By Matthew Bolstad
Overview
The tax-exempt status of not-for-profit corporations ("nonprofit organizations") carries unique responsibilities in terms of financial management. Fundamental to a 501(c) nonprofit organization is that it uses surplus revenue to achieve its goals rather than distributing the surplus as profit or dividends. Although nonprofit organizations may have compensation packages that resemble those found in for-profit corporations, they come from a different set of justifications and rules. Employee bonuses, the focus of this Quick Overview, must further the goals of the nonprofit organization rather than be a means to merely distribute surplus revenue. The Internal Revenue Service (IRS) has a multi-factor test for a permissible compensation package, including any bonus, which is discussed fully below.
Please note that this Quick Overview does not differentiate between the various types of 501(c) organizations. Although most of the case law in this area involves 501(c)(3) organizations, the IRS treats 501(c) organizations consistently and expects all types to fulfill their tax-exempt purposes. See, e.g., Internal Revenue Manual §§ 4.76.15.4, 4.76.15.4.1, 4.76.15.6 (03-01-2003)(setting forth compensation requirements in a 501(c)(6) organization, which are consistent with those discussed in this Quick Overview).
The IRS's 12-Factor Test of Compensation
A bonus is permissible, even one based partly on net earnings, if the employee's entire compensation package is reasonable and in furtherance of the organization's exempt purpose. Whether compensation is reasonable and in furtherance of an exempt purpose is a question of fact to be decided in light of all the circumstances up to and including the date of payment. Founding Church of Scientology v. United States, 412 F.2d 1197, 1197 (Ct.Cl. 1969), cert. denied, 397 U.S. 1009 (1970);26 CFR § 53.4958-4(b)(2)(i). In determining whether compensation is reasonable, all forms of compensation must be considered, including base compensation, incentive compensation, and any other economic benefits conferred by the organization onto the employee. See IRS General Information Letter 2002-0021, 3 (Jan. 9, 2002).
In its General Information Letter 2002-0021 (Jan. 9, 2002), the IRS synthesized 40 years of considerations regarding reasonable compensation in 501(c)(3) organizations. An Information Letter is issued by the National Office of the IRS to set forth a "well-established interpretation or principle of tax law ... without applying it to a specific set of facts." See Rev. Proc. 2006-1, 2006-1 I.R.B. 1, § 2.04. The IRS has also used the following list of factors in internal training materials. See CPE Text 2000 at 26 (Sept. 1, 1999).
A 501(c) tax-exempt organization may award a bonus to an employee if the employee's total compensation package:
- Is established by an independent board of directors or by an independent compensation committee; Is reasonable in terms of the employee's specialty and geographic locale; The result of arms' length bargaining; Includes a ceiling or reasonable maximum; Does not have the potential to reduce the charitable services or benefits the organization would otherwise provide; Takes into account measures of the employee's performance; Keeps the organization within budget without charging more for services; Does not transform the principal activity of the organization into a joint venture between it and the employee; Is not merely a device to distribute all or a portion of the organization's profits to persons who are in control of the organization; Serves a real and discernable business purpose of the exempt organization; Does not result in abuse or unwarranted benefits; and Rewards the employee based on services the employee actually performs.
IRS General Information Letter 2002-0021, 3 (Jan. 9, 2002). For several examples of each factor taken from IRS Private Letter Rulings, Revenue Rulings, General Counsel Memoranda, and cases, see Suzanne Ross McDowell, Incentive Compensation and Employment Agreements, Georgetown University Law Center Continuing Legal Education, 2007 WL 5269555 (April 26, 2007).
Legal Background: Prohibition on Private Inurement
The pertinent regulation, 26 CFR § 1.501(c)(3)-1(c) (2008), provides that a501(c)(3) "organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose." 1.501(c)(3)-1(c)(1). Further, an "organization is not operated exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals." 1.501(c)(3)-1(c)(2).
The regulation's use of "private individuals or shareholders" is understood to mean the organization's "founders or controlling members," often referred to as "insiders." Triune of Life Church, Inc. v. Commissioner of Internal Revenue, 85 T.C. 45, 55 (1985);IRS General Information Letter 2002-0021, 3 (Jan. 9, 2002). The term "inurement" means "a benefit … consisting in the use by a private shareholder or an individual who has an insider relationship with a tax-exempt organization of the organization's earnings or assets for personal gain other than reasonable and adequate compensation." Black's Law Dictionary, "inurement" (9th ed. 2009).
