These days there is a proliferation of information, interpretations and discussions on executive compensation in nonprofits. It is important to have a clear and current understanding of the “basics” and to avoid over OR under reacting
Administrative compensation (including heads) and faculty compensation structures need to be reviewed periodically to ensure that there is a philosophy of compensation consistent with the mission of the school and that salary structures fit within that compensation philosophy. That philosophy should flow from the mission of the school.
Administrative compensation must further “pass muster” with the IRS and often the charitable trust division of a state’s attorney general’s office. Independent schools need to be cognizant of what the existing Intermediate Sanctions Act requires of them and how the new Section 409A of the Internal Revenue Code will affect head compensation, and especially deferred compensation, arrangements.
This recent 409 legislation concerns non-qualified deferred compensation plans and is aimed at correcting abuses in this area. It will affect some non profit plans as well corporate entities. For most independent school heads, such changes will not affect plans now in place. For some, there will be an effect especially if plans are modified or there is an attempt to modify to achieve an earlier payout. More on this further in the article.
What do independent schools need to know about determining, reporting and justifying head and senior administrative compensation?
- The Emphasis Upon Data Gathering
Why is the accuracy of compensation data so important? As we discuss below, the IRS is increasingly requiring that non profits, including independent schools, understand and report all key components of compensation packages for their senior administrators AND obtain and keep a written record of “comparables” to substantiate and defend head compensation decisions.
Beginning in the early 1980’s, John Littleford personally contacted as many as 1000 schools heads a year to ascertain confidentially their actual packages as opposed to what was being reported to local, regional or national associations. Today, Littleford and Associates’ data base consists of proprietary data dating back to 1982 and is supplemented by ongoing work on this topic with over 2000 independent schools.
The vast majority of our data base is still captured from confidential interviews with school heads as well as from the facilitation of their compensation packages. The Firm maintains the largest and most accurate data base in the world on head compensation for independent and international schools. Some large accounting and benefits firms recommend our Firm to their clients.
Statistics obtained from trade associations are acceptable to the IRS. However, the data tends to under represent actual total compensation as do most written survey efforts.
If the pool for any subgroup answering a questionnaire or survey is too small, outliers will sway the averages and may convey a misleading trend. Key players within any one group may not reply to a compensation questionnaire. It is a well known fact that the most highly paid individuals in non profits tend not to return written surveys or not to provide complete information. In a recent written survey, for example, 69% of the heads of school who responded to a survey reported salaries of $175,000 or less.
Less than 30% reported having any deferred compensation, the fastest growing tool for attracting, retaining and rewarding heads over the last 7 to 10 years. The data from Littleford & Associates shows higher averages and percentages, largely because the data base is larger.
Another way to obtain data is from the 990 forms listed on Guidestar.com. This data is usually at least two years out of date and still excludes a number of elements of the total compensation package including housing. The rules are tightening here, however, and the amount of information that the IRS is requiring on 990’s has been steadily increasing.
Some preparers of the 990 (and they may be business managers, CFO’s or accounting firms) aggregate data so that individual components of the head’s package may be difficult to identify and track. The reliability of the data may be a function of who completed the form, the way in which it is reported, and where in the 990 reams of numbers the exact compensation for the CEO can be found.
However, since unlike written surveys, the 990 must be filed with the IRS. While these 990 forms are becoming more accurate and complete, they still tend to underreport deferred compensation. Religiously affiliated schools are not required to file a 990, and many do not if they are sufficiently controlled by, owned or affiliated with a specific church or religious organization.
- The Intermediate Sanctions Act: The Bottom Line for Independent Schools
The Intermediate Sanctions Act-Section 4958 has been in effect since 1996. While the IRS has apparently postponed its random study of independent schools and has chosen instead to focus on how compensation is set in other 501 (c) 3 organizations, this is not to say that independent schools will pass under the radar screen.
While we are not tax attorneys or auditors, Littleford & Associates keeps abreast of the latest developments in legislation in this area and provides our clients with expert advice on the basics of compliance. We also encourage them to seek competent legal and tax advice. What we set forth below is consistent with the counsel that we have provided for several years to our clients
Independent school boards and heads need to focus on the following concerns and action steps all of which are tied to one crucial concept: establishing a “rebuttable presumption of reasonableness” for head/senior compensation packages in order to avoid the penalty of an “excess benefit” transaction.
- The Link Between “Reasonableness” and Benchmarking
“Reasonable compensation means “what like organizations would pay for like services under like circumstances”. This relates to obtaining and showing appropriate accurate data on compensation for heads of comparable institutions (See Section I above). The most persuasive comparables will be institutions of roughly the same size (students/faculty as well as asset size) in the same sort of geographical area and providing the same educational activities.*
If the school uses an independent compensation consultant, it will automatically have a written record of how the comparables were selected and why they are comparable. The IRS will want to verify that correct comparables have been utilized and recommends the selection of about ten. Nevertheless, before a compensation decision is made, in order to demonstrate a good faith effort, the school would be wise to identify and put in writing comparable institutions on its own even if it anticipates engaging a compensation consultant.
- Establish a Compensation Committee
For many years, Littleford & Associates has been strongly recommending the formation of a Compensation Committee usually consisting of three trustees, including the Board Chair, with no one on the Committee having a conflict of interest. That is, the school’s bankers, insurance agents, architects or anyone having a financial relationship with the individual whose compensation is being considered should NOT serve on this Committee.
The Committee must deliberate on the package of the head without the head being present. Those present and their discussion should be recorded. The minutes should not only show due consideration of the data as to comparability BUT also the individual’s qualifications and performance. This exercise MUST be done before a decision is made on what to pay.
This is the process that Littleford & Associates has been following with its clients for some years, including an emphasis upon the importance of a written annual evaluation of the head of school.
A generous or “top” compensation package is “reasonable” as long as a high level of experience and education are required for the position AND there is a performance evaluation on record demonstrating that the individual has met and exceeded appropriate tangible goals.
The compensation consultant should not have designed the compensation arrangement. Littleford & Associates never recommends what the head should be paid and always suggests that the Board seek expert tax advice if any elements of the final package have a complicated tax component. Our role is to facilitate the process objectively and ensure accurate information and Littleford & Associates works only for boards, not heads, on this topic.
Finally, the Committee should document the decision, and note all elements of the compensation package, preferably in an employment agreement and in the general financial records. There should be copies of deferred compensation plans, if any, and they should be on file for up to seven years.
- The Compensation Package
In recording the components of the compensation package, identify: all forms of cash and non-cash compensation such as salary, bonuses, severance payments, and deferred and non-cash compensation, including the value of the head’s residence. Including the value of housing can be “tricky” as it varies. In some very affluent regions, it will seem “over the top”, whereas in other more rural depressed areas, the value of school owned housing may be deemed quite low.
Fringe benefits must be included such as the use of cell phones, automobiles, housekeeping services, vacations of significant value, medical insurance and life insurance. If no records are kept, the estimated amount of personal use will be automatically an “excess benefit” and subject to a penalty tax.
Any deferred and non-cash compensation NOT subject to a legitimate substantial risk of forfeiture (such as 403 (b) plans) should be identified. For independent schools, aside from the typical 403 (b) plan, Littleford & Associates has only recommended 457(f ) deferred compensation plans that are funded and WITH the “substantial risk of forfeiture” provision. Prior to creating this type of plan, most schools may create a simpler 457 (b) plan with TIAA/CREF. Contributions to that account, however, cannot exceed about $13,500 annually.
According to 457 (f) plans, only when the risk of forfeiture is eliminated at the time of departure does the payout appear as a lump sum accumulated and maturing after a number of years and is fully taxable to the head; OR the accumulated deferred is paid out in relationship to a consulting arrangement over time, taxable as it is received, and the risk of forfeiture is maintained until full payout. Most independent school plans DO and SHOULD contain specific language that the plan is at substantial risk of forfeiture.
The compensation consultant’s report should contain all of the above elements.
Even though the 990 data has historically in many cases understated compensation, going forward consult your tax attorney about reporting accurately on the 990 all elements of compensation including significant items of non-taxable income.
- How Often Do You Need to Establish Reasonableness?
Boards should conduct this exercise annually, but at a minimum, anytime there is a significant change in the terms of the contract upward. If the school is providing only cost of living adjustments to the head, then it is less crucial that the exercise occur every year. This does NOT eliminate the need to evaluate the head annually.
In any event, it is not wise to let 3-4 years go by without formally establishing “reasonableness”.
- The New Section 409A
In the past, there have been two broad principles that governed whether deferred amounts were required to be included in taxable income before actual receipt: the employee was able to draw down a payment upon request (“constructive receipt”); and/or the employee had effective use of the deferred amounts or had security that ensured ultimate receipt of the amounts (“economic benefit”).**
The IRS had few “teeth” to challenge most arrangements, and many loopholes were apparently found and used to circumvent these doctrines. In the past, there were virtually no practical restraints on event-based payouts of compensation.
However, tax-exempt organizations and state and local government entities have operated under Section 457 which restricted their ability to set up deferred compensation plans. Furthermore, assuming the plan was structured properly and its terms not violated, employees of these organizations, including independent schools, would not be required to include deferred compensation in taxable income before actual receipt. Why? The employee does not control the asset; the asset is not vested; and the payout methodology (a lump sum or a structured payout over time) is determined six to twelve months before departure.
On October 22, 2004, the President signed into law legislation that includes a new section of the Internal Revenue Code, Section 409A. The Section is aimed at deferred compensation arrangements including some which have not typically been thought of as falling into that category such as severance benefits and long-term bonuses. The new rules apply both to elective and non-elective deferrals and to employees and former employees.
The penalty for non-compliance is harsh: a tax of 20% plus interest on the understatement of tax that would have been incurred had the compensation been included in income when deferred (or when vested if later). Congress has directed the IRS to issue guidelines on Section 409A by December 21, 2004. These guidelines will address transition or timing issues since the effective date of the new legislation is January 1, 2005.
The new Section 409 affects the timing of deferral elections, the timing of distribution elections and distribution events. It seems as though Section 409A is aimed primarily NOT at organizations such as independent schools, but at for profits such as Enron where the top level executives were able to be paid out while employees lost their pension benefits.
On the other hand, since the new legislation DOES apply to nonprofits, the recommended course of action for independent schools who have established 457(f) plans is as follows: remain in contact with your tax attorney and request to be informed on the IRS guidelines when they are issued; do not make “material amendments” to existing plans until they are issued; and wait if possible until the IRS guidelines are issued before setting up any truly new deferral plan.
Littleford and Associates will provide an update when the IRS guidelines are announced.
With thanks to:
* Marcus S. Owens, Caplin & Drysdale, Washington, DC
** David Raish, Ropes & Gray, Boston, MA