Article summary. The IRS has issued long—awaited regulations addressing “intermediate sanctions.” Intermediate sanctions refer to excise taxes that the IRS can assess against any officer or director of a tax—exempt organization (including churches and other religious organizations) who receives excessive compensation. It is very important for clergy and church board members to understand intermediate sanctions in order to avoid the substantial excise taxes that the IRS can impose upon the recipients of excessive compensation (and the board members who approved it). This article will review the background of these new sanctions, summarize the new regulations, and address the impact of intermediate sanctions on church leaders.
Background
The Taxpayer Bill of Rights 2 (TBOR2), enacted by Congress in 1996, contained a provision allowing the IRS to assess “intermediate sanctions” (an excise tax) against “disqualified persons” in lieu of outright revocation of an organization’s exempt status. The intermediate sanctions may be assessed only in cases of “excess benefit transactions,” meaning one or more transactions that provide unreasonable compensation to an officer or director of the exempt organization. An excess benefit transaction is defined as:
any transaction in which an economic benefit is provided to a “disqualified person” (someone in a position to exercise substantial influence over the affairs of the organization) if the value of the benefit exceeds the value of the services provided by the disqualified person, or
to the extent provided in IRS regulations, any transaction in which the amount of an economic benefit provided to a disqualified person is based on the revenues of the organization, if the transaction results in unreasonable compensation being paid
• Key point. Senior ministers ordinarily will be disqualified persons, since they are in a position to exercise substantial influence over the affairs of their church. This means that they are subject to intermediate sanctions if they receive excessive compensation.
The payment of personal expenses and benefits to or for the benefit of disqualified persons, and non—fair—market—value transactions benefiting such persons, would be treated as compensation only if it is clear that the organization intended and made the payments as compensation for services. In determining whether such payments or transactions are, in fact, compensation, the relevant factors include whether the appropriate decision—making body approved the transfer as compensation in accordance with established procedures and whether the organization and the recipient reported the transfer (except in the case of nontaxable fringe benefits) as compensation on the relevant forms (i.e., the organization’s Form 990, the Form W—2 or Form 1099 provided by the organization to the recipient, the recipient’s Form 1040, and other required returns).
The presumption of reasonableness
A committee report to TBOR2 clarified that the parties to a transaction are entitled to rely on a presumption of reasonableness with respect to a compensation arrangement with a disqualified person if such arrangement was approved by a board of directors (or committee of the board) that: (1) was composed entirely of individuals unrelated to and not subject to the control of the disqualified person involved in the arrangement; (2) obtained and relied upon objective “comparability” information, such as (a) compensation paid by similar organizations, both taxable and tax—exempt, for comparable positions, (b) independent compensation surveys by nationally recognized independent firms, or (c) actual written offers from similar institutions competing for the services of the disqualified person; and (3) adequately documented the basis for its decision.
• Key point. The new law creates a presumption that a minister’s compensation package is reasonable if approved by a church board that relied upon objective “comparability” information, including independent compensation surveys by nationally recognized independent firms. The most comprehensive compensation survey for church workers is the annual Compensation Handbook for Church Staff, written by Richard Hammar and James Cobble, and available from the publisher of this newsletter.
A similar presumption arises with respect to the reasonableness of the valuation of property sold by an organization to a disqualified person if the sale is approved by an independent board that uses appropriate comparability data and adequately documents its determination.
Penalties
The intermediate sanctions that the IRS can impose, in lieu of revocation of a charity’ exempt status, include the following:
1. Tax on disqualified persons. A disqualified person who benefits from an excess benefit transaction is subject to a penalty tax equal to 25% of the amount of the “excess benefit” (the amount by which actual compensation exceeds the fair market value of services rendered). This tax is paid by the disqualified person directly, not his or her employer.
2. Additional tax on disqualified persons. If the 25% excise tax is assessed against a disqualified person, and he or she fails to “correct” the excess benefit within the “taxable period,” the IRS can assess an additional tax of 200% of the excess benefit. The new law states that the disqualified person can “correct” the excess benefit transaction by “undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.” The “correction” must occur by the earlier of the date the IRS mails a notice informing the disqualified person that he or she owes the 25% tax, or the date the 25% tax is actually assessed.
3. Tax on organization managers. If the IRS assesses the 25% tax against a disqualified person, it is permitted by the new law to impose an additional 10% tax on any “organization manager” (any officer, director, or trustee) who participates in an excess benefit transaction knowing it is such a transaction, unless the manager’s participation “is not willful and is due to reasonable cause.” This tax is limited to a maximum of $10,000 per manager.
• Key point. Intermediate sanctions apply to excess benefit transactions occurring on or after September 14, 1995.
• Key point. In 1997 the IRS provided the following clarification: (1) the IRS will impose intermediate sanctions only in extreme cases meeting a “front page test”; (2) the new sanctions were intended to change the behavior of nonprofit boards by encouraging them to take seriously the task of establishing compensation packages; (3) nonprofit boards are encouraged to maintain records documenting how they determined the compensation of higher paid employees; and (4) intermediate sanctions will result in an estimated $33 million of excise taxes over the next five years.
• Example. Many years ago, a church board adopted a resolution agreeing to pay its pastor “one—half of all revenues.” For the first several years, this formula resulted in modest compensation. But in recent years, the church has grown and the compensation paid to the pastor has increased dramatically. In 1997 the church received revenues of $500,000 and paid its pastor $250,000. How would the new law apply to this situation? Consider the following: (1) The level of compensation paid to the pastor is almost certainly unreasonable. As a result, it is possible that the IRS, if it learns of the amount of compensation paid by the church to its pastor, will revoke the church’s exempt status. This would have very negative consequences to the pastor, the church, and its membership. (2) Under the new law, the IRS has the option of applying “intermediate sanctions” against the church in lieu of outright revocation of its exempt status, if it establishes that the pastor is a “disqualified person” who was paid benefits in excess of the fair market value of his services. Sanctions available to the IRS include: (a) An excise tax of 25% of the amount of the pastor’s compensation that exceeds the fair market value of his services. If the IRS concludes that the maximum reasonable compensation under these circumstances would be $100,000, then the pastor was paid an “excess benefit” of $150,000, and the excise tax would be $37,500 for 1997 (25% x $150,000). This tax is paid by the pastor directly, not the church. (b) If the 25% excise tax is assessed against the pastor, and he fails to “correct” the excess benefit within the “taxable period,” the IRS can assess an additional tax of 200% of the excess benefit. In this case, this would amount to an additional $300,000! The new law states that the pastor can “correct” the excess benefit transaction by “undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.” The “correction” must occur by the earlier of the date the IRS mails a notice informing the pastor that he owes the 25% tax, or the date the 25% tax is actually assessed. (3) If the IRS assesses the 25% tax against the pastor, it is permitted by the new law to impose an additional 10% tax on any “organization manager” (any officer, director, or trustee) who participates in an excess benefit transaction knowing it is such a transaction, unless the manager’s participation “is not willful and is due to reasonable cause.”
