Friday, June 15, 2012
1) Determine the required withholding on all forms of compensation and
2) Determine the proper reporting of all compensation and benefits.
I am finally completing this series. I am to the step that most people are accustom to working with in order to do payroll. While most organizations do complete this step in regards to cash compensation, few seem to complete it correctly in regards to noncash compensation.
Some items of noncash compensation are not subject to withholding while others are. IRS Publications 15, 15A & 15B all deal with properly reporting compensation and fringe benefits. Since we now know what items the organization is providing to its employees, it should be fairly easy to determine any withholding requirements. (Remember that ministers are not subject to any mandatory withholding of federal income tax, so adding their benefits to payroll is fairly simple. Also, ministers are not subject to FICA/Medicare, so this also simplifies this process for their compensation.)
If an organization is using a payroll service, then it is best to remember that its payroll reports are generally prepared very quickly at the end of the quarter or the end of the year. Therefore, it is necessary to communicate with the service prior to the end of any reporting period. Otherwise an organization may find that it is necessary to amend payroll reports that have already been submitted to the IRS and the Social Security Administration in order to properly report some items of compensation.
Several items require special reporting on the Form W-2, so be specific about the benefits that are provided and review the instructions for preparing the Form W-2 each year. For example, dependent care benefits are reported in a separate box on the Form W-2 even though the benefit is not taxable to the employee if provided through a qualifying plan.
In summary, the number one area that can result in an IRS inquiry and/or in the assessment of monetary penalties is payroll reporting. Therefore, each organization should review all payroll filings carefully to determine if the proper amount of tax has been paid and if all items of compensation have been properly reported.
Tuesday, April 17, 2012
Step 7: What's Taxable
This is the most crucial step and is the one step that is often missed in properly reporting compensation. There is some frustration within the IRS that the only taxable compensation reported is the compensation that physically flows through an organization's payroll system. There is a tendency to ignore all the benefits and cash that do not flow through the payroll system. The result is that income has a tendency to be underreported. When an organization fails in its duty to properly report taxable income, it places its employees in serious jeopardy of potential penalties, additional taxes and even jail time.
Each element of the compensation package has to be evaluated to see if it is taxable. Remember, that everything is taxable until a provision in the Internal Revenue Code says that it is not. Therefore, it should be presumed that something is taxable until it can be proven that it is not taxable.
Remember, when determining taxability, it must be determined for purposes of federal income tax, social security tax (FICA) and Medicare tax, if the compensation is for a nonminister employee. If for a minister, then the employer is only concerned about the taxability for purposes of federal income tax.
Making Determinations by Comparison
One of the biggest dangers in this area is making the determination based on what someone else is doing. You know how the story goes, Minister Joe goes to breakfast with all the other area ministers and returns with the information that over at First Church, Minister Steve has full childcare at their facilities and doesn't pay any tax on that benefit. Based on this information, Minister Joe now requests that he be able to place his children in the church daycare center free of charge and the value of the benefit should not be taxable to him.
- get the correct facts; i.e., does Minister Steve know what is really taxable to him;
- don't assume that First Church is doing things correctly; i.e., it is possible for large and well established churches or organizations to not do things correctly; and
- look to see how First Church could be providing such a benefit tax free and then pursue that avenue.
There are many areas of the tax law that provide for tax free treatment of various fringe benefits. However, almost all of them require certain actions taken by the employer to achieve this preferential status. In the example above, First Church may have instituted a qualified dependent care plan. Such a plan, when it meets a series of qualifications, provides for tax free dependent care. Without meeting all the requirements, the benefit would be taxable to the emloyee.
Common Benefits Virtually Always Taxable
Cash - In any form, cash is virtually always taxable. This includes anniversary/birthday gifts; love offerings; flat allowances; and gift cards.
Autos - Outside of a documented reimbursement at the standard mileage rate, any other benefit connected to an auto has a taxable component. If the organization is actually providing the auto, there is always a taxable component. These rules have been around since 1984.
Housing - Housing provided to employees who are not ministers is more likely than not taxable. There are some exclusions, and they should be carefully considered. If the employee is a minister, it is taxable unless it is specifically designated, in writing and in advance of payment, that it is provided under IRC Section 107 as a housing allowance or a parsonage.
Common Benefits that Normally Require Written Plans and Nondiscrimination Requirements
Payment of Out of Pocket Medical Costs
Retirement Plan Contributions (there are some exceptions for churches)
The above discussion is not an exhaustive study of potential taxable income. This is the step in compensation planning that is generally left to the organization's bookkeeper, internal accountant and/or payroll service. Therefore, it is greatly beneficial for the organization to build a relationship with a trusted tax professional that will provide a resource to assist personnel with these determinations.
Wednesday, March 28, 2012
There is no special time during this process to complete this particular step, so I have chosen to place it in this slot. It is a crucial step in the process and must be completed at some point in time. Ministers have different tax treatment than other employees and this treatment is mandated by law. It isn't optional, so it is important to know who qualifies as a minister for federal tax purposes. (At this time we are only dealing with defining ministers for federal tax purposes and not for other purposes such as for Department of Labor purposes.)
Minister's Tax Status
Ministers have what is commonly referred to as "dual tax status".
Federal Tax Purposes: For federal income tax purposes, a minister is generally treated as a common law employee. Additionally, while he/she is subject to paying federal income tax, a minister is exempt from the mandatory withholding of the federal income tax.
Social Security/Medicare Tax Purposes: For payments into Social Security, the minister is always self employed. This translates into the fact that a minister can never pay into the Social Security/Medicare system the way a regular employee does through the traditional employee payment with an employer matching payment better known as FICA/Medicare. This is defined by law under IRC Section 1402 and 3121.
If you have a minister working for your organization and he/she is considered a minister for purposes of receiving a housing allowance and the minister is participating in the FICA/Medicare program through withholding and matching, this practice should be stopped immediately. The only way that a minister can pay into the Social Security/Medicare system is through the Self Employed Contributions Act by paying SE tax on his/her personal tax return.
Who is A Minister?
In order to be considered a minister for federal income tax purposes, the employee must have been commissioned, licensed or ordained by a church (credentials issued by organizations that are not churches do not qualify.) Additionally, the minister must be performing ministerial duties. For a church, ministerial duties include 1) the preaching, teaching and conducting of religious worship services; 2) the control, conduct & maintenance of a religious organization and their integral agencies; 3) the teaching and administration in a theological seminary; and 4) the performance of sacerdotal functions. If the employer is not a church, then ministerial duties are limited to #1 and #4.
The employer needs to document the ministerial duties being performed by the minister as well as maintain copies of the credentials in the minister's personnel files.
This is a very brief explanation of this particular area and is simply discussed just to bring attention to the important differences attributable to ministers in the area of payroll. If an employer has any concerns about the proper classification of its ministers, it should seek advice from a competent tax professional.
Wednesday, March 14, 2012
Last week we discussed identifying all of the benefits bestowed to an employee. This week we finally start to look at some numbers. Each of the benefits identified now has to have a value assigned to it. This may or may not be associated with the cost paid by the church for a benefit.
Example: First Church provides their senior pastor with a car. It pays all of the expenses associated with buying the car and maintaining the car. The Internal Revenue Regulations tell us explicitly how we should value the auto. The primary method uses what is called the annual lease value table. The assigned value from this table is used to value the car and it is not related to how much the church spends on the car during the year.
Some items are easy to value and some are more difficult. Some items have stated values, i.e., the value of a tuition discount granted to an employee at the school operated by the organization, while others require outside appraisers like may be needed to value housing provided by the organization.
It is imperative that the benefits be valued in order to complete Step #5.
Step #5 - Is It Too Much
Remember the earlier posts which discussed determining the "umbrella" of reasonable compensation. Now is the time to look to the umbrella. After all the elements of compensation are determined and then they are valued, the total value of the benefits provided has to be compared to the umbrella of reasonable compensation. If it doesn't fit under the umbrella, then something has to be cut or removed from the compensation package. If this exercise is performed as a part of the compensation planning at the beginning of the year, then there can be no surprises for the employee or the organization at the end of the year.
Step #6 - Write It Down
Once everything is defined, and it all fits within reasonable compensation, it is time to write it down. Compensation should be formally documented in a manner that is appropriate for the level of employee being compensated.
Example #1: A secretary may have her compensation approved and defined by one of the officers of the organization. The package would be written down, approved by the appropriate officer and then placed in the secretary's personnel file.
Example #2: The president of an organization is considered a disqualified person (see post on intermediate sanctions). His compensation package must be authorized by the appropriate governing body, i.e, the board of directors, the personnel committee, etc. and it must be writtten down in the minutes of the meeting where the compensation package is approved. Failure to formally document the compensation for a disqualified person can cause the entire package to be considered as not authorized for payment. Also remember that "documenting the compensation in writing" is one of the required steps in meeting the safe harbor test for excess benefit transactions and intermediate sanctions.
This post has covered three important steps in the compensation planning process. While it should be considered as mandatory for any employee that is considered to be a "disqualified person", it is a good practice for all employees.
Wednesday, March 7, 2012
Yes, it may sound simple, but it seems that many organizations don't really walk through this step. Before an organization can move on to dealing with compensation issues, it has to know what it is providing to an employee. This step requires a look at each employee to determine what is provided. A complete list should be made. List everything that benefits an employee and don't worry about the tax effects at this point. Determining how to treat an item of compensation for tax purposes takes place later in the process. Additionally, don't forget to include on the list the items that are noncash benefits. Don't limit the list to only cash items. Remember one of our first lessons: everything that benefits an employee is a form of compensation.
The following is not an all inclusive list, but just to help start the process think about some of the following items:
- Insurance - all kinds
- Medical programs
- Tuition - either paid for the employee or a discount at the school
- Love gifts
- Gift cards
Make the list and check it twice. This information is invaluable to the compensation decision makers, yet seldom do the decision makers have all this information.
Wednesday, February 29, 2012
The World of Excess Benefit Transactions and Intermediate Sanctions
Nonprofit organizations as a general rule are prohibited from participating in transactions that are deemed to be excess benefit transactions. These are transactions that involve disqualified persons and the provision of benefits in excess of what the organization receives in return for the benefit. In the mode of compensation, an organization is not allowed to pay more compensation than is reasonable for the services provided by the employee. Any compensation paid above reasonable compensation or above the "umbrella" to a disqualified person is considered to be an excess benefit transaction.
Disqualified persons are generally officers, directors, trustees and key employees of an organization. In addition, the term also includes the family members of any of these individuals. I often tell my classes that this group is generally the movers, shakers & decision makers of the organization and their families.
It is important that this group of people be identified in order that the organization can properly handle any transaction related to a member of this group. Compensation is one of those areas that requires special attention for this group.
Excess Benefit Transactions & Intermediate Sanctions
As described above, payment of unreasonable compensation creates an excess benefit transaction for a disqualified person. Excess benefit transactions are subject to a set of penalties called intermediate sanctions. These sanctions are assessed to the recipient of the excess benefit and to anyone who agreed to the transaction giving rise to the excess benefit.
If an excess benefit occurs, the following are the consequences:
1. The benefit is required to be repaid to the organization; and
2. The disqualified person is required to pay a penalty or tax to the IRS of 25% of the amount of the benefit.
If the IRS discovers the transaction and it is not corrected before they discover the transaction, additional penalties may be assessed to the disqualified person equaling 200% of the benefit.
If someone else within the organization agrees to the transaction giving rise to the excess benefit transaction, they can be assessed a penalty of 10%. This includes such persons as other officers, directors, and trustees.
