About Employee Compensation
About Employee Compensation
Compensation encompasses all forms of payment or benefits that a tax-exempt organization provides to an individual in return for the performance of services. This includes not only monetary payments but also any other items of value given as part of the employment relationship. It is important to note that all compensation, whether provided to executive or non-executive employees, and whether in nonprofit or for-profit organizations, must be deemed reasonable.
Non-executive compensation is generally more straightforward to quantify. This is because it typically consists solely of W-2 wages and retirement benefits, which are easily measurable and well-defined. In contrast, executive compensation often includes these basic components along with various additional components. As a result, calculating executive compensation can be more complex and challenging. Various components of executive pay may be difficult to measure or calculate, and sometimes, certain elements might be overlooked during the initial compensation assessment simply because they were not considered at the time.
What are the other components unique to religious nonprofit organizations that would be included in calculating executive compensation?
Generally, compensation packages for executives include several elements that are not typically part of compensation for non-executive employees. Regarding a religious nonprofit organization, these additional components can be varied and unique. For example, executive compensation might include bonuses, which are extra payments given as rewards for exceptional service. Additionally, collections might be taken up on the executive’s birthday, and “Love Offerings” given, which are special financial gifts typically given to a minister as a show of appreciation and gratitude from the congregation. Even though these offerings have a personal aspect, they are still considered part of the overall compensation.
Further, executives in religious nonprofit organizations might receive housing allowances, which are funds provided to cover living expenses, or they may be offered parsonage provisions, which involve the use of a residence owned by the church. Pension plans and other retirement benefits are also frequently included in compensation packages for executives.
Other components could be the provision or use of automobiles or memberships to country clubs, which provide them with leisure and networking opportunities that are not usually available to non-executive employees. Executives might be allowed to use a church credit card with a grace period for repayment, which can effectively function as an interest-free loan—something that would not typically be offered to non-executive staff. Lastly, executives might be privileged to use church assets for their personal benefit.
What are important considerations to keep in mind with respect to staff salaries?
The most basic component of employee compensation is salary. Two crucial aspects to consider regarding employee salaries are the amount of the salary and the implementation of “salary reduction agreements.” It is important to understand that if an organization provides unreasonably high compensation to an executive or any other employee, the organization risks losing its tax-exempt status. Additionally, the organization may face intermediate sanctions, including taxes on disqualified persons, additional taxes on those individuals, and taxes on organizational matters.
Organizations that compensate an executive (or any staff member) at a rate significantly higher than the highest 25 percent for comparable positions should seek a legal opinion from an experienced attorney. This legal opinion should confirm that the compensation amount is not “unreasonable” and will not subject the employee or the board to intermediate sanctions. Middlebrook Group can serve you as an experienced legal provider when making decisions that impact your organization’s future.
Many organizations have implemented “salary reduction agreements” as a means to manage certain staff expenses. These agreements aim to lower an employee’s taxable income since only the income remaining after various “reductions” is reported on the employee’s W-2 form at the end of the year. It is vital for organizations to recognize that they cannot reduce an employee’s taxable income through salary reductions unless such reductions are specifically permitted by law. There are three primary ways in which taxable income can be legally reduced through salary reduction agreements:
1. Tax-Sheltered Annuity Contributions: These are contributions made to a retirement savings plan that allows the employee to defer taxes on the income until it is withdrawn, typically during retirement.
2. Cafeteria Plans: These plans allow employees to choose from various pre-tax benefits, such as health insurance, life insurance, and flexible spending accounts for medical or childcare expenses.
3. Housing Allowances: These are funds provided to clergy members to cover housing expenses, which can be excluded from taxable income under specific conditions outlined by the tax code.
It is essential for organizations to ensure compliance with these legal provisions to avoid any adverse tax consequences for both the organization and its employees.
What is excessive compensation, and how does the IRS measure whether compensation is excessive?
Excessive compensation occurs when the total compensation paid to an executive or employee, including all types of compensation, exceeds the bounds of reasonableness as promulgated by the IRS. There is no clear-cut rule to determine if the compensation is reasonable or excessive, but the IRS has set forth factors to be taken into consideration. These factors include:
• Compensation levels paid by similarly situated organizations, both tax-exempt and taxable, for functionally comparable positions
• The location of the organization, including the availability of similar specialties in the geographical area
• Written offers from similar institutions competing for the services of the individual involved
• The background (including experience and education) of the individual involved
• The need of the organization for the services of the particular individual
• The amount of time an individual devotes to the position
An additional criterion that intermediate sanctions have brought to this area of the law is whether the compensation was approved by an independent board.
Who ultimately determines reasonableness?
Ultimately, only a trier of fact (a judge or jury) can definitively determine the reasonableness of compensation. Prior to that, the IRS may assess reasonableness during an inquiry or audit of a religious nonprofit organization. If the nonprofit has determined compensation using independent data and an independent board or committee has documented the process, the compensation is presumed to be reasonable. In this case, the IRS must then prove that the compensation is unreasonable. However, if the organization did not use independent data, an independent board, or proper documentation, the IRS may consider the compensation unreasonable. The burden would then be on the organization to prove that the compensation is reasonable.
Ensuring that your religious nonprofit organization adheres to IRS guidelines regarding compensation is critical for maintaining tax-exempt status and avoiding potential penalties. At Middlebrook Group, we understand the complexities and challenges involved in managing compensation for your organization. Our team is here to assist you in navigating these regulatory requirements and support you to ensure that your organization remains compliant and focused on its mission.