IRS Study Confirms the Obvious

I. Introduction

Tax exempt organizations, by design, do not
have to answer to shareholders.  The executives of these organizations
do not feel the same pressures as do executives of taxable, for-profit
organizations to run the entities in the most streamlined
shareholder-interest-maximizing manner.  Instead, the taxpaying public
(who arguably subsidizes the activities of the tax-exempt sector)
relies on detailed government regulation, the vast majority of which is
found in the Internal Revenue Code, to ensure that the tax exempt arena
neither becomes a black hole for this country's resources nor a
playground for the very wealthy.  As part of this monitoring charge,
the IRS recently completed a three-year investigation into the
compensation of executives of tax-exempt corporations.[1]  This article
discusses the objectives and methodology of this investigation, its
findings and its minimal impact.

II. Analysis

The Executive Compensation Compliance Project (aka "The Project")
was initiated in response to a budgetary reorganization that came about
in 2004 in which two new offices (the Exempt Organizations Compliance
Unit and the Data Analysis Unit) of the service were created.[2]  In
this, their maiden voyage, the offices sought to accomplish threefold:
(1) to "increase awareness of compensation as a compliance issue [and]
establish [an] enforcement presence," (2) to "observe the practices and
procedures exempt organizations use to determine compensation of their
officers, directors, trustees, key employees, and related persons" and
(3) to "assess and enhance tax law reporting and compliance with
respect to compensation practices . . .."[3]  By performing an informal
audit of existing practices within the tax exempt world of
compensation, the offices hoped to both strike the fear of an actual
crackdown into the hearts of the organizations, as well as assess the
existing law as a monitoring mechanism.

In order to achieve these ends, a bi-part plan of attack was
employed.  In Part I, letters were sent to four categories of public
charities and one category of private foundations whose tax filings
from the prior year had been deemed routinely suspect, generally
because of some compensatory omission.[4]  In Part II, a particular
aspect of compensation was addressed — that of improper compensation
through an "excess benefit transaction" to "disqualified persons"
within the meaning of section 4958 of the Code.[5]  Under this section,
any party deemed to be in a position to wield "substantial influence"
over the affairs of a tax exempt organization is limited in the benefit
that person can personally receive from the organization in the form of
compensation — compensation outside of the limited allowable sphere is
deemed an "excess benefit," and an excise tax is placed on those
disbursed funds or other value.[6]  Because "excess benefit" is a
particular area of abuse where there is oftentimes incestuous overlap
between the titles of benefactor, director and executive, this study
felt it important to scrutinize the compensation received by
"disqualified persons" in three categories of public charities, and one
category of private foundations.

The findings of the study were somewhat unsurprising.  Part I
revealed much "confusion" in the way that executive compensation was
intended to be reported — the letters sent to the various
organizations asking them for additional information regarding their
omissions were met primarily with "clarifying information" not
requiring of a re-file, but also many instances of refilings.[7]  Part
II resulted in the proposed collection of some $20 million in excise
taxes for various compensation and benefit violations.[8]  While the
results suggested that private foundations perhaps engaged in more
excess benefit transactions/excessive compensation than did the public
charities, these results were skewed by the facts that (1) the public
charities had some difficulty understanding some questions that
resulted in false positives for excess benefit transactions, and (2)
the questionnaires created enough of a notice effect that a great deal
of the excess benefit transactions supposedly being engaged in were
corrected before a formal audit.[9]

III. Conclusion

What does this study mean, going forward, with regard to what
the IRS can do to keep better tabs on the compensation that tax exempt
organizations are doling out?  "For better or for worse, the tax form
is the nonprofit disclosure instrument."[10]  Dan Prives, a blogger and
former finance director at World Relief questions the way that very
large nonprofit organizations — in this instance, Yale University —
report their specific expenses and securities transactions.[11]  In a
telephone interview with the New York Times, Prives is quoted as having
said that he was surprised "because usually A-list nonprofits like Yale
are pretty accurate in their reporting . . . It threw a whole
monkeywrench into my thinking about what's being achieved by publishing
these [tax] forms.  You can have errors in plain sight and nobody's
picking it up."[12]  While this study may have dug up a few instances
of underreporting and overcompensation, the fact remains that even an
intensive three-year study like this hardly makes a dent in the tax
exempt world.  Only 600 organizations total were targeted by this
study, compared to the more than 1.5 million organizations that make up
10% of this country's GDP — and these numbers are ever-growing.[13] 
It is possible that, at least insofar as public charities are
concerned, there is enough of a donation market (that is, competition
for donations among public charities) that public charities do have
incentives apart from the threat of audit to maintain efficient,
up-and-up administrations.  However, private foundations will likely
forever be an appealing option for wealthy individuals looking for a
tax shelter cloaked in goodwill.  This author doesn't have a solution
to the problem that studies like these merely confirm — let's just
hope that these societal costs are outweighed by whatever societal
benefit the world of tax exempt organizations is meant to impart.

 

[1] Report on Exempt Organizations Executive Compensation Compliance
Project–Parts I and II (Internal Revenue Service March 2007), available at www.irs.gov/pub/irs-tege/exec._comp._final.pdf.

[2] Id. at 1.

[3] Id. at 2.

[4] Id. at 3-4; see 26 U.S.C.A § 4958 (West 2007).

[5] Supra note 1 at 4.

[6] See 26 U.S.C.A. § 4958 (West 2007); see also supra note 1 at 2.

[7] Supra note 1 at 5-9.

[8] Id.

[9] Id.

[10] Stephanie Strom, I.R.S. Finds Errors in Tax Reports of Nonprofits, N.Y. Times, March 1, 2007.

[11] Id.

[12] Id.

[13] Stephen C. Gara, Khondkar E. Karim & Robert E. Pinsker, The Benefits of XML Implementation for Tax Filing and Compliance, The CPA Journal, December 2005, available at www.nysscpa.org/printversions/cpaj/2005/1205/p66.htm.