The purpose of this regulation is to ensure that the organization serves a public rather than private purpose. See Church of Scientology of Cal. v. Comm'r, 83 T.C. 381, 491 (1984), aff'd, 823 F.2d 1310 (9th Cir. 1987).The regulation creates two requirements related to (1) activities (private benefit) and (2) resources (private inurement). The distinction between these two requirements is discussed in the following two paragraphs, however, the factors that satisfy the two requirements are the same and many cases and rulings use the terms interchangeably. IRS General Information Letter 2002-0021; see, e.g., Bubbling Well Church of Universal Love Inc. v. Comm'r, 74 T.C. 531, 525 (1980), aff'd, 670 F.2d 104 (9th Cir. 1981).
An exempt organization must engage primarily in activities that accomplish one or more of its stated exempt purposes. Triune, 85 T.C. at 53. Only an insubstantial or incidental private benefit is permissible. Rev. Rul. 70-186, 1970-1 C.B. 128. Courts engage in a balancing test between the public benefits and the private benefits to determine whether exempt status is warranted. See Sonora Cmty. Hosp. v. Comm'r, 46 T.C. 519 (1966) (limited charitable care vs. benefit provided to doctors), aff'd, 397 F.2d 814 (9th Cir. 1968); Am. Campaign Academy v. Comm'r, 92 T.C. 1053 (1989) (benefit of campaign education in general vs. benefit to Republican Party).
The prohibition on the inurement of net earnings in whole or in part to private individuals or shareholders is absolute. 1.501(c)(3)-1(c)(2). Inurement may be found even if the benefit conveyed to insiders is relatively small. Founding Church of Scientology v. United States, 412 F.2d 1197, 1200 (Ct. Cl. 1969), cert. denied, 397 U.S. 1009 (1970). Moreover, net earnings may inure to an individual in ways other than by actual distribution of dividends. Unitary Mission Church v. Commissioner, 74 T.C. 507, 512-13 (1980), aff'd, 647 F.2d 163 (2d Cir. 1981).
Conclusion
The IRS permits the awarding of bonuses in a 501(c) tax-exempt organization as long as the employees' total compensation packages are reasonable and in furtherance of the organization's exempt purpose, as determined by the IRS's 12-factor test discussed above. If faced with a decision of whether the organization can distribute an annual bonus, the most important factors for in-house counsel to consider are: the employees' contributions, how the organization's exempt purpose would be furthered by the bonuses, whether the bonuses result from arms-length determinations, and the reasonableness of the employees' overall compensation packages given their responsibilities and locale.
Annual Employee Compensation Questionnaire
The following questionnaire was developed based on the IRS's test of compensation packages in nonprofit organizations. The questionnaire focuses on an individual employee's compensation and responsibilities, as well as the purpose of the organization. Thus, someone with that knowledge should complete the questionnaire. The questionnaire would ideally be used at the end of the fiscal year to consider whether a particular bonus or other incentive payment is appropriate as part of an employee's overall compensation package.
Employee name: __________________________
Employee title: ___________________________
Fiscal year: 20____ - 20____
Total compensation for fiscal year: $_____________ (include base compensation (salary), incentive compensation (bonus), and any other economic benefits conferred from [Organization] to the employee)
Date: _____________________
This form prepared by: ______________________
Does the employee's compensation package:
- Allow [Organization] to maintain and potentially grow the services it provides? Yes__ No__ Take into account measures of the employee's performance? Yes__ No__ Reflect the value of the services provided by the employee? Yes__ No__ Keep [Organization] within budget without charging more for services? Yes__ No__ Reflect the value of the services provided by the employee rather than functioning merely to distribute profits? Yes__ No__ Serve a real and discernable business purpose of [Organization]? Yes__ No__ Reward the employee based on service the employee actually performed? Yes__ No__ Was the employee's compensation package: Established by an independent board of directors or by an independent compensation committee? Yes__ No__ The result of arms' length bargaining (the employee and those determining the compensation are independent of one another and without conflicts of interest)? Yes__ No__ Is the employee's compensation package: Reasonable in terms of the employee's specialty and geographic locale (benchmark data available at http://www.nonprofitstaffing.com/salary-job-reports/, http://www.charitynavigator.org/, and http://www.bls.gov/ncs/)? Yes__ No__ Composed of arrangements with ceilings or reasonable maximums that do not permit unlimited earnings? Yes__ No__ Composed of arrangements that are protected from abuse or unwarranted benefits? Yes__ No__
If the answer to any of the above questions is "no," please explain: