Nonprofit Compensation and the IRS

Washington Monument September 2011, Catherine M. Pennington, CPA, Senior Manager, Renner and Company, CPA, PC
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Compensation is always a topic of interest to the IRS, even more than usual during 2011.     The Tax Exempt and Governmental Entities Division of the IRS has included compensation in its 2011 Workplan as a result of its reviews of Forms 990 filed in prior years.

The 2011 Workplan highlights several areas scheduled to receive particular attention during the year.    These areas include Wage and Annual Reporting, Executive Compensation, and Worker Classification.

Wage and Annual Reporting

The emphasis on Wage and Annual Reporting reflects the increasing ability of the IRS to match information provided by Nonprofit Organizations on various payroll tax returns with the annual Form 990.     Among the forms to be matched are:  Forms 941 (Employer’s Quarterly Federal Tax Return) and W-2 (Wage and Tax Statement), Forms 990 (Return of Organization Exempt from Income Tax) and 941, and Forms 990 and 940 (Employer’s Annual Federal Unemployment Tax Return).

Through its reviews of returns filed in recent years, the IRS has found that Nonprofit Organizations are not always consistent in the filing of these returns.    For example, if an organization files Forms W-2 for its employees, then the IRS would expect that quarterly Forms 941 would have been filed to reconcile the quarterly payroll tax payments made and the related wages.   Unfortunately the IRS has found enough instances for which this is not the case for the comparison to be an item of interest.

Similarly the IRS expects that those Organizations showing salaries expense on the Form 990 to have filed the related Forms 941 and 940 (not applicable to 501(c)3 organizations).

This interest in payroll tax returns reflects the importance of payroll taxes to the total amount of revenue collected by the IRS.     According to a survey of 2008 returns, 45% of revenues collected came from individual income taxes and 36% came from payroll taxes.  Payroll taxes in this instance include FICA, Medicare and federal unemployment taxes, but not individual income taxes withheld.    Because payroll taxes are such a significant source of revenue to the federal government, the IRS is focusing heavily on these taxes for 2011.

Executive Compensation

Another area of IRS focus in 2011 is Executive Compensation.     The revised Form 990 reflects this area of interest by both adding a supporting schedule (schedule J) to allow for more details concerning Executive Compensation, and also by expanding the number of organizations that need to provide details on Executive Compensation.   This information was previously required only of 501(c)3 organizations but may now be required of all entities filing a Form 990.     The IRS is especially interested in compensation to disqualified persons.

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A disqualified person is one who can exercise significant influence over a nonprofit organization’s operations.     Disqualified persons include board members, CEOs and CFOs and other top executives who can similarly influence the organization’s operations.     The reporting of compensation to these persons requires the utmost care.

Nonprofit organizations are often unsure of whether various items should be counted as compensation.    Cash salary payments are, of course, compensation but questions often arise concerning various fringe benefits.     The basic answer is that all fringe benefits paid to, or on behalf of, any employee are taxable unless specifically excluded by the Regulations.      A listing of theses exclusions can be found in IRS Circular E, Employer’s Tax Guide.

The 2011 IRS Workplan reveals that one specific area of attention in the area of compensation is loans to executives.      A properly documented, arm’s length transaction will generally not cause any issues but one that is not properly documented, contains below market rates, does not have or follow a repayment schedule or is not adequately secured may be recharacterized as compensation to the executive.      The real danger here is that because the loan was not properly reported as compensation, it automatically becomes an excess benefit and can result in intermediate sanctions against the tax exempt organization.

Inclusion of the fair market value on the worker’s Form W-2 is the proper reporting of any benefit not specifically excluded by the Regulations.

Worker Classification

The classification of workers are either employees or independent contractors is a puzzle than has gone on for years.     It generates a lot of interest by employers, employees and the IRS.      At stake are the employment taxes the IRS prefers to collect from employers and also the employee benefits that are denied those workers classified as independent contractors.

In the past, the IRS put forth a list of twenty questions that were designed to lead towards a correct classification of a worker.    None of the questions led to a definitive answer, but they were designed to allow the employer or worker to come to a reasonable conclusion.    Those twenty questions have been distilled into three areas that address the heart of the issue.     Those three areas are behavioral control, risk of financial loss and nature of the relationship.

Behavioral control addresses the how a job or project is to be done; not the what.    For example, if a company or organization has the right to tell the worker how to do a job, (even if it doesn’t exercise this right) behavioral control exists and is evidence of an employer/employee relationship.   If the company or organization provides the tools and facilities, tells the worker when and where to do the work or provides the necessary training to perform the work to the company’s liking, then it is probably an employer/employee relationship.     As with the original twenty questions, there is no one factor that will definitively define the worker’s relationship.      Evidence from each of the three areas must be weighed to determine the appropriate classification.

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The risk of financial loss goes straight to the heart of the status of an independent contractor.     If the worker can incur a financial loss, then this factor heavily favors classification as an independent contractor.     Specific items that may point towards an employer/employee relationship would be if the company pays the expenses related to the work or provides employee-type benefits.   A factor that would tilt the evidence toward an independent contractor is whether the worker made a significant financial investment in equipment, training or facilities.

The third area to be considered is the nature of the relationship between the worker and the company or organization.      A written contract that addresses the relevant terms of the job can be beneficial but, as previously mentioned, is not the sole determining factor in the classification of the worker.  Other factors to be considered are whether any employee-type benefits are provided and the permanence of the relationship (generally an employee is hired without a term limit).

If, after careful consideration, a worker’s classification is still unclear, the IRS can be petitioned to give a determination.       This petition is made on a Form SS-8.  While that petition is being processed, the  company has a safe harbor from penalties, if the final determination is found to be different than the current treatment of the worker.

The penalties for incorrect classification are heavy.      Any company that misclassifies an employee as an independent contractor is liable for all the missed withholding taxes and employer taxes.      Recovery of those taxes from the misclassified worker is not always possible.

The IRS has always been interested in payroll and compensation issues.     In the 2011 Workplan the IRS continues this emphasis for the nonprofit community, and will likely do so in the future.     Proper reporting and classification of workers will avoid unnecessary issues with the IRS.  ∆

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