Excess Benefit Transactions & Inurement of Benefit
Nonprofit organizations are prohibited from entering into transactions that create inurement of benefit to control parties, i.e., disqualified persons. The Internal Revenue Code indicates that the mere existence of inurement of benefit is grounds for revocation of the organization's exempt status. Virtually all excess benefit transactions create inurement of benefit. Therefore, if an excess benefit transaction occurs, the IRS has grounds to revoke the tax exempt status of the organization. Normally the IRS will utilize the above described sanctions to punish the guilty insider and not revoke unless the activity is egregious. However, the law allows the IRS to both revoke the tax exempt status of the organization as well as assess the penalties described above to the disqualified person.
Defining the "umbrella" of reasonable compensation is critical to avoiding the creation of excess benefit transactions and the related consequences of such transactions as well as being vital to protecting the tax exempt status of the organization.
Wednesday, February 22, 2012
One of my mentors who is a teacher and pastor once taught me that people retain concepts that are associated with pictures. I try to incorporate this philosophy into my technical training since technical topics tend to be "uninteresting" and sometimes downright boring. Keeping in line with this teaching technique, I created the idea of the compensation umbrella. The compensation umbrella is the amount of reasonable compensation that may be paid to an employee. In other words, it is the maximum amount that may be paid to an employee. It does not have to be paid, but it is the measuring stick used to determine the maximum that can be paid.
Defining the umbrella or the amount of reasonable compensation that may be paid should be accomplished using outside data compiled from an independent source.
These include salary surveys from organizations such as the National Association of Church Business Administrators and using independent compensation experts. These are people specifically trained in the arena of compensation and human resources and have practiced in this area for many years. (The IRS and some states' attorney general offices have declared that this does not include certified public accountants or attorneys unless compensation and human resources is their area of specific practice. In addition to a lack of qualifications, most attorneys and CPAs are not independent to the person whose compensation is being evaluated.) Additionally, smaller organizations, i.e., less than $1,000,000 in revenue may accumulate information from like size and like minded organizations.
After gaining data from outside sources, the data should be reviewed through the lens of the operations of the organization. To this end, the organization would want to consider the following factors:
- The employee/minister's qualifications
- The nature and scope of the employment arrangement
- The size and complexity of the organization
- The prevailing economic conditions of the area
- The organization's overall salary philosophy
- The financial condition of the church
The above steps only create the umbrella of reasonable compensation. The organization is not bound to pay this amount. However, if it pays more than this amount then the employee and the decision makers may be subject to penalties and the organization's exempt status could be jeopardized. This subject will be discussed in next week's post.
Tuesday, February 14, 2012
One of the most common areas that I speak on across the country is regarding the area of compensation. As a general rule, it seems that nonprofit organizations struggle with the intricacies of the rules regarding the payment of compensation and even the definition of what is compensation. Therefore, I have decided to start a multiple part blog series on this subject as a means of offering some much needed guidance. I plan to post once a week. I don't know how many weeks it will take, so join in for the next few weeks to brush up on your knowledge in this area and maybe learn a few new things along the way.
Compensation & the Overriding Philosophy of Tax Law
Perhaps the first stumbling block or hurdle to overcome in this area is to finally acknowledge how vast an array of information this topic covers. I generally find that the normal person does not realize one of the foundational truths of the U.S. tax code. This truth is based on two premises:
- Everything that benefits an employee is a form of compensation and
- Everything is taxable until the Internal Revenue Code says its not.
In general, it seems that the natural human response or thought process goes something like this:
- Compensation is what is reported on my paycheck stub and
- Nothing is taxable until somebody proves to me it is (or with my clients, until Elaine tells me it is.)
Needless to say, it is necessary for an organization to first come to a realization that compensation has a more far reaching definition than may have previously been considered and that taxation should be the assumed consequence of any benefit until otherwise proven. This is critical because there are very specific rules that apply to nonprofits, including religious organizations and churches. A deviation from these rules can be costly to the organization and the employee.
With this as the basis for the series, we will start to work through a 10 Step process for defining and dealing with compensation within a nonprofit organization. Next week - Step #1 - Who Gets to Decide on Compensation.