The Chronicle of Philanthropy reports that Sen. Grassley is once again attempting to change the rules that impact how certain exempt organizations set executive compensation. This time, Sen. Grassley wants to do away with the “rebuttable presumption process” that exempt entities have been relying on to provide some measure of assurance that their compensation decisions will not trigger intermediate sanctions.
Intermediate Sanctions. The intermediate sanctions rules directly penalize insiders that are paid excessive compensation. The law also penalizes directors and others that “knowingly” approve the excessive compensation. The potential penalties are significant and should serve as a powerful deterrent to abuse.
The burden of proof is generally on the exempt entity to prove that its compensation decisions are reasonable. However, the law includes a process known as the “rebuttable presumption process” that exempt entities can follow to shift the burden of proof to the IRS. This process requires a review by disinterested members of the governing body of appropriate comparability data and adequate documentation of the decision.
Appropriate comparability data includes compensation levels paid by by similarly situated organizations, both tax-exempt and taxable, for functionally comparable positions. The location of the organization, including the availability of similar specialities in the geographical area, independent compensation surveys by nationally recognized independent firms, and written offers from similar institutions competing for the services of the individual are all appropriate comparabiltiy data. Essentially, the rebuttable presumption process requires an objective investigation into how the relevant labor market values the knowledge, skills and talent of the individual whose compensation is under review.
Proposal to Remove the Rebuttable . . . Safe Harbor? According to the amendment’s official description, Grassley’s proposal is:
“[to] remove the safe harbor available to tax-exempt organizations with respect to reasonable compensation of executives.”
The rebuttable presumption process is not a safe harbor. Rather, it’s a presumption of reasonableness that the IRS can, with sufficient evidence, rebut and overcome. The description of the amendment goes on to state that organizations are using these procedures to:
“. . . justify paying compensation comparable to executives in for-profit organizations, including comparables from for-profit entities that had nothing in common with the tax-exempt organization.” (Italics added)
Comparables from organizations that have nothing in common with the exempt entity are unlikely to be appropriate comparables. For example, comparing the head of a small local preschool’s salary to the CEO of a large for-profit multistate college because both individuals are leading schools is clearly inappropriate. If the IRS can make a case that the comparables the exempt entity relied upon are inappropriate, then it can rebut the presumption of reasonableness and impose penalties. If the IRS cannot make its case, then the compensation is likely reasonable by market standards and should stand.
Impact of Proposed Amendment. The rebuttable presumption process has set the gold standard for determining executive compensation across the sector. We strongly recommend all of our clients follow it. Where there is abuse, the IRS has the ability to develop a strong case and rebut the presumption.
Removing the rebuttable presumption would permit the IRS to more easily attack compensation decisions without having to develop a strong case. It would also leave executives and boards of tax-exempt entities with significant concerns about their potential personal liability. Boards that are willing to follow the process should at least be rewarded with the knoweldge that the IRS will be forced to put together a strong case before challenging their decisions.
Sen. Grassley is also proposing legislation that would grant the IRS clear authority to require tax-exempt organizations to report certain governance practices, something they have already been doing without authority for over a year.