The Compensation Conundrum

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While the public and the media have been quick to criticize the “golden parachute” payments by Blue Cross Blue Shield to its former CEO as clearly improper, the broader questions raised regarding compensation paid by tax-exempt organizations—and in particular, when such compensation should be deemed inappropriately excessive—are far from straightforward.

The Internal Revenue Code provides for so-called intermediate sanctions in the form of an excise tax when tax-exempt organizations are deemed to have provided an excess benefit to disqualified people (meaning those people in a position to exercise substantial influence over the organization’s affairs, such as its officers and directors). An organization can seek to avoid intermediate sanctions by following prescribed procedures to create a rebuttable presumption that a compensation arrangement is reasonable. The rebuttable presumption is established if the compensation arrangement is approved in advance by an authorized body composed of individuals who do not have a conflict of interest concerning the transaction; prior to making its determination, the authorized body obtained and relied upon appropriate data as to comparability; and the authorized body adequately and timely documented the basis for its determination. Once an organization establishes the rebuttable presumption by following the required procedure, the burden is on the IRS to rebut the comparability data relied on by the organization.

Here in Massachusetts, state law gives the Attorney General the ability to undertake an investigation “whenever he believes that charitable funds have not been or are not being applied to charitable purposes or that breaches of trust have been or are being committed in the administration of a public charity.”  With respect to compensation, I imagine that the Attorney General would most likely not get involved unless a tax-exempt organization were paying compensation significantly higher than or otherwise different from that paid by similar organizations. For instance, Attorney General Coakley recently has undertaken an investigation with respect to the compensation of directors at the state’s tax-exempt health insurers, noting that “[t]he compensation of board members at public charities is extraordinarily rare in Massachusetts, and for good reason.”

In short, tax-exempt organizations are generally insulated from government scrutiny so long as their compensation arrangements with disqualified people are comparable to those paid by peer organizations. For instance, if a university paid its president $500,000, that amount might seem too high to members of the public if the university were to conduct a survey, but if comparable universities were paying equal or higher amounts to their presidents, the university could establish the rebuttable presumption and it seems unlikely that the AG would get involved. Similarly, if it were more common for tax-exempt organizations in Massachusetts to compensate their directors in amounts like those paid by the health insurers, it seems less likely that the Attorney General would have launched an investigation into the practice. But would the fact that such compensation was more common actually ensure that inappropriate benefits were not being provided? Isn’t it possible that a number of tax-exempt organizations could all choose to provide inappropriate benefits to people who exercise substantial influence over the organization?

Then again, it would be problematic—on many levels—for government regulators to start analyzing and second-guessing all of the compensation arrangements entered into by tax-exempt organizations. So is the best solution to continue telling tax-exempt organizations that they are essentially safe so long as they follow the pack? (I will put aside for now the fact that comparability analyses are themselves imperfect and highly manipulable.) Is there a better way we could strike a balance between ensuring that tax-exempt funds aren’t being used for private enrichment and preventing government from micromanaging the affairs of tax-exempt organizations?