New Transparency in Executive Pay
Author's Note: This article is the first of a two-part series addressing the executive compensation challenges arising from the new IRS Higher Education Initiative. The second article will shed light on the potential traps and examination triggers within the revised Form 990 and related questionnaire and discuss successful compliance strategies.
David M. Nygard
Changes to IRS Form 990 will have a profound effect on independent colleges and universities and foundations that support higher education public institutions. The IRS has redesigned Form 990 to shine a light on executive compensation at institutions of higher education. While the new form does not require the depth of discussion mandated for public companies, it will indicate the level at which trustees understand and are involved in and accountable for the process by which executive compensation decisions are made.
Form 990 Background
IRS Form 990 must be completed and filed annually by tax-exempt 501(c)(3) and 501(c)(4) institutions, including independent colleges, universities, and foundations that support higher education public institutions. Developed in 1941, the form collects information on how these tax-exempt organizations operate and makes this information available to the public. Viewed as a stripped-down annual statement and proxy filing rolled into one, Form 990 allows easy access to publicly disclosed information and expansive amounts of information reported and has become a key research tool for potential students, alumni, philanthropic donors, the press, and government officials. In addition, the IRS uses Form 990 filings to identify institutions for examination.
New (2008) Form 990 compensation disclosure requirements for higher education institutions are more in line with what is required of public companies. (See sidebar, "Executive Pay Disclosure at Public Companies: A Model for Higher Education?") The following is a high-level summary of Form 990 changes this year (2008, reported in 2009):
- Compensation for executives, officers, and directors (trustees) is now reported on a calendar-year basis, and more than one year will be presented in each disclosure.
- Disclosures of compensation and perquisites have been greatly expanded for officers, directors, and key employees.
- Disclosures will include compensation paid to officers, directors, and key employees from related organizations.
- The definition of a related organization has been broadened.
- New disclosures must be made of board policies and compensation determination practices.
The new form attempts to serve two primary purposes in the compensation area.
1. It tries to simplify and make transparent the disclosure of executive compensation by obtaining more uniform basic compensation reporting from all organizations, regardless of type or size, in Part VII of the core form.
2. In some instances, it attempts to obtain additional detailed information regarding a listed person's compensation and the organization's compensation practices, particularly in those cases where the organization has compensated one or more persons above certain amounts.
With the exception of questions regarding the executive compensation decision-making process, Part VII of the core form is very similar in structure, layout, and content to the 990s of prior years. Most of the important changes in the 2008 Form 990 are in Schedule J, Compensation Information, which requires detailed compensation information for individuals whose W-2 income exceeds $150,000 or whose compensation with nontaxable fringe benefits and expense reimbursements exceeds $250,000 and for all former officer, trustee, key employee, and highly compensated employees listed on the core form. Schedule J requires a person-by-person breakout of the following:
- Base salary.
- Bonuses and incentive payments.
- Other compensation (i.e., severance, income earned in prior years paid this year, qualified and non-qualified retirement contributions, etc.).
- Deferred compensation.
- Select nontaxable benefits (i.e., housing, education, life insurance, gross-ups, etc.).
- Compensation reported in prior Form 990s.
Parts IV and VI and Schedule J have a series of yes/no checkboxes that require narrative explanations for "yes" responses. This is where the transparency of board policies and executive perquisite disclosure is greatly enhanced. Questions include:
- Does the process for determining compensation include a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision?
- Was there a loan outstanding to or by a current or former officer, director, trustee, key employee, highly compensated employee, or disqualified person as of the end of the organization's tax year?
- Are there interlocking business or family relationships with other organizations?
- Do you have a whistleblower policy?
- Do you have a conflict of interest policy?
- Do you offer reimbursements for first-class or charter travel, spousal travel, tax indemnification and gross-up payments, discretionary spending accounts, housing allowances, business use of a personal residence, health or social club dues, and/or the services of a maid, chauffeur, bodyguard, chef, and so forth?
This is not the first time the IRS has cracked down on tax-exempt organizations. (See sidebar, "Going After Improper Gains From Tax-Exempt Organizations.") By redesigning Form 990, the IRS is beginning to take a closer look at executive pay practices at higher education institutions. Next month's article will shed light on the potential traps and examination triggers within the revised Form 990 and the IRS college and university compliance questionnaire and discuss successful compliance strategies.
Public outrage does not appear to be contained to troubled financial institutions that have awarded substantial bonuses after receiving emergency public funding. A recent article in The Wall Street Journal, "Pay at Nonprofits Gets a Closer Look," prominently featured pay levels within higher education. Tax-exempt organizations are now being asked to provide a more complete description of what executives are paid and the value of the benefits they receive. The combination of enhanced pay transparency in higher education with greater IRS vigilance and public discontent are likely to have a profound impact on executive compensation within higher education in both the short term and long term.
A Move Toward Transparency
The Securities and Exchange Commission (SEC) has a long-standing requirement that publicly traded companies must disclose the compensation paid to the directors serving their boards and to each company's top five executives. This requirement was addressed by compensation disclosures that were generally engineered by attorneys to both meet the letter of SEC disclosure requirements and limit the usefulness of the data disclosed. This changed in 1993 when the SEC altered its compensation disclosure rules to include more detailed disclosure guidelines and uniform disclosure table formats.
Public company compensation disclosure rules were modified again in 2006 to further increase the transparency of top executive pay in the wake of the Enron collapse and the new operating environment that followed the adoption of the Sarbanes Oxley internal control regulations. Proxy statement disclosures in public companies require an in-depth detailed discussion of compensation philosophy, compensatory elements, and decisions made regarding top executive compensation. The executive compensation disclosures of public companies also include detailed discussions of how performance incentive plans (i.e., measures, payout opportunities, participation breadth, etc.) and projected severance payments work in the event of an executive's termination or a change in corporate ownership.
In this, the third year under the new executive compensation disclosure rules, it would be difficult to argue that disclosure has played a role in slowing the escalation of executive pay levels. In fact, contrary arguments have been developed, especially for industries where boards routinely target pay levels at or above 50th-percentile observed levels. The recent changes in the economy and resulting political environment appear to have a much greater potential impact in capping executive pay in this and future years.
Executive pay transparency for publicly traded companies, however, has had a profound impact on incentive bonus design. The ability to analyze the incentive plan approaches and the mechanics used by direct competitors and aspirant organizations has prompted many companies to adopt and/or modify the incentive pay structures within their own companies.
In 1996, Congress enacted IRC Section 4958, the intermediate sanction on excess benefit transactions (EBTs). This section of the tax code was finalized in 2002. Intermediate sanctions allow the IRS to impose excise taxes on individuals (termed "disqualified persons"), institutions, and managers in the event of a transaction or series of transactions deemed to have received an improper gain from a tax-exempt organization. The only way the IRS could address EBTs prior to the enactment of Section 4958 was to revoke the organization's tax-exempt status or ignore the problem. The excise taxes that apply to EBTs can be significant (from 25 percent to 200 percent of the excess amounts identified), especially in cases where these transactions are not corrected in a timely manner.
These intermediate sanctions also contain an important protection for disqualified persons and organization managers: a rebuttable presumption that compensation levels are reasonable. Once invoked, a rebuttable presumption has the effect of shifting the burden of proof that a transaction is an unreasonable EBT from disqualified persons and tax-exempt organizations to the IRS. (The structure and requirements in establishing this rebuttable presumption will be discussed in detail in the second article in this series.)
In 2002, the IRS' Tax Exempt and Government Entities, Exempt Organizations Division (EO) created an Intermediate Sanctions Committee to coordinate the interpretation and enforcement of the code. It launched an Executive Compensation Compliance Initiative in 2004 to review the compensation practices within tax-exempt organizations and identify potential tax administration concerns and areas of abuse. The EO also initiated compliance projects for credit counseling, hospitals, and community foundations. These initiatives have created a number of issues:
- The instructions for completing Forms 990 are difficult to understand, which can lead to filing errors.
- Many tax-exempt filers have experienced significant compensation reporting errors and omissions requiring the amendment of past returns.
- The favorable terms and lack of repayment of loans offered to officers and employees are a source of significant concern, since many could be considered EBTs.
The collective findings from these initiatives led to the collection of millions of dollars in excise taxes. These compliance initiatives and the prospect of collecting additional taxes is the foundation used by the EO to restructure the format and definitions of Form 990. These changes have also been echoed in the questionnaire used by the EO to launch its Higher Education Initiative.
The IRS Higher Education Compliance Project
The EO launched the College and University Compliance Project in October 2008 when it sent a 33-page questionnaire (Form 14018) to approximately 400 small, midsize, and large independent and public four-year colleges and universities. The 33-page questionnaire contained 94 questions presented in four parts:
- Part 1 - Organization Information (22 questions; 6 pages).
- Part 2 - Activities (10 questions; 13 pages).
- Part 3 - Endowment Funds (27 questions; 5 pages).
- Part 4 - Executive Compensation (35 questions; 8 pages).
All executive compensation questions pertained to the six highest-paid officers, directors, trustees, and/or key employees for the 2006 calendar year. The questionnaire was essentially an expanded version of Schedule J in the new Form 990 and applies to the calendar year 2006. Nearly two pages (13 questions) of Part 4 (executive compensation) were devoted to loans and extensions of credit to officers. Significant attention was also focused on how compensation comparisons are conducted (if at all) and the filters used to select peer groups or survey data compensation comparison points.
The IRS recently published the results of a similar exercise for tax-exempt hospitals. A questionnaire was sent to a targeted group of hospitals, and an in-depth analysis was released on how these organizations serve public needs and on their executive compensation practices. The 178-page report of final project findings, which was released in February, stated: "Nearly all of the hospitals in the study reported complying with important elements of the rebuttable presumption procedure." Average and median pay generally increases with revenue size. The top 20 hospitals had average and median total executive compensation amounts of $1.4 million and $1.3 million, respectively. This prompted calls in the media for the elimination of the "rebuttable presumption" safe harbor, increased executive pay legislation, and even increased action from state attorneys general.