The IRS report is back: Are you paid too much?

By David Middlebrook and Robert W. Rucker

As has been widely reported in media sources, in 2004 the Internal Revenue Service (IRS) through its Exempt Organizations Office, undertook a fairly broad investigation of the nonprofit world and its compensation practices. The “Executive Compensation Compliance Initiative” was launched with little prior notice or warning and without providing any period of time for nonprofits to review their compensation practices or discuss issues with the IRS, but in a unilateral and confrontational fashion.

While not explicitly stated, the operating assumption of the IRS for this “project” was that there was widespread, flagrant abuse in the nonprofit world relating to compensation of the organizations’ executives. The 1,826 organizations selected to participate in the project (a disingenuous way to describe a governmental “inquisition”) were across a variety of nonprofit sectors.

According to the IRS, no churches were selected for investigation because they are not required to file Form 990s. However, we are aware of churches that received compensation-driven inquiries during this same time frame. They may or may not have been part of this project from a statistical standpoint, but their compensation practices were questioned in the exact same way as the other organizations.

Selected because of prominence

The IRS creates the impression that the organizations were selected by virtue of being small, medium and large, or based upon stated revenues. It is our view that many of these organizations were not selected based upon random computer sampling or any other statistical basis, but because of the prominence of the organizations coupled with some innuendo or suspicion of compensation abuses.

While it claims to have sent letters to organizations of all levels, for the most part these organizations were larger, established operations. And what evidence existed that there was sufficient abuse to warrant such an investigation? The IRS does not fully describe its motives or supporting evidence, but the answer appears to be anecdotal evidence. “Anecdotal evidence” means rumor or gossip from various, largely unattributed sources or from sources having no direct knowledge or understanding.

So, what were the results of this investigation? Was there widespread, flagrant compensation abuse in the nonprofit sector? According to the report, the answer is “no.”  Regarding overcompensation, the IRS said that “[e]xaminations completed to date do not evidence widespread concerns other than reporting (approximately 10 percent of the examinations remain open).” The report goes on to say that “[a]lthough high compensation amounts were found in many cases, generally they were substantiated based upon appropriate comparability data.”

The most significant problem encountered was how the compensation was being reported, with more than 30 percent of the organizations being asked to amend their Form 990 returns. The IRS found that additional education and guidance, as well as training for its own agents, was needed in reporting requirements and that changes to Form 990 would also reduce errors in reporting. The report found that “many organizations were initially confused when completing the [IRS] forms or did not understand the instructions.”

Significant penalties assessed

On the other hand, when compensation abuses were found (25 out of the potential 1,826), the resulting excise tax penalties that were assessed were significant. The taxes assessed were in excess of $21 million against 40 disqualified persons. The taxes were based upon payment for such things as (a) excessive salary and incentive compensation, (b) payments for vacation homes, personal legal fees, or personal automobiles, (c) payments for personal meals and gifts to others on behalf of disqualified persons that were not reported as compensation and (d) payments to an officer’s for profit corporation in excess of the value of services provided by the corporation.

For many of the organizations, the IRS used the figure of $100,000 compensation to an officer, director or key employee as being a benchmark worthy of further examination. Some organizations were investigated because they self-reported, incorrectly in most cases, that they had taken part in an excess benefit transaction (giving too much compensation) or had transactions with a disqualified person.

Based upon the IRS report, and contrary to what appears to be the current public perception, there isn’t a compensation abuse problem in the nonprofit sector. As a part of the nonprofit sector, churches are expected to only pay their key employees reasonable compensation. What is reasonable is subject to disagreement, but it should be remembered that there is a safe harbor approach that includes (a) having an independent governing body, (b) getting comparable data/compensation studies and (c) adequate documentation. By following the safe harbor guidelines the burden to prove compensation as being unreasonable, shifts to the IRS.

Investigations a disturbing trend

Aside from the practical applications of the report, the more disturbing trend is that the government is becoming increasingly active in investigating nonprofits and doing so with little regard for procedural safeguards or due process. For churches and their members, the First Amendment to the United States Constitution guarantees freedom of religion, freedom of expression and freedom of association.

An unrestrained or even partially restrained governmental inquisition, particularly one that is based upon a hunch that is shown to be wrong, is an infringement upon that freedom. The IRS has made it clear in the report’s recommendations that future investigations will be undertaken, most likely with the same practices and procedures.

Nowhere in its report does it state any concern for protecting the First Amendment freedoms of those under its scrutiny.

Why should it? Most people in this modern age appear ready to accept the need for an efficient administrative and bureaucratic function of government, and view the concept of freedom from governmental intrusion to be an abstraction not worth fighting over. The government has decided that church leaders do not make too much money, right now. What will it decide next?

David Middlebrook is a partner; Robert W. Rucker is an attorney, with Anthony and Middlebrook P.C., in Irving, TX, which specializes in the practice of nonprofit law. [churchlawgroup.com]