Intermediate Sanctions

CRITERIA FOR REASONABLENESS

Intermediate sanctions regulations are silent as to exactly what criteria are to be used in ascertaining the reasonableness of compensation in tax-exempt, non-profit organizations. However, applying the factors and process in IRC Section 162(a) with its multi-factor test for pay deductibility in for-profit businesses is appropriate. Section 162(a) allows companies to deduct the pay of employees for the services they perform as a business expense. The term pay may include wages, salaries, vacation allowances, bonuses, commissions, and benefits. To be deductible, these costs must meet two tests: reasonableness and services rendered.

Let's take a look…

Test 1: Reasonable

The pay must be reasonable. It's up to the company to prove that the pay is reasonable based on the particular circumstances that existed when the employee's services were incurred. The IRS considers these factors:

• Duties performed by the employee
• The employee's qualifications
• The size and complexities of the business
• The prevailing general economic conditions
• Measurement period
• The prevailing rates of compensation for comparable positions in comparable business entities / concerns
• Ability and achievements of the individual employee performing the service
• Pay compared with the gross and net income of the business, as well as with distributions to shareholders if the business is a corporation
• Organization's policy regarding pay for all of its employees
• History of pay for each employee

Note that these factors include those that are specific to the individual and those that are specific to the company. This determination of reasonable pay is made on an individual employee basis, not for any group of employees nor for the company as a whole. For example, if an independent board of directors negotiates the salary formula, the presumption is that the salary is reasonable. The regulations state that reasonable compensation must be evaluated considering all the circumstances. The determination of reasonableness is based on the circumstances that existed when the contract was created, not circumstances existing when the salary is questioned.

Test 2: For Services Rendered

The pay must be for services rendered. Events that increase the value of the company but are unrelated to the executive's job or efforts are not a reasonable reason for large increases in compensation. This test also proves to be important at times when family members or minority stockholders are involved.

(For a closer look at these tests, please see DLC Course 12: IRS Reasonable Executive Compensation, which examines under and overcompensation in private closely held companies.)

Reasonable Pay Guidelines

Based on Section 162(a), reasonable pay for an individual under intermediate sanctions may be described in the following way.

Compensation is considered reasonable if the amount paid is what would be ordinarily paid:

• for like services actually rendered
• by like organizations
• under like circumstances

This would include the following comparisons:

• Similarly situated organizations (both public and private)
• Functionally comparable positions
• Location of the organization
• Availability of persons with requisite skills (the labor market)
• Offers from other organizations for the services of the individual

Other important criteria are the:

• Needs of the organization for the person's skills
• Education, training, and experience of the person
• Particular nature of the person's duties and responsibilities
• Size of the organization (assets, revenues, budget, employees)
• Amount of time the individual devotes to the position