Principals of Tax-exempt Status and its Impact on Variable /Incentive/Bonus Compensation

Written by Daniel Crespo

Designing variable pay plans that are motivational, achieve strategic objectives, and are compliant can be complicated.  An example of one of Lawrence Associates’ innovative incentive plans is featured on NPR’s All Things Considered [1] – and remains in effect today.  Here, we provide a quick overview of key aspects of compliance for tax-exempt organizations.

Private Inurement, Intermediate Sanctions, and Unrelated Business Income

 In developing a variable compensation program for a non-profit organization, it is important to keep in mind that the distinguishing factor between non-profit and for-profit organizations is that non-profits reinvest or otherwise utilize their surplus revenues/operating income to achieve the organization’s tax-exempt mission and purpose rather than distributing the surplus as profits or dividends. An example of the IRS’s efforts to assure a focus on tax-exempt mission is that ‘Hospital organizations use Schedule H (Form 990) to provide information on the activities and policies of, and community benefit provided by, its hospital facilities and other non-hospital health care facilities that it operated during the tax year”.[2] (Note: Lawrence Associates recommends documenting and highlighting mission-related behaviors, in keeping with incentives, should the IRS inquire.)

A basic tenet of tax-exempt status is that compensation paid by a tax-exempt organization cannot result in private inurement,[3] or the accrual of a portion of the earnings or assets of the organization (other than reasonable compensation) to a non-profit company insider or shareholder. Indeed, private inurement is strictly and explicitly prohibited by the tax code and a key focal point for the IRS in evaluating the reasonableness of compensation and permissibility of variable compensation payments.

Specifically, the Code states that a 501(c)(3) organization “will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.”[4] The Code further states that a 501(c)(3) organization “is not operated exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals.”[5] As these provisions make clear, the penalty for private inurement can result in the loss of an organization’s exempt status.

The draconian nature of losing exempt status led the IRS to request the Intermediate Sanctions law and regulations,[6] allowing for “intermediate” penalties on compensation deemed not to be reasonable.  The IRS has also come to recognize that nonprofits want to encourage executives to find new ways for the organization to grow and prosper. The IRS believes that some revenue-generating activities encouraged by nonprofits may not support the mission.  Unrelated Business Income Tax (UBIT) can be charged for those activities.  An extensive discussion of UBIT can be found here.[7]

 Variable Pay, Incentives, Bonuses as Tools to Communicate and Motivate Strategy

 Although non-profit compensation packages may resemble the pay packages of for profits, it is important to understand that non-profits are subject to different rules. Specifically, the IRS requires that non-profit employee compensation must (1) be reasonable; and (2) further the exempt purpose of the organization.  Because bonuses and other variable compensation should be based on achievement of performance, this element of pay tends to be closely scrutinized.

Simply put, the IRS views payment of bonuses primarily based on an organization’s profitability, revenue or investment income as suspect. Typical strategic measures might include annual objectives for financial viability, customer satisfaction, quality or a Balanced Scorecard. Longer-term measures might include growth, marketshare, or financial stability.

To help organizations navigate this complex space, the IRS has published a 12-factor test for assessing the reasonableness of compensation paid by tax-exempt organizations. In determining whether compensation is reasonable, the IRS looks at whether the compensation:[8]

1)Was established by an independent board of directors or by an independent compensation committee

2)Reasonable in terms of the employee’s specialty and geographic locale;

3)The result of arms’ length bargaining;

4)Includes a ceiling or reasonable maximum;

5)Does not have the potential to reduce the charitable services or benefits the organization would otherwise provide;

6)Takes into account measures of the employee’s performance;

7)Keeps the organization within budget without charging more for services;

8)Does not transform the principal activity of the organization into a joint venture between it and the employee;

9)Not merely a device to distribute all or a portion of the organization’s profits to persons who are in control of the organization;

10)Serves a real and discernable business purpose of the exempt organization;

11)Does not result in abuse or unwarranted benefits; and

12)Rewards the employee based on services the employee actually performs.

Non-profit organizations should carefully consider (A) how the variable compensation plan will further the exempt purpose of the organization; (B) whether the amount of the bonus is determined in an arms-length manner; and (C) the reasonableness of the employee’s overall compensation relative to their role and responsibilities relative to the geographic location and the compensation paid by similar organizations for similar services.

[1]Brian Reed, NPR, For Firms that Cut Wages Keeping Workers a Worry, Nov. 23, 2009, available at: https://www.npr.org/templates/story/story.php?storyId=120709869?storyId=120709869

[2]IRS, Instructions & Forms, “About Schedule H (Form 990), Hospitals”, last updated Mar. 20, 2020, available at: https://www.irs.gov/forms-pubs/about-schedule-h-form-990

[3] See IRS, Overview of Inurement/Private Benefit Issues in IRC 501(c)(3), at pp. 1-3, available at: https://www.irs.gov/pub/irs-tege/eotopicc90.pdf

[4] 26 CFR § 1.501(c)(3)-1(c)(1), available at: https://www.law.cornell.edu/cfr/text/26/1.501(c)(3)-1

[5] 26 CFR § 1.501(c)(3)-1(c)(2), available at: https://www.law.cornell.edu/cfr/text/26/1.501(c)(3)-1

[6] IRS, “Intermediate Sanctions Overview”, last updated: Feb. 13, 2020, available at: https://www.irs.gov/charities-non-profits/charitable-organizations/intermediate-sanctions

[7] Robert Wexler & Stephanie Petit, Revenue Generating Activities of Charitable Organizations: Legal Issues, Alder & Colvin, Apr. 2016, available at: https://www.adlercolvin.com/revenue-generating-activities-of-charitable-organizations-legal-issues/

[8] IRS, General Information Letter, No. INFO 2002-0021, Release Date: Mar. 29, 2002, (as drafted: Jan. 9, 2002), available at: https://www.irs.gov/pub/irs-wd/02-0021.pdf (synthesizing 40 years of non-profit compensation law into a coherent set of 12 operative variables for consideration in 501(c)(3) compensation program design).