• Example. A small rural church with total income of $20,000 in 1998 pays its pastor “75% of gross income.” It is doubtful that this arrangement will trigger intermediate sanctions, even though compensation is based on a percentage of church income, since the resulting compensation paid to the pastor is minimal.
• Example. A pastor retires in 1998 after serving for 30 years in the same church. The church board authorizes a retirement gift of $100,000. Assume that the pastor also receives a salary of $50,000 for 1998. Assume that the IRS determines that the maximum “reasonable compensation” for this pastor for 1998 would be $100,000. This may expose the pastor to intermediate sanctions, beginning with a 25% excise tax applied to the amount of the pastor’s total compensation for 1998 that exceeds what the IRS has determined to be “reasonable.” This would yield a tax of $12,500 (25% x $50,000). If the excess compensation ($50,000) is not refunded to the church by the time the 25% tax is assessed, then the pastor can be assessed an additional excise tax of 200% times the amount of the excess compensation (for a total tax of $100,000). This is in addition to the 25% tax. In addition, members of the board may be assessed a tax in the amount of 10% times the excess compensation amount (or $5,000). The threat of intermediate sanctions could be reduced or eliminated under these circumstances if the board distributed the retirement gift over more than one year, so that the total compensation received by the pastor in any one year is reduced below what the IRS might consider to be unreasonable or excessive. Any such multi—year arrangement must avoid the “constructive receipt” rule, which is described in chapter 4 of Richard Hammar’s Church and Clergy Tax Guide.
• Example. A pastor lives in a church—owned parsonage for 25 years. The parsonage has a current value of $100,000, and is debt—free. The church board authorizes a gift of the parsonage to the pastor. This transaction may trigger intermediate sanctions. The analysis in the previous example should be reviewed.
The new IRS regulations
The new IRS regulations provide clarification on a number of important questions. Here is a run—down of the key provisions:
Application to churches
Can intermediate sanctions be applied to church employees and church “managers”? The regulations confirm that intermediate sanctions apply to churches. However, a special rule applies-the regulations specify that the procedures of the “Church Audit Procedures Act” will be used “in initiating and conducting any inquiry or examination into whether an excess benefit transaction has occurred between a church and a disqualified person. The Church Audit Procedures Act imposes detailed limitations on IRS examinations of churches. The limitations can be summarized as follows:
Church tax inquiries
The IRS may begin a church tax inquiry only if
(a) an appropriate high—level Treasury official (defined as a regional IRS commissioner or higher official) reasonably believes on the basis of written evidence that an intermediate sanctions excise tax is due from a disqualified person with respect to a transaction involving a church, and
(b) the IRS sends the church a written inquiry notice that explains (1) the specific concerns which gave rise to the inquiry, (2) the general subject matter of the inquiry, and (3) the provisions of the Internal Revenue Code that authorize the inquiry and the applicable administrative and constitutional provisions, including the right to an informal conference with the IRS before any examination of church records, and the first amendment principle of separation of church and state.
Church tax examinations
The IRS may begin a church tax examination of the church records or religious activities of a church only under the following conditions:
(a) the requirements of a church tax inquiry have been met, and
(b) an examination notice is sent by the IRS to the church at least fifteen days after the day on which the inquiry notice was sent, and at least fifteen days before the beginning of such an examination, containing the following information: (1) a copy of the inquiry notice, (2) a specific description of the church records and religious activities which the IRS seeks to examine, (3) an offer to conduct an informal conference with the church to discuss and possibly resolve the concerns giving rise to the examination, and (4) a copy of all documents collected or prepared by the IRS for use in the examination and the disclosure of which is required by the Freedom of Information Act.
Church records
Church records (defined as all corporate and financial records regularly kept by a church, including corporate minute books and lists of members and contributors) may be examined only to the extent necessary to determine the liability for and amount of any income, employment, or excise tax (including the excise taxes associated with intermediate sanctions).
Deadline for completing church tax inquiries
Church tax inquiries not followed by an examination notice must be completed not later than ninety days after the inquiry notice date. Church tax inquiries and church tax examinations must be completed not later than two years after the examination notice date.
Written opinion of IRS legal counsel
The IRS can make a determination based on a church tax inquiry or church tax examination that an excise tax is owed only if the appropriate regional legal counsel of the IRS determines in writing that there has been substantial compliance with the limitations imposed by the Church Audit Procedures Act and approves in writing of such assessment of tax.
Statute of limitations
Church tax examinations involving the liability for any tax may be begun only for any one or more of the three most recent taxable years ending before the examination notice date.
Limitation on repeat inquiries and examinations
If any church tax inquiry or church tax examination is completed and does not result in an assessment of taxes, then no other church tax inquiry or church tax examination may begin with respect to that church during the five—year period beginning on the examination notice date (or the inquiry notice date if no examination notice was sent) unless such inquiry or examination is (a) approved in writing by the Assistant Commissioner of Employee Plans and Exempt Organizations of the IRS, or (b) does not involve the same or similar issues addressed in the prior inquiry or examination.
• Example. A local IRS office suspects that Rev. A is receiving excessive compensation from First Church. It sends the church an inquiry notice in which the only explanation of the concerns giving rise to the inquiry is a statement that “you may be involved in an excess benefit transaction.” This inquiry notice is defective since the Church Audit Procedures Act requires that such a notice explain (1) the specific concerns which gave rise to the inquiry, (2) the general subject matter of the inquiry, and (3) the provisions of the Internal Revenue Code that authorize the inquiry and the applicable administrative and constitutional provisions, including the right to an informal conference with the IRS before any examination of church records, and the first amendment principle of separation of church and state. Further, an inquiry notice may not be issued unless a regional IRS commissioner (or higher official) authorizes it.
• Example. The IRS receives a telephone tip from a disgruntled church member who claims that her church is paying excessive compensation to her senior pastor. A telephone tip cannot serve as the basis for a church tax inquiry since such an inquiry may commence only if an appropriate high—level Treasury official reasonably believes on the basis of written evidence that a church is not tax—exempt, is carrying on an unrelated trade or business, or otherwise is engaged in activities subject to taxation.
• Example. An IRS inquiry notice does not mention the possible application of the first amendment principle of separation of church and state to church tax inquiries. Such a notice is defective. However, a church’s only remedy is a stay of the inquiry until the IRS sends a valid inquiry notice.
• Example. In 1998, the IRS conducts an examination of the tax—exempt status of First Church. It concludes that the church was properly exempt from federal income taxation. In 1999, the IRS commences an examination of First Church to determine if its managers authorized the payment of excessive compensation to their senior pastor. Such an examination is not barred by the prohibition against repeated examinations within a five—year period, since it does not involve the same or similar issues.
• Need more information? The Church Audit Procedures Act is explained fully in Richard Hammar’s book, Pastor, Church & Law (2nd ed. 1992). While this text is currently out—of—print, the full text (along with all back issues of this newsletter) is available on our Online Legal and Tax Library. You may become a member directly online at www.iclonline.com. Select the link Become a library member under the Church Law & Tax Report heading on the home page.
“Correcting” an excess benefit transaction
The intermediate sanctions law specifies that a disqualified person who receives excess compensation is subject to an excise tax equal to 25% of the amount of compensation in excess of a reasonable amount. Further, if the excess benefit is not “corrected,” the disqualified person is liable for a tax of 200% of the excess benefit. The correction must occur before the earlier of (1) the date the IRS mailed a “notice of deficiency” for the 25% tax, or (2) the date on which the 25% tax is assessed.
How can a disqualified person “correct” an excess benefit transaction? The regulations answer this question as follows:
Correction means, with respect to any excess benefit transaction, undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person had been dealing under the highest fiduciary standards. Correction of the excess benefit occurs if the disqualified person repays the applicable tax—exempt organization an amount of money equal to the excess benefit, plus any additional amount needed to compensate the organization for the loss of the use of the money or other property during the period commencing on the date of the excess benefit transaction and ending on the date the excess benefit is corrected. Correction may also be accomplished, in certain circumstances, by returning property to the organization and taking any additional steps necessary to make the organization whole. If the excess benefit transaction consists of the payment of compensation for services under a contract that has not been completed, termination of the employment or independent contractor relationship between the organization and the disqualified person is not required in order to correct. However, the terms of any ongoing compensation arrangement may need to be modified to avoid future excess benefit transactions.
• Example. A church pays its pastor a salary that the board later determines to have resulted in an excess benefit of $100,000. The board persuades the pastor to “correct” the arrangement by returning the excess amount to the church. This is not enough to “correct” the excess benefit transaction, and so the pastor is exposed to the 200% excise tax ($200,000). The regulations clarify that a “correction” involves more than a return of the excess benefit. The recipient of the excess benefit must repay the church or other tax—exempt organization “an amount of money equal to the excess benefit, plus any additional amount needed to compensate the organization for the loss of the use of the money or other property during the period commencing on the date of the excess benefit transaction and ending on the date the excess benefit is corrected.” In this example, this means that the pastor must pay the church an amount sufficient to compensate it for the earnings it would have received on the excess amount had it not been paid to the pastor.
Tax on managers
“Managers” who approve an excess benefit transaction are subject to an excise tax equal to 10% of the amount of the excess benefit-up to a maximum of $10,000. The new regulations provide the following clarifications:
Manager defined
The regulations define a manager of a church or other tax—exempt organization as
any officer, director, or trustee of such organization, or any individual having powers or responsibilities similar to those of officers, directors, or trustees of the organization, regardless of title. A person shall be considered an officer of an organization if-(A) that person is specifically so designated under the certificate of incorporation, by—laws, or other constitutive documents of the organization; or (B) that person regularly exercises general authority to make administrative or policy decisions on behalf of the organization. Independent contractors, acting in a capacity as attorneys, accountants, and investment managers and advisors, are not officers. Any person who has authority merely to recommend particular administrative or policy decisions, but not to implement them without approval of a superior, is not an officer.
• Example. A church purchases land as the site of a future building. Before signing the contract of sale, the church obtained written assurance from the seller that there were no known environmental hazards on the property. In fact, the seller was aware that it had dumped hazardous materials on a portion of the property. The church sued the former owner for fraud and won a judgment of $1 million. The attorney retained by the church had taken the case on a “contingency fee” basis, meaning that her compensation was one—third of any amount she recovered. According to the regulations, the attorney is not a “manager” since she was an independent contractor acting on behalf of the church. And, as we will see later, she is not a disqualified person, and so she will not be subject to intermediate sanctions.
• Tip. Many church board members will meet the regulations’ definition of a manager.
Participation
A manager must participate in the decision to pay excessive compensation to a disqualified person in order to be subject to the 10% excise tax. What is participation? The new regulations specify that
participation includes silence or inaction on the part of an organization manager where the manager is under a duty to speak or act, as well as any affirmative action by such manager. However, an organization manager will not be considered to have participated in an excess benefit transaction where the manager has opposed such transaction in a manner consistent with the fulfillment of the manager’s responsibilities to the applicable tax—exempt organization.
Knowing
A manager’s participation in an excess benefit transaction must be “knowing” in order for the 10% excise tax to apply. The regulations specify that
a person participates in a transaction knowing that it is an excess benefit transaction only if the person-(A) has actual knowledge of sufficient facts so that, based solely upon such facts, such transaction would be an excess benefit transaction; (B) is aware that such an act under these circumstances may violate the provisions of federal tax law governing excess benefit transactions; and (C) negligently fails to make reasonable attempts to ascertain whether the transaction is an excess benefit transaction, or the person is in fact aware that it is such a transaction.
• Key point. The regulations clarify that “knowing” does not mean having reason to know. Actual knowledge is required. However, evidence tending to show that a person has reason to know of a particular fact or rule is relevant in determining whether the person had actual knowledge of the fact or rule. So, for example, evidence tending to show that a person has reason to know of an excess benefit transaction is relevant in determining whether the person has actual knowledge of it.
Willful
A manager’s participation in an excess benefit transaction must be “willful” in order for the 10% excise tax to apply. The regulations clarify that
participation by an organization manager is willful if it is voluntary, conscious, and intentional. No motive to avoid the restrictions of the law or the incurrence of any tax is necessary to make the participation willful. However, participation by an organization manager is not willful if the manager does not know that the transaction in which the manager is participating is an excess benefit transaction.
Advice of counsel
The regulations specify:
If a person, after full disclosure of the [facts] to legal counsel (including in—house counsel) relies on the advice of such counsel expressed in a reasoned written legal opinion that a transaction is not an excess benefit transaction, the person’s participation in such transaction will ordinarily not be considered knowing or willful … even if such transaction is subsequently held to be an excess benefit transaction …. [A] written legal opinion is reasoned so long as the opinion addresses itself to the facts and applicable law. However, a written legal opinion is not reasoned if it does nothing more than recite the facts and express a conclusion. The absence of advice of counsel with respect to an act shall not, by itself, however, give rise to any inference that a person participated in such act knowingly, willfully, or without reasonable cause.
Limit on manager liability
The new regulations clarify that the tax that must be paid by participating managers for any one excess benefit transaction cannot exceed $10,000.
• Example. A church board gives a retiring pastor the church parsonage (having a value of $150,000). The board members later learn about intermediate sanctions, and are concerned that they may each be liable for up to $10,000 as managers. The new regulations clarify that the board members will not individually be liable for the 10% excise tax (up to $10,000). Rather, they will collectively be liable for an excise tax (as managers) of 10% of the amount of the excess benefit up to a maximum tax of $10,000. The total tax assessed for this single transaction will be allocated to the board members who participated in the decision.
Who is a “disqualified person”?
Since intermediate sanctions apply only to disqualified persons (and managers of tax—exempt organizations that approve an excess benefit transaction), it is important for church leaders to be familiar with this term. The new regulations provide helpful guidance, as noted below.
General definition
The regulations define a disqualified person as
any person who was in a position to exercise substantial influence over the affairs of the organization at any time during the five—year period ending on the date of the transaction.
Family members
The regulations clarify that some persons will be disqualified persons because of their relationship with a disqualified person. These include a spouse; brother or sister (by whole or half blood); a spouse of a brother or sister (by whole or half blood); an ancestor; child; grandchild; great grandchild; and a spouse of a child, grandchild, or great grandchild.
• Example. A church wants to make a large retirement gift to its retiring pastor, Rev. G. The board does not want to expose Rev. G to intermediate sanctions, so it makes the retirement gift to Rev. G’s spouse. This arrangement does not avoid intermediate sanctions. According to the new regulations. Rev. G’s spouse will be deemed to be a disqualified person if Rev. G meets that definition.
Persons having substantial influence
A disqualified person is someone who “was in a position to exercise substantial influence” over the affairs of the church or other charity. What is substantial influence? The regulations clarify this term by listing persons who are presumed to exercise substantial influence, as well as those who are not. The regulations then address persons fitting within either of these categories.
1. Persons who are presumed to exercise substantial influence. These include any individual who serves on the governing body of the organization who is entitled to vote on matters over which the governing body has authority as the president, chief executive officer, or chief operating officer of the organization as treasurer or chief financial officer of the organization.
• Key point. The regulations specify that “an individual serves as a treasurer or chief financial officer, regardless of title, if that individual has or shares ultimate responsibility for managing the organization’s financial assets and has or shares authority to sign drafts or direct the signing of drafts, or authorize electronic transfer of funds, from organization bank accounts.
2. Persons not having substantial influence. The new regulations specify that persons who do not meet the tax code’s definition of a highly compensated employee will not be deemed to exercise substantial influence over a charity and therefore will not meet the definition of a disqualified person. As a result, intermediate sanctions will not apply to them. The code defines a highly compensated employee as one who had compensation for the previous year in excess of $80,000 (and, if an employer elects, was in the top 20 percent of employees by compensation). The $80,000 amount is indexed annually for inflation.
Caution. Not all clergy earning annual compensation of less than $80,000 are exempt from the definition of a disqualified person. The new regulations specify that the exemption of persons earning less than this amount does not apply to (1) family members (as defined above) of a disqualified person, or (2) a board member, president, or treasurer of the church or charity.
• Example. Rev. T is senior pastor of a church, and serves as president of the corporation and a member of the board (with the right to vote). Rev. T’s church salary for the current year is $50,000. Since Rev. T serves as both president and a member of the board, he is not automatically exempted from the definition of a disqualified person even though he is not a highly compensated employee. As a result, he will be subject to intermediate sanctions if the church pays him excessive compensation. However, Rev. T’s current level of compensation is not excessive. In summary, while he is a disqualified person, he is not subject to intermediate sanctions because his compensation is reasonable.
• Example. Rev. C is an assistant pastor. He does not serve on the church board and is not an officer of the church. His church compensation for this year is $40,000. In addition, the church board is considering a gift of the parsonage to Rev. C. The parsonage has a current value of $75,000 (and is debt—free). The board is concerned that the gift of the parsonage to Rev. C will expose him to intermediate sanctions. They do not need to be concerned. It is true that Rev. C will be a highly compensated employee if the parsonage is given to him. But this in itself does not make him a disqualified person. The regulations require that he be in a position to exercise substantial influence over the affairs of the church. An assistant pastor who is neither an officer nor member of the board probably does not meet this test. Since Rev. C is not a disqualified person, he is not subject to intermediate sanctions.
• Example. Same facts as the previous example, except that Rev. C is a senior pastor who serves on the church board (with the right to vote). Under these circumstances, Rev. C will be deemed a disqualified person because of his status as a church board member. This will expose him to intermediate sanctions if the total amount of his church compensation for the current year is excessive.
• Example. Rev. N is a part—time assistant pastor. She does not serve on the church board and is not an officer of the church. Her church compensation for this year is $15,000. In addition, the church board is considering a gift of a new car to Rev. N. The car has a current value of $25,000. The board is concerned that the gift of the car to Rev. N will expose her to intermediate sanctions. They do not need to be concerned. First, her total compensation (including the gift of the car) would not make her a highly compensated employee, and so she is presumed not to exercise substantial influence over church affairs. Therefore, she cannot be a disqualified person and is not subject to intermediate sanctions.
3. Other cases. Some persons will not fit within either of the previous two categories. They do not serve as a board member, president, or treasurer of their church or charity; and, they satisfy the definition of a highly compensated employee. Whether or not such persons will be deemed disqualified persons depends on the circumstances.
The new regulations clarify that circumstances tending to show that a person has substantial influence over the affairs of a church or charity include, but are not limited to, any one or more of the following:
The person founded the organization.
The person is a “substantial contributor” (as defined in section 507(d)(2) of the code). This definition includes any person who contributed “an aggregate amount of more than $5,000” if such amount is more than 2 percent of the total contributions received by the church or charity before the close of the taxable year in which the contribution is received.
The person’s compensation is based on the revenues of the church or charity.
On the other hand, circumstances tending to show that a person does not have substantial influence over the affairs of a church or charity include but are not limited to, the following: (1) the person has taken a vow of poverty on behalf of a religious organization; or (2) the person is an independent contractor, such as an attorney, accountant, or investment manager or advisor, acting in that capacity-unless the person might economically benefit (aside from fees received for the professional services rendered).
• Key point. A compensation arrangement based on a percentage of a church’s revenue suggests that the recipient exercises substantial influence over church affairs and therefore is a disqualified person subject to intermediate sanctions. However, this rule will apply only if the recipient (1) is not a board member, president, or treasurer of the church; and (2) receives annual church compensation of $80,000 or more. Obviously, this rule will apply to very few ministers.
• Example. Rev. G is a pastor of a church and serves as president of the church corporation and a member of the board. The board agrees to pay him compensation equal to one—third of all church offerings. For 1998, the church receives offerings of $900,000, and Rev. G is paid $300,000. Rev. E is a disqualified person because he is president of the church and a member of the board, and as a result is presumed to exercise substantial influence over church affairs. The fact that the church pays him a percentage of revenue is another fact supporting his status as a disqualified person.
• Example. Same facts as the previous example, except that Rev. G is not an officer or director of the church. The fact that Rev. G is compensated on the basis of a percentage of church revenue is a fact that tends to show substantial influence over church affairs. As a result, it is likely that Rev. G will be deemed to be a disqualified person by the IRS.
• Example. B is a member of a local church. In 1998, B contributes $50,000 to the church. The church received contributions of $700,000 in 1998. B is a substantial contributor since she contributed more than $5,000 in 1998, and her contributions exceeded 2 percent of the church’s total contributions for the year. As a result, she may be deemed to exercise “substantial control” over church affairs, and this would make her a disqualified person. This exposes her to intermediate sanctions, in the event that the church pays her excessive compensation. However, since the church pays B no compensation, there is no exposure to intermediate sanctions.
What is an excess benefit transaction?
The IRS can assess intermediate sanctions against a disqualified person who is involved in an excess benefit transaction with a church or charity. Both conditions must be satisfied. The IRS cannot impose intermediate sanctions against someone who is not a disqualified person-even if he or she receives substantial compensation. Of course, such arrangements will be rare. And, the IRS cannot impose intermediate sanctions against a disqualified person who does not receive an excess benefit. We have defined the term “disqualified person” in the preceding pages. The remaining task is to define an excess benefit transaction. The new regulations provide the following definition:
An excess benefit transaction means any transaction in which an economic benefit is provided by an applicable tax—exempt organization directly or indirectly, to or for the use of, any disqualified person, and the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received by the organization for providing such benefit. An excess benefit transaction also includes certain revenue—sharing transactions ….
Certain economic benefits are disregarded
The regulations list a few economic benefits that are not considered in determining whether or not a disqualified person is paid excessive compensation. The most relevant exceptions are as follows:
1. Reimbursement of some expenses. A church’s payment of reasonable expenses for officers and directors to attend board meetings is not taken into account in applying intermediate sanctions. However, the new regulations warn that “reasonable expenses do not include luxury travel or spousal travel.”
2. A member of a charitable class. The new regulations specify that “an economic benefit provided to a disqualified person that the disqualified person receives solely as a member of a charitable class that the applicable tax—exempt organization intends to benefit as part of the accomplishment of the organization’s exempt purpose is generally disregarded” for purposes of assessing intermediate sanctions.
3. Insurance or indemnification of excise taxes. The payment of a premium for an insurance policy providing liability insurance to cover intermediate sanctions or indemnification of a disqualified person for such taxes will not constitute an excess benefit transaction if the premium or the indemnification is treated as compensation to the disqualified person when paid, and the total compensation paid to the disqualified person is reasonable.
• Example. Rev. L has served as senior pastor of his church for 30 years. The congregation has a membership of 200 and annual revenue of $300,000. The board sets Rev. L’s salary at $50,000 for 1999. In July of 1999, Rev. L informs the board and congregation that he will retire at the end of the year. The board votes to present Rev. L with the church parsonage as a retirement gift. The parsonage has a value of $150,000, and is debt—free. Will the church’s generous gift represent an excess benefit that will trigger intermediate sanctions? Possibly. The new regulations define an excess benefit transaction as any transaction in which the value of an economic benefit provided by a church or charity to a disqualified person “exceeds the value of the consideration (including the performance of services) received by the organization for providing such benefit.” The critical question is whether the value of the parsonage, when combined with Rev. L’s salary, exceeds the value of his services. Obviously, this is not an easy question to answer. But it is possible if not likely that the IRS would assert that the compensation paid to Rev. L is excessive. Consider the following: (1) The church previously agreed to pay Rev. L an annual salary of $50,000. This represented an “arm’s length” transaction that presumably reflected the “value” of Rev. L’s services. As a result, the gift of property valued at $150,000 represented additional compensation over and above what the church had already determined to be the value of Rev. L’s services for the year. (2) The total value of Rev. L’s compensation for 1999 ($200,000) is substantial, and is well beyond the upper end of clergy salary ranges for churches with a membership of 200 and annual revenue of $300,000. (3) The total value of Rev. L’s compensation for 1999 represents 67 percent of the church’s total income. As a result, the gift of the parsonage exposes Rev. L and the church board to intermediate sanctions. If the IRS determines that the maximum reasonable compensation for Rev. L in 1999 would be $100,000, then he has received an excess benefit of $100,000. He would be liable for an excise tax of $25,000 (25 percent of the excess), and an additional $200,000 (200 percent of the excess) if he did not “correct” the situation by returning the excess to the church. In addition, the church board would be subject to an excise tax of $10,000 (paid collectively, not individually). The church board should not have entered into this arrangement without seeking the advice of a tax attorney. It is possible that the church could have structured the gift in a way to “spread” it over more than one year, so that Rev. L’s annual compensation would never be excessive.
• Example. Same facts as the previous example, except that the church has 1,000 members and annual revenue of $1.5 million. It is less likely that Rev. L’s total compensation for 1999 would be excessive under these facts, since ministers serving congregations of this size have higher incomes. Nevertheless, because of the serious consequences associated with intermediate sanctions, prudence dictates that church boards seek the opinion of a tax attorney when considering a significant gift to a minister in order to minimize or eliminate the risk of sanctions.
What is reasonable compensation?
Compensation in excess of what is “reasonable” constitutes an excess benefit that will expose a disqualified person to intermediate sanctions. What, then, is reasonable compensation? The regulations simply note that “compensation for the performance of services is reasonable if it is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.” The regulations clarify that compensation includes all items of compensation provided by a church or charity in exchange for the performance of services, including but not limited to:
All forms of cash and noncash compensation, including salary, fees, bonuses, and severance payments paid.
All forms of deferred compensation that is earned and vested, whether or not funded, and whether or not paid under a deferred compensation plan that is a qualified plan under section 401(a), but if deferred compensation for services performed in multiple prior years vests in a later year, then that compensation is attributed to the years in which the services were performed.
The amount of premiums paid for liability or any other insurance coverage, as well as any payment or reimbursement by the organization of charges, expenses, fees, or taxes not covered ultimately by the insurance coverage.
All other benefits, whether or not included in income for tax purposes, including payments to welfare benefit plans on behalf of the persons being compensated, such as plans providing medical, dental, life insurance, severance pay, and disability benefits, and both taxable and nontaxable fringe benefits … including expense allowances or reimbursements or foregone interest on loans that the recipient must report as income on his separate income tax return.
Compensation based on a percentage of revenue
The compensation of some ministers is based on a percentage of church income. In other cases, ministers receive a “bonus” if the church reaches a revenue goal. Do such arrangements result in “excess benefits” exposing the ministers to intermediate sanctions? Possibly, but not necessarily. The new regulations state that the answer depends on “all relevant facts and circumstances”. The regulations provide some clarification by noting that relevant facts and circumstances include, but are not limited to:
the relationship between the size of the benefit provided and the quality and quantity of the services provided, and
the ability of the person receiving the compensation to control the activities generating the revenues on which the compensation is based
The new regulations contain the following additional clarification:
A revenue—sharing transaction may constitute an excess benefit transaction regardless of whether the economic benefit provided to the disqualified person exceeds the fair market value of the consideration provided in return if, at any point, it permits a disqualified person to receive additional compensation without providing proportional benefits that contribute to the organization’s accomplishment of its exempt purpose.
The application of the new regulations to revenue—based pay is illustrated by the following examples.
• Example. Rev. C serves as an officer and director of his church. His annual compensation is one—half of all church income. In 1998, total church income was $60,000, and Rev. C was paid $30,000. The board is concerned that this compensation arrangement may trigger intermediate sanctions against Rev. C and the board members personally. The new regulations clarify that not all “revenue—based” compensation arrangements result in an excess benefit leading to intermediate sanctions. Rather, all of the “relevant facts and circumstances” must be considered. The regulations state that “relevant facts and circumstances” include, but are not limited to (1) the relationship between the size of the benefit provided and the quality and quantity of the services provided, and (2) the ability of the person receiving the compensation to control the activities generating the revenues on which the compensation is based. Rev. C’s compensation will not be excessive under these criteria. First, the size of his compensation is reasonably related to the quality and quantity of services performed (i.e., full—time professional services). And second, Rev. C has only limited ability to “control the activities” generating church revenue. Unlike many organizations, the amount of a church’s revenue is based on many variables that are beyond a minister’s control. Ultimately, church revenue is based largely on the theology and religious commitment of individual members concerning the importance of stewardship. It is doubtful that the IRS can even engage in intrusive inquiries into the motivation of church members in giving to their church. As a result, the second “fact and circumstance” cited in the new regulations will have limited application to local churches.
• Example. Same facts as the previous example, except that Rev. C is not an officer or director of his church. There is no possibility that the compensation arrangement will result in intermediate sanctions, since Rev. C is not a disqualified person.
• Example. Rev. C serves as an officer and director of his church. The congregation has 300 members. His annual compensation is one—half of all church income. In 1998, total church income was $600,000, and Rev. C was paid $300,000. The board is concerned that this compensation arrangement may trigger intermediate sanctions against Rev. C and the board members personally. The new regulations clarify that not all “revenue—based” compensation arrangements result in an excess benefit leading to intermediate sanctions. Rather, all of the “relevant facts and circumstances” must be considered. The regulations state that “relevant facts and circumstances” include, but are not limited to (1) the relationship between the size of the benefit provided and the quality and quantity of the services provided, and (2) the ability of the person receiving the compensation to control the activities generating the revenues on which the compensation is based. Rev. C’s compensation may be excessive under these criteria since the IRS may conclude that the amount of Rev. C’s compensation is not proportional to the quantity and quality of the services he provides. This is a difficult and somewhat subjective inquiry, but note the following: (1) It is highly irregular for the chief executive officer of any organization (nonprofit or for—profit) to receive half of all the organization’s revenue. While such an arrangement may be justifiable when the organization’s revenue is modest, it becomes increasingly irregular as the organization’s revenue increases. Being paid half of a church’s revenue probably is reasonable for a small congregation with revenues of $60,000 (see the previous example). But the same cannot be said of a church with revenue of $600,000. (2) It is likely the IRS will assert that Rec. C’s compensation is excessive in light of the quality and quantity of services performed. It is true that Rev. C is providing professional and valuable services. However, these services must be placed in perspective. How many ministers serving a congregation of 300 members receive annual compensation of $300,000? Few if any. As a result, Rev. C will have a difficult if not impossible task in convincing the IRS that his compensation is reasonably related to the value of his services. How can it be reasonable if few (if any) ministers serving congregations of similar size receive this level of compensation? This conclusion is reinforced by the annual Compensation Handbook for Church Staff, published annually by this newsletter. It is our recommendation that any doubt with regard to reasonableness of clergy compensation should be resolved on the side of caution-because of the enormity of the sanctions that can be assessed against disqualified persons who are paid excessive compensation. In this example, if the IRS determines that Rev. C’s “reasonable” compensation would be $100,000, then he has an excess benefit of $200,000. He will face an excise tax of $50,000 (25 percent of the excess), and an additional tax of $400,000 if he does not “correct” the overpayment by returning it to the church. In addition, the church board members who authorized this arrangement may be assessed a tax of $10,000 (collectively, not individually).
• Example. Same facts as the previous example, except that the congregation has more than 1,000 members and its revenue for 1998 was $1.5 million, resulting in compensation to Rev. C of $750,000. There is little if any doubt that Rev. C’s compensation will be deemed excessive by the IRS, and that Rev. C will be exposed to the 25 percent and 200 percent excise taxes discussed earlier in this article. In addition, the board is exposed to the 10 percent tax on managers.
