Academic journal article Journal of Accountancy

NPO Compensation in the Spotlight: Best Practices Help Tax-Exempt Entities Avoid Penalties

Academic journal article Journal of Accountancy

NPO Compensation in the Spotlight: Best Practices Help Tax-Exempt Entities Avoid Penalties

Article excerpt

[ILLUSTRATION OMITTED]

EXECUTIVE SUMMARY

* Intermediate sanctions impose a penalty tax on key employees of certain tax-exempt organizations who receive unreasonable compensation, and on managers who approve it knowingly.

* Intermediate sanction regulations provide a framework of appropriate policies and procedures regarding compensation for tax-exempt organizations.

* Intermediate sanction rules require organizations to publicly disclose on Form 990 that intermediate sanctions have been imposed.

* The amount of required disclosure continues to grow. Changes to Form 990 in recent years have generated additional reporting requirements and a redesigned form has been proposed by the IRS that it expects to use for the 2008 tax year.

* Related-party transactions must be disclosed on Form 990 and explain existing relationships between officers, directors, trustees, key employees, highest-paid employees, and highest-paid professional or other independent contractors of certain tax-exempt organizations.

* A recent IRS study of Form 990 compliance resulted in the proposal of millions of dollars in intermediate sanctions.

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In recent years public companies became subject to rules requiring a heightened level of disclosure on executive compensation and related-party transactions. The tax-exempt sector, on the other hand, has had extensive experience with similar reporting requirements for many years, and the disclosure requirements are still evolving. Compliance in this area became important for certain tax-exempt organizations in the mid-1990s when intermediate sanctions were introduced to impose penalty taxes on key employees who receive unreasonable compensation and managers who knowingly approve it.

This article discusses the intermediate sanctions framework in relation to tax-exempt organizations, disclosure requirements for compensation and related-party transactions, and best practices on processes and procedures for compensation, expense reporting and related-party transactions.

INTERMEDIATE SANCTIONS AND FORM 990

Intermediate sanction regulations provide a blueprint of appropriate policies and procedures regarding compensation for certain tax-exempt organizations as described in IRC [section] 501(c)(3) or social welfare organizations described in section 501(c)(4). Intermediate sanctions do not apply to private foundations because they are subject to a different excise tax regime for similar transactions.

   Internal Revenue Code [section] 4958 and
   accompanying Treasury Regulations
   are the foundation for intermediate
   sanctions.

For tax-exempt organizations, all forms of compensation and benefits, including deferred compensation and some related-party transactions, must be disclosed annually to the IRS and the public on Form 990, Return of Organization Exempt From Income Tax. In addition to penalizing key individuals who receive unreasonable compensation and those who approve it, these rules require organizations to publicize on Form 990 that intermediate sanctions have been imposed. The public disclosure of sanctions can be embarrassing for an organization and its leadership.

Congress enacted intermediate sanctions to give the IRS more flexibility in addressing situations involving excess benefits. Before intermediate sanctions were enacted, the only action the IRS could take against a tax-exempt organization or certain employees who received unreasonable compensation was to revoke the organization's tax-exempt status. In most cases, this sanction was considered too far-reaching

Under the intermediate sanctions rules, if a key employee (also referred to as a disqualified person) of a tax-exempt organization receives a benefit that exceeds the fair market value of the services performed, that employee must repay the excess benefit to the organization with interest and pay a penalty tax of 25% of the excess over fair market value. …

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