The issues of governance and executive compensation are closely intertwined. We are concerned that the governing boards of tax-exempt organizations are not, in all cases, exercising sufficient diligence as they set compensation for the leadership of the organizations. There have been numerous recent reports of executives of both private foundations and public charities who are receiving unreasonably large compensation packages.
Neither a public charity nor a private foundation can provide more than reasonable compensation. Reasonable compensation is determined with respect to the market value of the services performed and depends upon the circumstances of the case. In general, reasonable compensation is measured with reference to the amount that would ordinarily be paid for comparable services by comparable enterprises under comparable circumstances.
Section 501(c)(3) provides that the assets of an organization cannot inure to the benefit of private shareholders or individuals. If an organization pays or distributes assets to insiders in excess of the fair market value of the services rendered, the organization can lose its tax exempt status. Moreover, insiders of public charities and of private foundations are subject to excise taxes on any overpayments they receive. Although an overpayment to an insider of a public charity could result in a revocation of tax-exempt status, section 4958 of the Internal Revenue Code (Code) provides an intermediate sanction that ameliorates that result in many cases. Under section 4958, an excise tax can be imposed on the insider who received the overpayment and on certain managers who knowingly approved the overpayment.
The payment of excessive compensation to an insider of a private foundation likewise may give rise to excise taxes under section 4941 of the Code on both the insider and on certain managers who knowingly approved the overpayment. In addition, the foundation itself and its managers may be subject to tax on any overpayment under section 4945 of the Code. Although the private foundation rules permit the payment of reasonable and necessary compensation to foundation insiders, most other transactions between a private foundation and its insiders are prohibited outright, without regard to subjective factors such as the reasonableness of the amounts, fair market value of property involved, or whether the transaction benefits or harms the foundation.
IRS Tax Exempt Compensation Initiative: This summer, we are launching a comprehensive enforcement project to explore the seemingly high compensation paid to individuals associated with some exempt organizations. This is an aggressive program that will include both traditional examinations and correspondence compliance checks. The purpose of the project is to enhance compliance by learning what practices organizations use to set compensation; learning how organizations report compensation to the IRS and the public; and creating positive tension for organizations as they decide on compensation arrangements. These organizations need to know that their decisions will be reviewed by regulatory authorities. This project also will have educational components.
We will be contacting hundreds of organizations. During the first stage, we will be looking at public charities of various sizes and private foundations. We will be asking these organizations for detailed information and supporting documents on their compensation practices and procedures, and specifically how they set and report compensation for specific executives. Organizations also will be asked for details concerning the independence of the governing body that approved the compensation and details of the duties and responsibilities of these managers with respect to the organization. Other stages will follow, and will include looking at various kinds of insider transactions, such as loans or sales to executives and officers. We also will be looking at organizations that failed to, or did not fully complete, compensation information on Form 990.
This information will help inform the IRS about current practices of self-governance, both best practices and compliance gaps, and will help us focus our examination program to address specific problem areas.
Private foundation market segment initiative: In the early 1980s, the IRS conducted an examination study of private foundations and concluded that there was a high level of compliance by these organizations. This led to lower audit coverage of private foundations, even compared to the decline in overall audit rates. That information is now dated. In addition, we are seeing a steady growth in what had been a fairly stable sector, now estimated as close to 100,000 entities. As a result, we have not only increased our coverage, we have developed a market segment initiative to learn about compliance issues raised by private foundations. Market segment initiatives are analogous to the National Research Program (NRP) in that they concentrate on a particular unique portion of the tax-exempt community to gauge its compliance with the tax laws. This project will study different categories of private foundations in several phases and ultimately will involve approximately 400 examinations. The goal is to measure compliance levels and ascertain whether anecdotal information, both good and bad, reflects foundation behavior generally. Depending upon what we find, we expect the results to allow us to develop improved enforcement mechanisms, a more focused educational effort, and improvements to Form 990-PF, the annual information return filed by private foundations. This market segment initiative will commence by November 2004.
Terrorist Financing and Charities
Obviously, a key concern is the financing of terrorism through the use of charities. Although that topic is beyond the scope of this hearing, we note that on March 4, 2004, we sent you a letter laying out our FY2005 initiative targeted toward this problem. We look forward to working with the Committee on this issue of national import.