Today, not-for-profit organizations operate with heightened awareness of executive compensation. During the past several years, we have witnessed the continued interest of public officials in limiting the compensation of key executives, and we believe this is likely to continue.
While credit union boards want to provide CEO compensation packages that motivate and reward their institution’s top executive—and also help them recruit a new person when needed—directors also need to know what constitutes reasonable compensation under the current guidelines.
Making such determinations can be tricky. Indeed the question of “who oversees whom” looms large in the arena of CEO compensation at CUs, as regulators—including the Internal Revenue Service, the National Credit Union Administration and state attorney general offices—move to rein in abusive compensation programs and practices by auditing compensation programs, investigating concerns and assigning penalties.
Many CUs would be well advised to actively test for excessive executive compensation—as well as any corporate governance deficiencies. Problems uncovered by regulators in these areas could lead to regulatory action against executives and directors , opening them to personal liability for penalties.
State vs. Federal Charter
Because state-chartered and federal credit unions are typically tax-exempt, not-for-profit organizations, you might think the oversight and regulations in place for executive compensation would be similar for both types of institutions. They are not. The chart on the next page outlines the key differences.
While FCUs currently aren’t governed by IRS 4958 and intermediate sanctions, NCUA has discussed/proposed enhanced rules on executive compensation and, in particular, incentive-based compensation and bonuses.
Additionally, if you are a FCU director, you should be concerned about the ambiguity in the rules for FCUs regarding executive compensation excess. While FCUs are not considered “governmental entities” under IRS code, they are at times being treated like governmental agencies in practice. This opens the door to additional scrutiny from the IRS and states’ attorneys general. In addition, the lack of clear guidelines concerning NCUA’s annual review of executive compensation could create a potential threat for FCUs that should not be overlooked.
An “impermissible excessive benefit transaction” is one in which the economic benefit provided directly or indirectly to a “disqualified person” exceeds the value received by the organization, including the value from the performance of services. A disqualified person is anyone who was in a position to exercise substantial influence over the affairs of the organization during the five years before a finding of excess (whether or not that influence was exercised).
IRS 4958 imposes “intermediate sanction” taxes on top leaders of certain not-for-profit organizations, including state-chartered credit unions, who receive an impermissible excessive benefit transaction from their organizations, and penalties on board members who approve such payments.
Fortunately, the regulations provide a simple procedure for ensuring that the compensation of top officials is in full compliance and that the executives themselves are not liable for additional taxes and penalties.
The procedure is to create a “rebuttable presumption of reasonableness”— essentially a demonstration that the executive’s compensation is reasonable. That is, the compensation provided is not unreasonable considering what would ordinarily be paid in the marketplace for like services by a like enterprise under like circumstances.
While creating a rebuttable presumption of reasonableness is not required, doing so often proves to be quite advantageous to individuals and organizations covered by IRS 4958. Done correctly, a rebuttable presumption creates a wall between the organization’s governing body and the IRS. Once the rebuttable presumption is in place, the IRS may refute the compensation’s reasonableness only if it provides sufficient evidence rebutting the value of the comparability data the organization used to prove the executive’s compensation was reasonable.
Notably, the practice of creating a rebuttable presumption lends itself to a credible governance strategy even for federal CUs not directly affected by IRS 4958. Creating a rebuttable presumption is essentially a process of due diligence in reviewing executive compensation each year.
Once a process for creating this rebuttable presumption of reasonableness is established (as described in the next section), it often becomes a routine task. However, creating a rebuttable presumption may be unnecessary in smaller CUs, such as those with assets of less than $50 million, that don’t pay their CEO upwards of $100,000, a salary level more likely to trigger scrutiny.
Judging What is ‘Reasonable’
Steps to Prove Reasonableness
The basic requirements for establishing the “rebuttable presumption” are as follows:
- Executive compensation arrangements must be approved in advance by an authorized body of the tax-exempt organization, composed of individuals who do not have a conflict of interest with the transaction. (In the case of CUs, this authorized body is the board of directors, and the board’s compensation committee).
- Before making its determination, the authorized body should obtain and rely upon appropriate comparison data.
- The authorized body, adequately and in a timely manner, must document the basis for its determination concurrently with that determination.
The needed documentation must include: (1) the terms of the transaction and the date of approval, (2) the members present during the debate and vote on the transaction, (3) the comparability (i.e. compensation) data obtained and relied upon, (4) the actions of any members having a conflict of interest, and (5) documentation of the basis for the determination.
To establish that executive compensation is not excessive, comparable data from external sources is required. While IRS 4958 does not specify what data is to be used, the code does reference “industry surveys, documented compensation of persons holding similar positions in similar organizations, expert compensation studies or other comparable data.”
Executive Compensation Best Practices
Regardless of whether your CU is subject to IRS 4958, you may wish to consider adopting some of the following strategies and best practices for compensating your CEO:
- Make executive compensation transactions a priority in board meetings.
- Use caution when entering into transactions with your CEO. Be sure to conduct the appropriate due diligence in reviewing market survey data to make informed compensation decisions.
- Use the rebuttable presumption of reasonableness procedures to shift the burden of proof to the IRS. This is an accepted best practice that could provide a substantial advantage in the event of an audit or regulatory review.
- Create a customized executive compensation philosophy and policy for your CU’s CEO that balances the need to reward outstanding performance with the reasonableness requirements.
- Use appropriate and relevant comparable compensation and benefit survey data to conduct a total compensation review for your CEO.
- Adopt a comprehensive conflict of interest policy to help protect directors, trustees and officers from liability.
- Use an independent consultant to ensure impartiality and to avoid any opportunity for conflict of interest.
- Thoroughly document the basis for CEO compensation and governing body compensation decisions. This would include terms of the approved compensation transaction; date of approval; board/committee minutes; and a thorough description of the data used to make the decisions, including the origin of the data.
In the final analysis, the CU board carries the legal burden associated with improper compensation. To maintain not-for-profit tax exempt status and avoid tax penalties, it is incumbent upon a CU’s governing body to ensure that the CEO is compensated reasonably. To ensure long-term success, directors and their CEOs must be thoughtful, open to successful board governance strategies and best practices, as well as transparent and consistent in the application of sound and reasonable executive compensation programs.
Potential Penalties Under IRS Section 4958
Potential penalties for an executive participating in such actions can include being personally liable for returning the value of the excess compensation or benefits to the organization; paying an excise tax of either 25 percent of the value of the excessive benefit if returned prior to receiving a deficiency notice from the IRS or 200 percent of the value of the excessive benefit if the benefit or compensation is returned after receiving the IRS deficiency notice.
Potential penalties for a director for knowingly helping to approve an excessive compensation or benefit transaction can be a 10 percent tax. Liability under section 4958(a)(2) is joint and several liability. This means directors can be found individually responsible for fines and penalties and, at the same time, the entire board can be made liable for payment of these same penalties, capped at $20,000 per transaction. In addition, the credit union could lose its tax-exempt status.
Scott Dettmann is a partner and principal consultant with Carlson Dettmann Consulting, LLC, Middleton, Wis., and Bob Cartwright, SPHR, is president/CEO of Intelligent Compensation, LLC , Pflugerville, Texas.