Compensation Planning

Building the Basic Foundation - Part 2

Building off the first four blocks of compensation planning discussed in my post of February 4, 2019, we continue our discussion with a look at the last four basic blocks in compensation planning.  

Building Block #5 – Identify What Is or Can Be Provided

Many nonprofit organizations do not take the time to inventory benefits provided to employees or benefits that may easily be provided.  Compensation is more than just an employee's paycheck.  An organization must think broader than just the amounts in the paycheck. Often there are noncash benefits provided or that can be provided.  For example, dependent care provided through a nonprofit's daycare operation is a noncash benefit.  Other benefit opportunities are available through the establishment of benefits plans, such as an educational assistance plans to provide for employees’ extended education and training, or through benefit plans available offered by national organizations, such as church denominational programs. The benefits provided or considered should assist an organization in meeting its goals defined in building block #4.

Building Block #6 – Valuation of What is Provided to Employees

Since compensation is often related to the paycheck, it is easy for nonprofit organizations to forget to value other aspects of the compensation package.  This oversight may cause organizations to run afoul of the reasonable compensation amounts determined in building block # 3.  Organizations may determine an amount of reasonable compensation, but then only compare it to the regular cash salary paid.  Reasonable compensation encompasses all of what is provided to employees and not just cash salary.  Therefore, value the benefits provided, both the cash and noncash benefit programs.  After the valuation has been accomplished, then it's total can be compared to the amount determined as reasonable compensation in building block #3.

Building Block #7 – Write It Down

Failing to document processes, procedures and decisions, is one of the greatest weaknesses in the compensation process performed by nonprofit organizations.  One of the first documents requested in an IRS examination are the board minutes for the organization to verify the documentation to the executives’ compensation packages.  For religious organizations, a minister’s housing allowance must be documented in writing prior to its being paid to the minister.  Documentation of compensation decisions provides authorization for the compensation, including benefits, to be provided to employees. Without documentation, it may be asserted that the compensation was not authorized.  Unauthorized compensation may create inurement of benefit, potentially threatening an organization’s exempt status, or creating excess benefit transactions, potentially resulting in excise taxes.

Building Block #8 – Set Up the Payroll Correctly

A few years ago, the IRS instituted a payroll tax compliance initiative and audited 6000 for-profit and nonprofit organizations.  The initiative resulted from the IRS’ frustrations that  Forms W-2 only reflect the amounts paid through the regular paycheck functions of organizations omitting other taxable benefits provided to employees.  When nonprofit organizations are examined by the IRS, significant time and attention is spent reviewing operations for unreported taxable benefits provided to employees.  Once building blocks #5 and #6 are a part of the compensation planning process, evaluate the taxation of each element of the compensation package and then appropriately adjust the payroll system to properly report taxable compensation.  Taxation of benefits depends on many factors.  Great care should be taken to address all the factors regarding the taxation of any specific benefit including any requirements for written plan documents or nondiscrimination requirements.

Summary

Compensation planning can be complicated.  Organizations should, at a minimum, address the eight factors discussed in these two blog discussions creating policies and procedures to embody the concepts and objectives. There are many excellent resources for compensation planning, and nonprofit organizations have access to more resources than ever before.  However, even with available resources, organizations may still struggle getting a compensation structure in place properly.  Two resources associated with this author are PPC's Nonprofit Tax and Governance Guide:  Helping Organizations Comply available at https://store.tax.thomsonreuters.com/accounting/Audit-and-Accounting/PPCs-Nonprofit-Tax-and-Governance-Guide-Helping-Organizations-Comply/p/100201592 and Christianity Today's Church Compensation: From Strategic Plan to Compliance available at https://store.churchlawandtax.com/church-compensation-from-strategic-plan-to-compliance/.  

Compensation Planning

Building the Basic Foundation - Part 1

Virtually all organizations face a lot of moving parts and pieces in establishing compensation plans for employees, but nonprofit organizations face even more considerations in the planning process.  In 2012, this blog presented a series of posts related to compensation planning and covered many of the planning considerations.  This presentation summarizes some of the most important aspects of creating a strong foundation for handling compensation processes in organizations of all sizes. 

There are eight basic blocks to building a nonprofit organization's foundation for compensation planing.  Four of the blocks are presented in this post with the other four presented in a future blog:

Building Block #1 – Define the Decision Makers

Approval of compensation plans is critical for many positions in nonprofit organizations.  Therefore, all organizations should know who makes decisions on compensation plans and who approves any changes or unusual transactions during the year.

It isn’t enough to define the decision makers.  Consider any potential conflicts of interest that may exist in the decision-making process.  For individuals defined as “disqualified persons” under IRC Section 4958, it is critical that the decision makers are independent of the person being compensated.

Building Block #2 – Define the Position

No one enjoys the tasks of creating job descriptions, but a strong job description is a valuable building block in the foundation for compensation planning.  Job descriptions should describe the duties to be performed and the criteria and qualifications required of the person holding the position.  It is also a good place to define the position for wage and hour rules.  For religious organizations, clarify if the position qualifies under the DOL’s ministerial exception or as a minister under the IRS rules and regulations.  The job description is the first document requested by either of these regulatory agencies to support these positions.  If the position should qualify as ministerial for the IRS, the job description should require ministerial credentials as a part of the position's qualifications.

Building Block #3 – Know the Compensation Limits for a Position

While all organizations should not pay more than “reasonable” compensation, this requirement is even more important in compensation planning for nonprofit organizations.  The payment of unreasonable compensation can be cause for the revocation of an organization’s tax-exempt status and/or the assessment of excise taxes against individuals.   Reasonable compensation can be determined through salary surveys, comparison with other similar organizations and/or using an outside compensation expert.

Building Block #4 – Determine the Goals of the Compensation Package

Funds in nonprofit organizations are often stretched thin.  The result is compensation packages may be below market value for the position and fringe benefit plans may be limited.  However, it is important that nonprofit organizations see compensation planning as more than just the paycheck.  A nonprofit organization should acknowledge the varied needs of its employees and determine what is important for the organization to provide.  Organizations should consider if they desire or intend to provide for benefits such as health benefits, retirement needs, educational programs or dependent care programs. 

Summary

There are many excellent resources for compensation planning.  Nonprofit organizations of all types have access to more resources than ever before.  However, even with all of the resources, organizations still struggle getting a compensation structure in place properly.  Two publications associated with this author are PPC's Nonprofit Tax and Governance Guide:  Helping Organizations Comply available at https://store.tax.thomsonreuters.com/accounting/Audit-and-Accounting/PPCs-Nonprofit-Tax-and-Governance-Guide-Helping-Organizations-Comply/p/100201592 and Christianity Today's Church Compensation: From Strategic Plan to Compliance available at https://store.churchlawandtax.com/church-compensation-from-strategic-plan-to-compliance/.  

For the final four building blocks in building a solid foundation for an organization's compensation process see next week's blog. 

Unrelated Business Income - More Than Income These Days

The tax-exempt community has long been immune from many of the tax provisions meant to raise tax revenue from the business community by determining certain expenses are not tax deductible.  For example, businesses may deduct only 50% of the amount spent on business meals and certain expenses for business autos may be limited.  Since tax-exempt entities do not calculate tax on their regular operations, these rules have never affected them.  

The Tax Cuts and Jobs Act of 2017 (the Act) provides lower tax rates on business activities, but it also reduces several deductions for various business expenses.  One of the deduction eliminated by the Act is the elimination of deductions for expenses paid by an employer for qualified transportation fringe benefits provided to employees. 

Qualified transportation fringe benefits, defined by Internal Revenue Code (IRC) Section 132(f), include: 

• Commuter transportation in a commuter vehicle; 
• Transit passes; 
• Qualified parking at regular work facilities; and 
• Qualified bicycle commuting reimbursement.

Prior law allowed these benefits to be provided to employees, within certain limitations, tax-free and allowed the employer to deduct the costs of the benefit.  Therefore, the benefits were a win-win for the employer and the employee. The Act still allows for an employer to provide the benefits to employees tax-free, but the employer may no longer deduct the cost of the benefit for federal income tax purposes.  (Since most state tax laws follow federal tax law, the expenses are also not deductible for state income tax purposes.)  

How does this affect the tax-exempt community?  The Act also enacts a new provision for unrelated business taxable income creating a taxable event when a tax-exempt employer pays these same expenses for its employees.  Since other employers will pay tax on the costs of the benefits through the disallowance of the deduction for the benefit, the tax-exempt employers will join them in paying tax on the costs. IRC Section 512(a)(7) now states that any expenses incurred for qualified transportation fringe benefits and are disallowed by IRC Section 274, will be included in unrelated business taxable income (UBTI).  [The provision in IRC Section 512(a)(7) also includes costs associated with on premises athletic facilities, but the Act did not create a corresponding disallowance under IRC Section 274 for these expenses.  Therefore, at this time, the costs for on premises athletic facilities are escaping the effect of IRC Section 512(a)(7).]

Example

A church, in a large metropolitan downtown area, has limited parking facilities.  Because of limited parking facilities, employees must pay to park in nearby facilities.  The church reimburses its 10 ministers for these parking expenses.  The parking expenses are $260 per minister, per month, so the full parking reimbursement is a qualified transportation fringe benefit and is excluded from the ministers’ taxable income. (The parking benefit is limited to $260 per month.)  Because of the new provisions, the church must file Form 990-T reporting the cost of the benefit, $2,600, as UBTI.  After the standard deduction of $1,000 allowed in computing UBTI, the net taxable income is $1,600. The church's tax owed is $336 (calculated at the corporate rate of 21%). 

While the provision does not affect most churches, it may affect churches in metropolitan areas providing parking or transit passes to employees.  Churches providing these benefits must understand the benefit has limitations on the tax-free amount available to employees and the potential of the benefit to create an income tax and a requirement to file Form 990-T.  The new provisions are effective for amounts paid or incurred after December 31, 2017.

The essence of the law requires someone to pay tax on the transportation costs.  Therefore, the tax burden may be shifted to employees by opting to include the value of the benefits in employees’ taxable income.  Employers, both taxable and tax-exempt, must decide who will bear the new tax burden, the employer or the employee. 

Limited Relief Offered for Employer Reimbursement of Individual Health Insurance Premiums

Finding a way onto the very end of the 21st Century Cures Act, signed by President Obama on December 13, 2016, are provisions allowing eligible employers to operate Health Reimbursement Accounts (HRA) on a limited basis without requiring full compliance with the provision of the Affordable Care Act (ACA).  

Under the ACA, an HRA must provide for certain preventative services to be provided free of charge, and it may not establish any annual limits on the dollar amount of benefits available for any individual.  HRA plans integrated with group health insurance plans meeting these two requirements are deemed to fulfill the requirements of the ACA.  However, HRA plans integrated with individual health insurance policies are not deemed to fulfill the requirements of the ACA, even if the individual policies meet the two ACA requirements.  HRA plans integrated with individual health insurance are subject to a penalty of $100 per day per participant since the health plans do not comply with the ACA.  (Notice 2015-17 provided penalty relief through June 30, 2015.)

The above provisions greatly affected and continue to affect nonprofit organizations of all sizes, but they dealt a substantial blow to smaller nonprofit organizations who are unable to justify the cost of the group health plans available to them.  Faced with substantial ACA penalties, many organizations are unable to offer any type of assistance to employees for health insurance.  

The 21st Century Cures Act addresses this issue in two different ways. 

ACA Penalties for Non-Compliant Health Plans

 In regards to the penalties, limited relief from the penalties arising from these rules was previously offered via Notice 2015-17 allowing for penalty relief for employers reimbursing employees for the cost of individual health insurance policies through June 30, 2015.  The "Cures" Act extends this relief for all years beginning on or before December 31, 2016.  For calendar year organizations, this covers all years through 2016.  For fiscal year organizations, it covers all years beginning on or before December 31, 2016.  

Exception to ACA Requirements for Small Employer HRA Plans

In regard to allowing for HRA plans (including those reimbursing for individual health insurance policies), the "Cures" Act creates a Small Employer HRA.  While the Small Employer HRA provides some relief, the relief is limited.   Qualifications of a Small Employer HRA are: 

• The employer has fewer than 50 employees;
• The employer may not offer a  group health plan to any of its employees;
• The plan must be provided to all eligible employees, i.e., employees who are not part time or seasonal, have completed 90 days of services and are 25 or older (this prohibits a plan providing for just one or two employees and not for all eligible employees);
• The plan must be funded solely by the eligible employer and not through a salary reduction plan; 
• The plan only covers eligible medical expenses defined by IRC 213(d); 
• The employer receives confirmation from participating employees that the employee maintains a policy providing minimum essential health coverage; and 
• The total amount of the payments available during the plan year do not exceed $4,950 ($10,000 in the case of the arrangement providing for expenses of family members.)

Small Employer HRA plans are allowable for years beginning after December 31, 2016.  

Taxation of Payments:  Payments to the employee under the plan will be tax free as long as the employee maintains minimum essential health coverage.  If an employee does not maintain such coverage, the benefits paid under the plan are included in taxable compensation of the employee. 

Notification Requirements:  Employers offering the plans must provide written notice to employees including the (i) amount of the employee's permitted benefit under the plan; (ii) instructions to the employee to provide the plan benefits to any health insurance exchange in cases where the employee is applying for an advance payment of the premium assistance tax credit; and (iii) information regarding the taxable nature of the benefit where an employee does not maintain minimum health coverage.  

The written notice must be provided to employees at least 90 prior to the beginning of a plan year.  Since this is not possible for the 2017 plan year, the notice is required to be provided within 90 days of the enactment of the "Cures" Act or March 13, 2017.  

Summary

The new law offers some relief to small employers, but it does not return these employers to a pre-ACA position.  The new law's provision allowing for a monthly benefit of $412.50 to $833.33 may allow for the offset of a significant portion of an individual health plan premium, but it likely will not offset 100% of the premium especially for family plans.  Additionally, the requirement to provide the plan to all eligible employees prohibits an employer from providing the plan solely to one or more key employees, i.e. to an executive director or to a senior pastor.  Since penalty relief has only been granted through 2016, small nonprofit organizations should carefully review the application of the new law and swiftly act to create the plan, if it can be effectively used within the organization. 

Designating Housing Allowances - A "Must Do" Step for the Church

Ministers performing qualifying ministerial services may have a portion of their compensation designated as a housing allowance pursuant to Section 107(2) of the Internal Revenue Code.  (Terminology varies interchanging such words as housing, parsonage, rental or manse depending on the culture of the church.  The Internal Revenue Code and Regulations refer to it as "rental allowance".)  Within certain limitations, this portion of a minister's compensation is not subject to federal income tax. 

Internal Revenue Regulation 1.107(b) requires that in order to be "rental allowance", the amount must be designated as such pursuant to an official action taken in advance of the payment of the allowance by the employing church or other qualifying organization. Two cases decided in 2013 remind us of the critical need to properly designate housing or rental allowances.

In Ricky Williams v. Comm., pro se TC Summary Opinion 2013-60, the minister entered into an employment contract with his church.  The initial contract provided for a housing allowance for a period of six months.  Any provision extending beyond the six months would have to be formally decided at a later date.  The church never revisited this issue, so none of Reverend Williams' future compensation was designated as housing.  During an examination of his 2007 Form 1040, Rev. Williams asserted that over $33,000 of his compensation should be considered as housing allowance.  The IRS disagreed, so off to court they went.  The court ruled that Rev. Williams could not claim the housing allowance, since the church had never formally designated an amount as housing allowance after the initial six month provision.  Therefore, for 2007, no housing allowance existed.  Rev. Williams produced a new employment agreement dated in 2012 that included the housing allowance provision, but the court reiterated the requirement of having the designation prior to receiving the funds. The 2012 employment agreement was too little, too late.

In Donald L. Rogers, V. Comm., TC Memo 2013-177, Rev. Rogers' church paid his mortgage payments and utilities directly rather than pay him an allowance for the expenses.  Despite making the payments directly, the church failed to formally designate the payments as payments made pursuant to IRC Section 107.  Lacking the formal designation, the court agreed with the IRS that the payments represented taxable compensation to Reverend Rogers. 

Many churches are lax in their housing allowance designations.  I recommend that housing allowance designations be approved every year and be approved by either the appropriate committee, the board of directors or by a high ranking employee that has specifically been granted the authority to make the designations on behalf of the church or other qualified organization.  Remember the designation has to be done prior to the payment of the allowance, so beware of late designations or of designations that attempt to reclassify prior payments.  In this area, it pays to do it well and do it early in order to provide the maximum benefit to the minister.

Cautionary Note:  In Freedom From Religion Foundation, Inc. v. Lew, 112 AFTR 2d 2013-7107, the court ruled that IRC Section 107(2) is unconstitutional.  This ruling makes the housing allowance, but not the provision of a parsonage, unconstitutional.  The judge delayed the mandate for the IRS to enforce the ruling until the conclusion of the appeals process.  The government has appealed the decision to the 7th Circuit Court of Appeals.  Therefore, the future fate of this tax provision is in the hands of the U.S. Department of Justice and the 7th Circuit Court of Appeals.

Compensation Planning - Part 7 of ?

My apologies for the break in this series.  As we approached the April 17th filing deadline, I found that blogging rated way down on the list of activities that had to be performed.  Thank you for your patience in waiting for the next installment in this series.

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. 

Basic Rule
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.

Cautions:

• 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.

Know the Hoops to Jump Through
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
Life Insurance
Dependent Care
Tuition Assistance
Tuition Reduction
Payment of Out of Pocket Medical Costs
Retirement Plan Contributions (there are some exceptions for churches)

Summary
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.

Compensation Planning - Part 4 of ?

Step 3 - Identify All Benefits

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:

• Cash


• Housing


• Auto


• Insurance - all kinds


• Medical programs


• Childcare


• Retirement


• Tuition - either paid for the employee or a discount at the school


• Clothing


• 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.

Compensation Planning - Part 3 of ?

Compensation planning is obviously a multiple step process even though nonprofit organizations have a tendency to either combine some of the steps or skip a few steps. Last week we discussed creating the umbrella of reasonable compensation for an employee. This week we are expanding on this step by reviewing the reasons why determining reasonable compensation is important to organizations.

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
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.

Conclusion
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.

Compensation Planning - Part 2 of ?

As we continue our journey of taking an in-depth look at compensation, we will look this week at Step 2 - Defining the Umbrella.

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.

Compensation - The Ins & Outs - Part 1 of ?

Reason for the Series
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:

1. Everything that benefits an employee is a form of compensation and



2. 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:

1. Compensation is what is reported on my paycheck stub and



2. 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.

Payment of Personal Expenses Kills Religious Organization

In a recent private letter ruling, the IRS issued a final adverse determination letter to an organization due to the extensive nature of personal expenses paid on behalf of its founder. The organization had been formed to spread the Christian Gospel though speaking engagements and conferences. Revenues were generated through contributions, love offerings for speaking engagements and conference registration fees.