• Example. A church with 200 members has annual revenue of $300,000. The board enters into a compensation arrangement with its pastor, Rev. E, under which Rev. E is paid an annual salary of $50,000 and in addition receives a “bonus” of $25,000 if membership or revenue increases by 10 percent in any year. Assuming that Rev. E is a disqualified person, it is doubtful that this arrangement will result in an excess benefit leading to intermediate sanctions. The new regulations clarify that not all “revenue—based” compensation arrangements result in an excess benefit leading to intermediate sanctions. Rather, all of the “relevant facts and circumstances” must be considered. The regulations state that “relevant facts and circumstances” include, but are not limited to (1) the relationship between the size of the benefit provided and the quality and quantity of the services provided, and (2) the ability of the person receiving the compensation to control the activities generating the revenues on which the compensation is based. Rev. E’s compensation will not be excessive under these criteria. First, the size of his compensation is reasonably related to the quality and quantity of services performed (i.e., full—time professional services). Second, Rev. E has only limited ability to “control the activities” generating church revenue (see the previous examples). Third, the new regulations specify that “a revenue—sharing transaction may constitute an excess benefit transaction regardless of whether the economic benefit provided to the disqualified person exceeds the fair market value of the consideration provided in return if, at any point, it permits a disqualified person to receive additional compensation without providing proportional benefits that contribute to the organization’s accomplishment of its exempt purpose.” However, an example in the new regulations clarifies that if additional compensation is based entirely on a “proportional benefit” to the charity, then the added pay is not an excess benefit. The example states that a manager of a charity’s investment portfolio, whose compensation consists of an annual salary plus a bonus equal to a percentage of any increase in the value of the charity’s portfolio, is not receiving an excess benefit. While the manager’s compensation (the bonus) is linked to the charity’s revenue, the arrangement gives the manager “an incentive to provide the highest quality service in order to maximize benefits.” Further, the manager “can increase his own compensation only if [the charity] also receives a proportional benefit. Under these facts and circumstances, the payment to [the manager] of the bonus described above does not constitute an excess benefit transaction.” It could be argued that Rev. E’s “bonus” is tied directly to a proportional benefit being received by the church (a 10 percent increase in membership or revenue), and therefore is not excessive.
• Example. Rev. N serves as her church’s minister of music, and is a member of the church board. Because she occasionally composes religious music in the course of her employment, she and the church enter into an agreement specifying that the church owns the copyright in such “works made for hire” but that Rev. N will receive half of all royalties the church earns from publication of the music. This is a “revenue—based” pay arrangement, since Rev. N’s compensation is based in part on the church’s royalty revenue. However, it will not result in an excess benefit to Rev. N. The new IRS regulations contain a similar example which contains the following conclusion (the names have been changed): “Rev. N receives the revenue—based compensation, i.e., the percentage of royalties, as an incentive and a reward for producing work of especially high quality. In addition, any time the church benefits by receiving royalties, Rev. N benefits as well and to a proportionate degree. Finally, because the copyright belongs to the church, Rev. N has no control over how the copyright is used nor the stream of revenue it generates. Under these facts and circumstances, the church’s payment of revenue—based compensation to Rev. N does not constitute an excess benefit transaction under the rules of this section.
• Example. A televangelist raises $10 million in annual revenue. The ministry’s board of directors adopts a compensation arrangement establishing the televangelist’s annual income at ten percent of the ministry’s total revenue. The televangelist engages in fundraising on every broadcast, and in addition conducts intensive fundraisers twice each year. The board is concerned that this compensation arrangement may trigger intermediate sanctions against the president and the board members personally. The new regulations clarify that not all “revenue—based” compensation arrangements result in an excess benefit leading to intermediate sanctions. Rather, all of the “relevant facts and circumstances” must be considered. The regulations state that “relevant facts and circumstances” include, but are not limited to (1) the relationship between the size of the benefit provided and the quality and quantity of the services provided, and (2) the ability of the person receiving the compensation to control the activities generating the revenues on which the compensation is based. The televangelist’s compensation probably is excessive under these criteria since the IRS likely would conclude that the amount of the televangelist’s compensation is not proportional to the quantity and quality of the services he provides. This is a difficult and somewhat subjective inquiry, but note the following: (1) Annual compensation of $1 million for the chief executive of any charity is presumably excessive. This certainly is true for religious organizations. For example, the president of the United States receives annual compensation of $250,000, and members of Congress, state governors, and university presidents receive much less than this. (2) It is highly irregular for the chief executive officer of any organization (nonprofit or for—profit) to receive one—tenth of all the organization’s revenue. While such an arrangement may be justifiable when the organization’s revenue is modest, it becomes increasingly irregular as the organization’s revenue increases. (3) It is likely the IRS will assert that the televangelist’s compensation is excessive in light of the quality and quantity of services performed. (4) The new regulations specify that “the ability of the person receiving the compensation to control the activities generating the revenues on which the compensation is based” is one factor to be considered in evaluating the reasonableness of a revenue—based pay arrangement. The IRS likely would conclude that the televangelist has the ability to control the activities generating the revenues because of his central role in fundraising activities.
The rebuttable presumption of reasonableness
Disqualified persons (and “managers”) may benefit from a “rebuttable presumption” that compensation is reasonable. The new regulations describe this presumption as follows:
Payments under a compensation arrangement between [a church or charity] and a disqualified person shall be presumed to be reasonable, and a transfer of property, right to use property, or any other benefit or privilege between an applicable tax—exempt organization and a disqualified person shall be presumed to be at fair market value, if the following conditions are satisfied-(1) The compensation arrangement or terms of transfer are approved by the organization’s governing body or a committee of the governing body composed entirely of individuals who do not have a conflict of interest with respect to the arrangement or transaction; (2) The governing body, or committee thereof, obtained and relied upon appropriate data as to comparability prior to making its determination; and (3) The governing body or committee adequately documented the basis for its determination concurrently with making that determination.
1. Conflict of interest. The rebuttable presumption of reasonableness only arises if compensation is determined by a board or committee composed entirely of individuals not having a conflict of interest. If only one member of a board or committee has a conflict of interest, then the rebuttable presumption does not apply. The regulations state that a member of a board or committee has a conflict of interest if he or she
Is a disqualified person.
Is related to any disqualified person participating in or economically benefiting from the compensation arrangement or transaction. “Related” means a spouse; brother or sister (by whole or half blood); a spouse of a brother or sister (by whole or half blood); an ancestor; child; grandchild; great grandchild; and a spouse of a child, grandchild, or great grandchild.
Is in an employment relationship subject to the direction or control of any disqualified person participating in or economically benefiting from the compensation arrangement or transaction.
Is receiving compensation or other payments subject to approval by any disqualified person participating in or economically benefiting from the compensation arrangement or transaction.
Has no material financial interest affected by the compensation arrangement or transaction.
Does not approve a transaction providing economic benefits to any disqualified person participating in the compensation arrangement or transaction, who in turn has approved or will approve a transaction providing economic benefits to the member.
• Key point. The new regulations specify that “a person is not included on the governing body or committee when it is reviewing a transaction if that person meets with other members only to answer questions, and otherwise recuses himself from the meeting and is not present during debate and voting on the transaction or compensation arrangement.” What does this language mean? Unfortunately, it is not clear. It may mean that clergy who serve as a member of a church board will remain eligible for the rebuttable presumption of reasonableness if they recuse themselves from board meetings where their compensation is addressed. This interpretation is reasonable, but not certain.
• Example. A parachurch ministry’s board includes the president. If the IRS later asserts that the president was paid excessive compensation, the president will not be able to rely on the presumption of reasonableness because of his presence on the board. However, if he recuses himself from the board meeting in which his compensation is discussed (and so is not present for the debate and voting on the compensation arrangement), he may not have a “conflict of interest” that would preclude the presumption of reasonableness.
• Example. Same facts as the previous example. The president does not serve on the board, but his wife does. The president recuses himself from the board meeting in which his compensation is determined, but his wife does not. The president will not be able to rely on the presumption of reasonableness, because one board member (the wife) is related to the president, and she did not recuse herself from the meeting that addressed her husband’s compensation.
2. “Comparability data”. The rebuttable presumption of reasonableness only arises if the governing board “obtained and relied upon appropriate data as to comparability prior to making its determination”. The new regulations specify that a board “has appropriate data as to comparability” if it “has information sufficient to determine whether … a compensation arrangement will result in the payment of reasonable compensation or a transaction will be for fair market value.” The regulations clarify that relevant information includes, but is not be limited to:
Compensation levels paid by similarly situated organizations, both taxable and tax—exempt, for “functionally comparable positions”
the availability of similar services in the same geographic area
independent compensation surveys compiled by independent firms
actual written offers from similar institutions competing for the services of the disqualified person
independent appraisals of the value of property that the organization intends to purchase from, or sell or provide to, the disqualified person
• Example. A church with 500 members and an annual budget of $1 million pays its senior pastor compensation of $200,000 in 1998. The pastor participated in the board meeting in which his compensation was determined. The church board is concerned that the pastor’s compensation may be excessive. They begin doing “salary comparisons” of other churches and businesses in the area with a similar membership or budget. Such efforts will serve no purpose if the board is attempting to qualify the pastor for the rebuttable presumption of reasonableness. The pastor’s presence on the board, and his participation in the meeting in which his compensation was determined, disqualify him for the presumption of reasonableness. However, salary surveys will be relevant in determining whether or not the pastor’s compensation is excessive.
• Example. Same facts as the previous example, except that the pastor recused himself from the board meeting in which his compensation was determined. The board’s efforts to obtain “salary comparisons” may be helpful. If the board determines that “similarly situated organizations, both taxable and tax—exempt”, are paying persons in a “functionally equivalent position” a similar amount of compensation, then this may establish a rebuttable presumption that the pastor’s compensation is reasonable. This assumes that the pastor’s recusing himself from the board meeting in which his compensation was determined avoided any “conflict of interest”.
• Example. Same facts as the previous example. Assume that the board learns that the average annual compensation paid to senior pastors by 20 “similarly situated” churches in the same area is $75,000. The board also determines that the average annual compensation paid by 10 local businesses with annual revenue of $1 million is $100,000. The results of the board’s salary surveys clearly will not support the rebuttable presumption of reasonableness.
• Example. A church pays its senior pastor annual compensation of $75,000 for 1998. The pastor serves as a member of the church’s governing board. In 1998 the church board also provides the pastor with a new car (with a value of $25,000) in recognition of 30 years of service. The pastor recused himself from the board meetings in which his salary and the gift were approved. The gift of the car is fully taxable, and so the pastor’s total compensation for 1998 will be $100,000. The board obtains a copy of the Compensation Handbook for Church Staff, written by Richard Hammar and James Cobble, and determines that senior pastors in “similarly situated” churches are paid an average of $85,000 per year. This information may be used to support a rebuttable presumption of reasonableness, since the pastor’s compensation (including the gift of the car) is not substantially above the average. This assumes that the pastor’s recusing himself from the board meeting in which his compensation was determined avoided any “conflict of interest”.
- Tip. The intermediate sanctions law creates a presumption that a minister’s compensation package is reasonable if approved by a church board that relied upon objective “comparability” information, including independent compensation surveys by nationally recognized independent firms. The most comprehensive compensation survey for church workers is the annual Compensation Handbook for Church Staff, written by Richard Hammar and James Cobble, and available from the publisher of this newsletter.
3. Special rule for compensation paid by small organizations. The new regulations specify that for organizations with annual gross revenue of less than $1 million, the governing board will be considered to have appropriate comparability data if it has data on compensation paid “by five comparable organizations in the same or similar communities for similar services.” The regulations also clarify that a rolling average based on the three prior years may be used to calculate annual gross revenue of an organization.
4. Rebutting the presumption. The regulations specify that the presumption “may be rebutted by additional information showing that the compensation was not reasonable or that the transfer was not at fair market value.”
5. Adequate documentation. In order to qualify for the rebuttable presumption of reasonableness, the governing board must “adequately document” the basis for its decision at the same time that it makes the decision. The new regulations specify that for a decision to be documented adequately, the “written or electronic records” of the board must note:
- the terms of the transaction that was approved and the date it was approved;
- the members of the governing body or committee who were present during debate on the transaction or arrangement that was approved and those who voted on it
- the comparability data obtained and relied upon by the committee and how the data was obtained, and
- the actions taken with respect to consideration of the transaction by anyone who is otherwise a member of the governing body or committee but who had a conflict of interest with respect to the transaction or arrangement
• Key point. For a decision to be documented concurrently, records must be prepared by the next meeting of the board occurring after the final action is taken. Records must be reviewed and approved by the governing body “within a reasonable time period thereafter”.
Effect on tax—exempt status
The new regulations caution that the ability of the IRS to assess intermediate sanctions “does not affect the substantive statutory standards for tax exemption under sections 501(c)(3) …. Organizations are described in [that section] only if no part of their net earnings inure to the benefit of any private shareholder or individual.” In other words, churches and other charities are still exposed to loss of their tax—exempt status if they pay excessive compensation. The fact that such compensation arrangements may trigger intermediate sanctions does not necessarily protect the organization’s tax—exempt status from attack.
© Copyright 1998 by Church Law & Tax Report. All rights reserved. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Church Law & Tax Report, PO Box 1098, Matthews, NC 28106. Reference Code: m71 m24 ,c0698
