses on the paradox of "not-for-profit" versus an allegedly "outrageous" amount of compensation. These stories are especially disturbing during difficult economic times, and unfortunately, the stories not only taint the organization that is the subject of the article, but the entire tax-exempt community. There are unfortunately some bad apples where abuse has occurred. However, there are also some unusual situations where particularly complex organizations or highly specialized positions simply defy a simple explanation of the compensation arrangements in use. These organizations would be well-advised to pay particular attention to the practices used to govern their compensation arrangements. The remainder of this article offers some thoughts on how these organizations might address these issues. The overriding principle in executive compensation for tax-exempt organizations is reasonableness. The term "executive compensation" used throughout this article includes the aggregate of all pay, benefits and any perquisites offered to the organization's policymaking executives. Reasonableness can be assessed from several perspectives, including the following: Compensation is set at levels and structured in a manner required to attract, engage and retain qualified personnel needed to fulfill the organization's mission and should not enrich or inure any individual(s). Compensation deliberations and decision making is performed by objective and independent members of the organization's governing body and should not involve the executive(s) in question. Information and/or professional advice about compensation levels and methods offered by other organizations that compete for comparable executive resources is an essential requirement for sound decision making. These decisions should not be based on unsupported hunches or flattering comparisons. Adequate documentation of deliberations and decisions made about executive compensation must be kept to support the rationale for compensation levels and methods. An organization should not rely on individuals' recollections or after-the-fact expression of intentions. The IRS Intermediate Sanctions offer a "presumption of reasonableness" to those tax exempt organizations adopting the required practices to ensure that "reasonableness" characterizes the organization's executive compensation practices. All organizations, especially the unusual and/or unique ones, should pay particular attention to ensure that these practices are effectively implemented and well- suited to their own unique context. Failure to do so inevitably leads to embarrassment or penalties when compensation practices are exposed or challenged. The recommended practices associated with the Intermediate Sanctions are outlined in the next section of this article. We have highlighted some points that are particularly applicable to unusual and/or unique organizations. Governance There is a requirement that the organization rely on its independent board members (or designated committee of independent board members) to be formally charged with oversight responsibility for executive compensation arrangements. It would be difficult to overemphasize the importance of this group in an organization's efforts to comply with the Intermediate Sanctions and address the needs of an unusual organization or executive position. The unique and/or unusual situation will gain a particular benefit from members that are thoroughly familiar with the organization and/or position(s) in question. This allows members to understand, consider and decide compensation issues in the context of the organization's special issues. This is especially important for identifying relevant benchmarks for comparisons in the external marketplace that warrant consideration as comparable in some critical characteristic or competing for similar executive expertise. Knowledgeable board members can examine relevant external market data, even from sectors that are not directly comparable to the organization and/or position at hand, and use it as a context for good decision making. External information There is a requirement that information about methods and levels of compensation offered by other organizations competing for comparable executive resources is provided to the organization's board or committee charged with responsibility for executive compensation. The primary characteristic sought for this type of external information is that it is reasonable and relevant to the organization and position(s) in question. It need not be limited to tax-exempt organizations or just the most directly comparable organizations, though one would certainly expect them to be represented. In some cases, it might be necessary to incorporate information from multiple sources, where no one source is completely comparable to the organization in question, to arrive at an overall consensus of executive compensation in the competitive market. The key point here, particularly for the unique and/or unusual organization, is that there must be a reasonable basis for the data selected and an explanation of its significance from the standpoint of the context of the organization's decision making. Documentation This final requirement involves the maintenance of a thorough and timely record of board deliberations and decisions regarding executive compensation. Of course, this documentation supplies much of the support required to demonstrate the organization's efforts to comply with the two previously described requirements. It details when, how and what has been done (as well as by whom) to arrive at the organization's executive compensation decisions. The importance of this requirement, especially for the unique and/or unusual organization, ought to be obvious. All documentation maintained about the organization's executive compensation practices represent an excellent opportunity to detail the particulars associated with the efforts to: involve the appropriate individuals in the governance process; establish a reasonable basis for evaluating competitive practices; and the rationale for deciding the organization's executive pay practices. The more unusual the organization, the more unique the position, or the greater the compensation, the more important it is for excellent documentation. In summary, to take advantage of the Intermediate Sanctions' presumption of reasonableness, each of the three broad requirements we have covered here must be addressed. Failure to satisfy any one of them puts the burden of proof back on the organization to establish that executive compensation practices are reasonable. ---------- Michelle M. Cain, CPA is a partner with Mengel, Metzger, Barr & Co. LLP. She can be reached at Mcain@mmb-co.com. Published: Tue, Dec 6, 2011