Looking to Benchmark Pay?
LEGAL REQUIREMENTS
Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act was a major rewrite of the U.S. tax code. Effective the beginning of 2018, the law imposed a 21% excise tax on total annual compensation exceeding $1 million paid to covered employees and on certain excess parachute payments paid to covered employees. The organization, not the employee, is responsible for paying the tax. Beginning in 2026, the One Big Beautiful Bill Act defines covered employees as any employee whose compensation is above $1 million in any tax year, and all covered employees from previous years. Once an employee is a covered employee, the employee is always a covered employee. Compensation paid to licensed medical professionals, including veterinarians, is excluded. Licensed medical professionals may still qualify as covered employees if they receive compensation for performing a service in any other capacity.
It should be noted that Sections 74 and 274 of the Tax Cuts and Jobs Act address employee achievement awards. Employees will not be able to exclude from taxable income cash, cash equivalents, gift cards, gift certificates, vacations, meals, lodging or tickets to theater or sporting events, stock, bonds, and other securities for amounts paid or incurred after December 31, 2017.
Intermediate Sanctions
Developing compensation plans in nonprofit organizations (those that are tax-exempt) can be a complex task and closely reviewed by the Internal Revenue Service. Established by the 1996 Taxpayer Bill of Rights, intermediate sanctions are administered under Section 4958 of the Internal Revenue Code and can be levied on excess benefit transactions that occurred on or after September 14, 1995. Intermediate sanctions are fines (excise taxes) that the Internal Revenue Service imposes when a disqualified person receives compensation or benefits that exceed the value of goods, services, or donations they have provided the tax-exempt organization. Section 4958 of the Internal Revenue Code imposes an excise tax on excess benefit transactions between a disqualified person and an applicable tax-exempt organization.
Disqualified Person
Under the IRS regulations, a disqualified person is, with respect to a transaction, any person in a position to exercise substantial influence over the affairs of a tax-exempt organization at any time during a 5-year period ending at the date of the transaction. For a more detailed definition, see DLC Course 18: Intermediate Sanctions
| Private inurement | Private inurement occurs when an individual who is a highly paid official of an organization directly or indirectly benefits unduly from a transaction with the organization. The individual is called a disqualified person. |
|---|
Excess Benefit Transaction
According to intermediate sanctions, private inurement is an excess benefit transaction.
| Excess benefit transaction | The IRS states, "An excess benefit transaction is a transaction in which an economic benefit is provided by an applicable tax-exempt organization, directly or indirectly, to or for the use of a disqualified person, and the value of the economic benefit provided by the organization exceeds the value of the consideration received by the organization." |
|---|
For the purposes of this course, the transaction is the compensation paid to the person. Compensation includes all forms of cash and non-cash compensation, including salary, fees, bonuses, severance payments, and deferred compensation at the time it vests or is not subject to substantial forfeiture.
With a qualified pension, the transaction occurs on the date the benefit vests. With a transaction involving substantial risk of forfeiture, the transaction occurs on the date there is no longer any substantial risk of forfeiture.
Reasonable Compensation
To avoid intermediate sanctions, the compensation of the disqualified person must be shown to be reasonable.
The IRS says that reasonable compensation is the amount that would ordinarily be paid for like services by like enterprises, whether taxable or tax-exempt, under like circumstances. The IRS definitions of those terms follow:
- Like Services - Finding a job match with substantially similar duties and responsibilities, including such factors as the number of employees managed; the size of the budget or assets managed; hours worked; and scope (national or local).
- Like Enterprises - Organizations used for comparison must be similar in size, usually measured by budget, assets, number of employees, or number of persons served. Equally important, the organizations must provide similar services, usually classified using the National Taxonomy of Exempt Entities (NTEE). While some for-profit compensation comparables can be used to determine reasonable compensation, the IRS says that exclusive reliance on them will “draw increased scrutiny and may lead to the tax-exempt organization not being able to rely on the rebuttable presumption of reasonableness.” If the tax-exempt organization can show that tax-exempt and for-profit entities compete for the same pool of specialized talent, then the for-profit data can be used.
- Like Circumstances - All forms of compensation must be included in the comparison. For example, are there expense allowances or housing paid for some jobs and not for others? All financial benefits need to be included in the analysis. Geographic area should also be reviewed. If sufficient comparable data are not available for the geographic area, then a larger area might be necessary, in addition to potential cost-of-living adjustments.
It is up to the organization to prove that compensation is reasonable based on the particular circumstances that existed when the employee services were incurred.
Q: What significant characteristic does the IRS seek for proof?
A: An arm's-length negotiation between employer and employee.
To learn more about nonprofit reasonable executive pay, see DLC Course 18: Intermediate Sanctions.
Memory Jogger
Under intermediate sanctions, a top executive in a nonprofit organization is considered to be: