“How do we establish compensation? What are the IRS regulations?”
These are two of the most frequent questions we get asked at Foundation Group. The IRS guidelines are that compensation established be “reasonable” for duties to be fulfilled. What is “reasonable”? We’ll answer that question in just a moment. First, the board needs to determine that a job position is warranted, meaning there are duties that need to be accomplished which cannot be done by either the board members or volunteers assisting the organization. Your board should prepare a job description, noting the duties that are needed to be fulfilled, and select an appropriate job title before considering compensation. In this way, you show that you need an employee. Then determining compensation comes into the fold.
So we’re back to the question, what is “reasonable”? Reasonable compensation is that which has been researched, discussed by the board of directors, and voted on by the board based on the research and discussion.
What research? Form 1023 asks, “Do you or will you approve compensation arrangements based on information about compensation paid by similarly situated taxable or tax-exempt organizations for similar services, current compensation surveys complied by independent firms, or actual written offers from similarly situated organizations?” Form 990, the annual information return filed by tax exempt organizations, asks, “Did the process for determining compensation of the following persons include a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision?”
You should be able to say “yes” to these questions. However, saying “yes” to these questions is not sufficient to demonstrate that you do this. That’s where your board meeting minutes come in to play.
Board meeting minutes, once signed by the secretary to demonstrate that they are an accurate reflection of what took place in a meeting, are a legal binding document demonstrating not only the decisions that have been made by the board of directors, but also, the details of what was considered to make the decision. This answers the next question on Form 1023: “Do you or will you record in writing both the information on which you relied to base your decision and its source?” You should be able to answer “yes” to this question as well. So, where did you go to get the information that is being considered? Did you call other organizations and ask about their employee compensation? Did you review Form 990s of similar organizations? Did you rely on a website such as www.salary.com that allows you to search by geographic location? Did you review a compensation survey? Maybe you searched the US Bureau of Labor Statistics Occupational Outlook Handbook at http://www.bls.gov/ooh/ No matter where the data came from, it should be a reliable source, and it should be documented.
These details become especially important if an “insider” will be hired to be an employee. Insiders are founders and board members, and to a certain extent, their relatives. The burden remains on the organization to demonstrate that decisions are made at arms-length. So, no one to be hired should be voting on the potential hiring or compensation. Likewise, individuals should recuse themselves if a family member is being considered, or a business partner, as those relationships may influence decisions being made.
Section 1.501(c) (3) – 1(d)(1)(ii) of the regulations provides that an exempt organization must serve a public rather than a private interest. The organization must demonstrate that it is not organized or operated to benefit private interests such as “designated individuals, the creator or his family, shareholders of the organization, or persons controlled directly or indirectly, by such private interest.” Thus, if an organization is operated to benefit private interests rather than for public purposes, or is operated so that there is prohibited inurement of earnings to the benefit of private shareholders or individuals, it may not retain its exempt status.
In New Dynamics Foundation v. United States, 70 Fed. Cl. 782 (2006) “the court, in reviewing whether the taxpayer had modified its activities, noted that gaps in the record may be resolved against the taxpayer since the burden is on the taxpayer to provide evidence that it meets the requirements of section 501(c) (3) of the Code.”
What does this mean? It means the IRS wants your meeting minutes to demonstrate what sources and information were considered by the Board of Directors. What questions or concerns were raised? How were they addressed? Is further research necessary, or can a decision be made? Ending with the vote of the board, noting any interested parties who are not voting, whether by recusal, or exiting the room while the vote is taken.
These same points are true for any financial arrangement, especially with an insider: contracting with their company, leasing property they own, establishing a loan repayment arrangement, etc.
Why is this important? As a board member, the IRS is particularly concerned that the individuals are not receiving any private benefit from any transactions with the organization. Remember that public interest reference above?
If a board member has a property that is suggested and they are charging rent to the organizations, then you need to be able to show a clear and compelling demonstration that: 1) the rate is SIGNIFICANTLY lower than the organization could obtain elsewhere. It should be noted what rates you are seeing elsewhere that helps you make this decision, or what the fair market value of similar properties goes for. (The IRS has been known to request certified independent appraisals to demonstrate that the agreed rent is fair market value or less, benefitting the organization.) 2) that if any permanent (infrastructure) changes are made to the property that the nonprofit does not pay for those and that 3) the board member owning the property and anyone related to them by blood, marriage or business relationship (including the for profit company you own) not only did not vote on the matter, but were present for the discussion, but rather left the room when it was time to vote to accept the proposal. The minutes should reflect that fact clearly.
The same approach needs to be taken in contracting out services. Multiple service providers should be considered, to make sure you are establishing the best arrangement for the organization. Minutes should record what quotes were received, and what was included with those quotes. (If written, those can be attached to the meeting minutes.) What questions or concerns were raised? How were they addressed? Is further research necessary, or can a decision be made? Ending with the vote of the board, noting any interested parties who are not voting, whether by recusal, or exiting the room while the vote is taken.
The IRS’s suggested language for a Conflict of Interest policy includes the following:
Records of the Proceedings. The minutes of the governing board and all committees with board delegated powers shall contain: (a) The names of the persons who disclosed or otherwise were found to have a financial interest in connection with an actual or possible conflict of interest, the nature of the financial interest, any action taken to determine whether a conflict of interest is present, and the governing board’s or committee’s decision as to whether a conflict of interest in fact exists. (b) The names of the persons who were present for discussions and votes relating to the transaction or arrangement, the content of the discussion, including any alternatives to the proposed transaction or arrangement, and a record of any votes taken in connection with the proceedings.
By following the suggestions we have made above, you will satisfy this requirement. While your Conflict of Interest policy does not have to be verbatim, the message it conveys must remain the same.
With IRS scrutiny on the rise regarding private inurement to insiders in tax-exempt organizations, the need to document the decision making process is more important than ever.
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