What We Learned About Executive Compensation From the IRS Report on Colleges and Universities

by: Smith and Howard

August 12, 2013

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At the end of April, the IRS released its final report on the findings from its Colleges and Universities (C&U) Compliance Project. Several years ago, the IRS sent questionnaires to 400 randomly-selected colleges and universities.  Based on the responses received, the IRS selected 34 schools for examination.

The compliance project report primarily focuses on two areas of potential noncompliance: unrelated business income and executive compensation.  

The compensation area of the C&U study focused on amounts paid to officers, directors, trustees and key employees.  The study examined total compensation, taxable and nontaxable, to determine if the amounts paid to these individuals were reasonable based upon industry standards. 

Normally taxpayers are required to provide evidence to support any tax positions taken.  Tax exempt organizations can shift the burden of proof for compensation to the IRS under the “rebuttable presumption test.”  Although more complex than addressed in this article, to meet the test, an organization should:

  • Use an independent body to review and determine compensation (i.e. compensation committee);
  • Rely on appropriate comparability data to determine compensation, and
  • Document the compensation-setting process, including nontaxable benefits.

The body (or committee? As referred to in next sentence) charged with setting compensation should be comprised of individuals who do not have any conflicts of interest with executives.  The committee should meet regularly to recommend compensation components and amounts.  In recommending compensation, use of independent studies using comparable data is advised. 

Although nonprofit organizations are permitted to use “for profit” organizations when determining reasonable salary, the IRS determined that colleges and universities have enough comparable organizations to rely upon within their sector.  

For the schools examined, the IRS challenged how comparability data was chosen and listed several factors that should be considered when choosing comparable organizations, including:

  • Location
  • Endowment size
  • Revenues
  • Total net assets
  • Number of students

In addition, compensation studies need to state whether amounts are taxable compensation only, or all compensation, both taxable and nontaxable.

The IRS adjusted all employment tax examinations related to the C&U project.  Wages were adjusted for several reasons:

  • Failure to include the value of personal use of automobiles, housing, social club memberships and nonbusiness or spousal travel in income,
  • Misclassification of W-2 employees as independent contractors,
  • Failure to withhold taxes for wages paid to non-resident aliens, and
  • Failure to include the value of certain graduate tuition waivers and reimbursements in income.

Organizations can take several actions to ensure the compensation they are paying is determined using the best methods:

  1. Appoint an independent compensation committee.
  2. Use appropriate comparability data.
  3. Document the process used to determine compensation at least annually.

Throughout the process of determining executive compensation, the committee should keep records of its activities.  The records should be updated in a timely manner and include data or studies used to set compensation.  The recording of this process will be vital in the event of an IRS audit. 

The area of nonprofit executive compensation is a focus at the IRS.  With the right processes in place, organizations can push the burden of proving unreasonable compensation to the IRS and protect against draconian penalties to officers and board members.

Smith and Howard is available to assist your organization with compliance in this area.  If you have questions or need assistance, please contact one of our professionals at 404-874-6244 or call our nonprofit hotline at 1-877-354-3820.

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