Private Letter Ruling 9112006
Does a tax-exempt organization jeopardize its exempt status by paying employees a "bonus" that is based on performance?
That was the issue addressed by the IRS in a recent ruling. Churches and other organizations exempt from federal income taxes under section 501(c)(3) of the Internal Revenue Code may not pay "unreasonable compensation" to their workers. If they do, they risk losing their tax-exempt status.
The "PTL" organization lost its tax-exempt status retroactively to 1984 on the basis of unreasonable compensation paid to three of its top employees. What about employer bonuses that reward employees for outstanding achievement? Do they jeopardize an exempt organization's tax-exempt status?
The case before the IRS involved a nonprofit hospital that proposed to pay bonuses to its employees. The hospital created a "funding pool" out of which the bonuses were paid. This pool did not ordinarily exceed 2-3% of the hospital's payroll. Half of the pool was distributed to all employees based on the hospital's overall performance, and the other half was distributed to the employees of individual departments that exceeded specific goals. These limitations ensured that the bonus available to any one employee ordinarily was modest.
Further, the hospital had its independent auditors (a CPA firm) review compensation of the higher-paid employees (physicians and executives) to ensure that no one received more than reasonable compensation. The independent auditors surveyed 18 of the largest hospitals in the country to determine the reasonableness of compensation paid to physicians and executives. The auditors also used their own experience as a national accounting firm to make this decision.
In evaluating the reasonableness of compensation, the auditors took into account the performance bonuses, as well as all other forms of compensation. If a bonus would increase a particular employee's total compensation to a level that the auditors deem to be unreasonable, then the bonus is not paid.
In concluding that this arrangement did not jeopardize the hospital's tax-exempt status, the IRS observed:
The information submitted indicates the participation of all employees, the development of multi-level standards for increased productivity and cost efficiency, as well as for the quality of health care provided, the various levels of independent review, the operation of a quality assurance program, the relatedness of the plan's employee distribution to the services performed, the review of the total compensation paid by independent auditors of incentive payments, and the limitations established to safeguard against possible abuses, all as described above and in the case file, should not produce distributions to your employees that are in excess of reasonable compensation for the services performed …. Accordingly, based on the information submitted, we conclude that your proposed incentive compensation plan will not adversely affect your tax-exempt status under section 501(c)(3) of the Code. However, this ruling is based on the understanding that all payments under your incentive pay plan remain within the range of reasonable compensation for employees covered.
This ruling is of interest to churches and religious organizations that pay above-average compensation to clergy and church executives. It is our position that any church or religious organization paying total annual compensation of $100,000 or more to any individual should obtain a written opinion from a tax attorney or CPA that the amount of compensation is not unreasonable. Compensation includes not only salary, but also housing allowances, business expense reimbursements under a nonaccountable plan, taxable fringe benefits, personal use of an employer-owned vehicle, and various other items.
The recent IRS ruling indicates that a charity can reduce the risk of jeopardizing its tax-exempt status by having an annual review of compensation by a tax attorney or CPA firm. An evaluation of the reasonableness of compensation will involve several considerations, including a comparison of what other similarly situated clergy and executives are earning in related organizations.
Churches and religious organizations should bear in mind that an IRS finding of unreasonable compensation may result in loss of tax-exempt status. This would have a variety of negative consequences, including the following: (1) the church's net income would be subject to federal (and possibly state) income taxation; (2) donors no longer could deduct contributions to the church; (3) ineligibility to establish "403(b)" tax-sheltered annuities; (4) possible loss of property and sales tax exemptions; (5) loss of preferential mailing rates; (6) possible loss of a housing allowance exclusion for ministers serving the church; (7) possible inapplicability of a minister's exemption from social security taxes to compensation received from the church; and (8) clergy compensation might not be exempt from federal income tax withholding.
Clearly, any activity that jeopardizes a church's exemption from federal income taxation, and correspondingly the benefits summarized above, is a matter that must be taken very seriously.