During the course of an examination, the IRS noted a consistent pattern of expenditures for clothing, hair cuts, spa services, auto expenses, payments on personal credit cards and other miscellaneous personal living expenses. None of these expenses had been treated in the accounting records as compensation to the founder. However, the outside accountant would often take steps to clean up the activity after it had occurred by filing delinquent payroll tax returns and attempting to report the personal expenses as compensation to the founder.

The IRS found that the regular occurence of this activity over a period of years indicated that the organization was not operated exclusively for exempt purposes but rather for the private benefit of the founder. The exempt status was revoked. Additionally, the founder was required to pay the intermediate sanctions on personal expenses as well as pay the corrections amount required under IRC Section 4958 to another charity.

This ruling illustrates one more time the importance of drawing definite lines between the persons involved in an exempt organization and the organization. It is important that compensation be clearly defined and that there be no comingling of personal funds and organizational funds.

Private Letter Ruling 200928046 7/10/2009

Hope For The Lost Form 4361

Ministers are allowed to opt out of Self Employment tax by filing Form 4361 with the IRS. There is a slim window of time during which a minister can file the form. After being filed in triplicate with the IRS, the IRS returns an approved copy of the form to the minister.

Whenever I work with a minister that has filed Form 4361, I always tell them it is their most valuable asset. An approved Form 4361 is very difficult to replace. Without the approved form it is hard to convince an IRS agent that the minister is exempt from Self Employment tax. The courts have allowed the exemption without an approved form where the minister has retained proof that he filed the form. Apparently, a Form 4361 that is properly completed and timely filed is rarely not approved by the IRS.

Every year I come in contact with ministers who do not have copies of their approved Forms 4361. To make matters worse, they also do not have any evidence of filing the form with the IRS. In the past, I have had little guidance to give to them regarding how to obtain a duplicate of the approved form. However, the IRS recently published a Minister Audit Technique Guide reviewing all the rules regarding ministers for its agents. One of the sections explains to the IRS agent what to do if the minister cannot provide his/her Form 4361.

The IRS gives its agents three avenues for confirming the exemption:

1. For ministers who filed the Form 4361 after 1988, the agent can order a transcript for the year under audit. Included on this transcript should be an indicator that tells the agent the minister is exempt from Self Employment tax.
2. If the transcript is not an option, the agent can contact the Taxpayer Relations Branch at the IRS Service Center where the Form 4361 was filed and request a copy of the form.
3. The last option is to contact the Social Security Administration in Baltimore and ask them to provide confirmation of a minister's exempt status.

I still believe that an approved Form 4361 is a minister's most valuable asset. I recommend a copy of the approved Form 4361 be given to the minister's CPA as well as placed in with all those other valuable papers, i.e. passports, birth certificates, and social security cards. If you are the minister who cannot find your approved Form 4361, you should explore the above avenues to confirm your exemption. It is better to know for sure you are exempt, then to discover you are not exempt when a large tax bill is sent your way.

Minister Sentenced to 21 Months For Tax Evasion

Recently a minister was sentenced to 21 months in jail for failing to report all of the income received from his church. In reporting his taxable income, the church failed to include payments made on the minister's personal credit cards, payments for life insurance premiums, values for automobiles as well as other personal expenses that were paid by the church. U.S. v. Clark, 103 AFTR 2d 2009-1349, 3/20/2009.



This case indicates the importance in identifying and properly reporting all aspects of a minister's compensation. While many of you may find the above items unusual, it is not unusual for a tax exempt organization to end up paying for personal expenses of its top executives. However, in most cases, the only amounts reported for payroll purposes are just what is run through the payroll system. This type of activity is one of the reasons the new Form 990 requires extensive reporting on compensation paid to an organization's officers, directors and key employees. Additionally, the IRS has in the past, and stated it will in the future, conducted examinations of the compensation section of specifically selected Forms 990.



Tax Tip: A nonprofit organization should review all of the payments made to or on behalf of staff members and determine which payments are taxable and which are not. Then properly treat the taxable benefits according to all the rules regarding payroll reporting and taxation.