Is it Time to Update Your Form 990 Compensation Study?By Magdalena M. Czerniawski | October 1, 2019
In 2018, the Tax Cuts and Jobs Act (“TCJA”) brought parts of Form 990 Return of Organization Exempt From Tax into the spotlight – 11 years since the IRS originally issued the redesigned form. This is because one of the laws enacted by the TCJA, IRS Code Section 4960, imposes an excise tax of 21% on remuneration in excess of $1 million paid to a covered employee. While most nonprofits do not pay compensation in excess of $1 million, the organization might still be subject to tax under this code section during the year when the compensation is paid out of 457(f) retirement plan or there is an excess parachute payment.
In 2008, the redesigned Form 990 added additional questions and schedules that organizations had not been asked to provide before. Among those changes was Part VI, known as Governance, Management and Disclosure. Section B of this part, “Policies,” specifically states, “This Section B requests information about policies not required by Internal Revenue Code.” Interestingly, even though the information is not “required,” it is open for public inspection and monitored closely, whether by donors, the government or board members. Therefore, from a good governance perspective, almost all organizations answer these questions and provide additional information where necessary.
Considering the provisions in the TCJA together with Form 990 presents a challenge. Form 990 Part VI includes questions 15a and 15b, which most donors are familiar with. They ask the following, in two parts: “Did the process for determining the compensation of the following persons include a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision?” One part of the question applies to the top management official, such as Executive Director, CEO or President. Then the same question is asked for all other officers or key employees of the organization. In practice, answering “no” to the two questions is not beneficial to the organization, as it signals poor governance.
When the updated Form 990 was first released, many organizations were faced with a dilemma of how to answer questions 15a and b correctly. Answering yes or no is just a small fraction of the task—once the organization answers the question “yes,” it is then required to describe the process. Given the sensitivity of the question, and with the disclosure of personal compensation on the informational tax return, there was a significant amount of time spent on these questions. Furthermore, organizations that don’t document and determine the amount of reasonable compensation could fall under “excess benefit transaction,” which essentially translates to paying more for services than the organization is receiving. The IRS also took it a step further on Schedule J Additional Compensation Information, where it asks the question again, for the top management official only: “Indicate which, if any, of the following the filing organization used to establish the compensation of the organization’s CEO/Executive Director.” The similarity of the questions almost makes it appear as if the IRS wants to trip up organizations that don’t line up their answers.
As a result, many organizations, especially those with large amounts of compensation or a combination of compensation and retirement plans, took a close look at their practices and raced to put policies in place that would allow them to answer the questions “yes” and have enough substance to formulate an accurate description of the process. Since determining reasonable compensation is a very time-consuming process, many organizations outsourced the study of compensation to third parties. These third-party compensation studies helped organizations determine the right amount to fall under reasonable compensation and protect the organization and the board from the potential of excess compensation.
You may ask: Why is this important now? The right answer is that it is always important—but the practical answer is that now, with added TCJA tax as a “penalty,” it is more important than ever to pay nonprofit executives just the right amount. Most of the compensation studies previously mentioned were conducted between 2008 and 2010, and not many have been updated since. Even when an organization hasn’t substantially changed its methodology, it’s important to have either an update or full study done every 3 - 5 years, or when the circumstances change. In addition, with market conditions changing and constant fluctuations in the stock market, it’s critical to have relevant information to ensure adequate compensation for top management.
It’s important to note that outsourcing a compensation study and latter Board approval of compensation packages for executives is not enough to answer questions 15 a and b "yes." There has to be deliberation and discussion. This should be done on a yearly basis and reflected in the minutes, though often, it is only done when the executive is hired and is subsequently forgotten. Approval of a budget that lists the compensation for executives is not considered approval in light of these questions
Question 15b, which refers to other officers and key employees, can also present challenges. First, the organization needs to look at who on Part VII, the listing of Officers, Directors, Trustees, Key Employees and highest compensated, is reporting as an officer or key employee. Once it determines who falls under those designations, then it needs to ensure that the same process is followed for all. Meaning, that if a compensation study is done for one role, let’s say the CFO, but not others, then the question is answered “no.” Additionally, the persons approving that compensation and having the deliberation and discussion need to be independent. Therefore, if the CEO or Executive Director is directing that discussion, they should recuse themselves from the discussion or the organization will be forced to answer the question “no.”
Considering both the “old” Form 990 and the new tax law, it’s time for organizations to review their policies for establishing compensation and also ensure that the basis for that compensation is still relevant. The 21% tax imposed by the TCJA is a new issue for organizations and the calculations of it are cumbersome. (More on that can be found in our first quarter newsletter.) Organizations with compensation that is not going to fall under the provisions of the TCJA still fall under the provisions of reasonable compensation – and consequences for those not being adequate are far more than the 21% tax. Reviewing and updating policies for compensation as well as compensation studies that may be a decade old by now is a wise decision for organizations of all types.
About Magdalena M. Czerniawski
Magdalena M. Czerniawski, CPA, MBA, is a Tax Director at Marks Paneth LLP and a member of the firm’s Nonprofit, Government & Healthcare Group. With over 15 years of nonprofit industry experience, she provides tax services to a wide array of nonprofits, including charitable organizations, schools, social welfare organizations, professional associations and private foundations. In addition to providing tax planning and advisory services, Ms. Czerniawski specializes in matters related to... READ MORE +