Reasonable Compensation: A Section 4958 Primer

Reasonable Compensation: A Section 4958 Primer

IRS study of colleges and universities spotlights rebuttable presumption deficiencies and future examination focus
Article posted in Compliance on 23 May 2013| comments
audience: National Publication, Dennis Walsh, CPA | last updated: 18 June 2013


Last month the Internal Revenue Service published its final Colleges and Universities Compliance Project report, which included an examination of executive compensation in connection with the excess benefit transaction rules under IRC section 4958. In this article, PGDC contributing author Dennis Walsh, CPA examines the findings of the report and suggests actions to be taken and questions to be asked by nonprofits when setting executive compensation.

By Dennis Walsh, CPA

The highly successful executive director of a federated fundraising agency received a $1.2 million annual pay package. With more than $40 million in funds raised, to some this might have appeared as a reasonable exchange of value for services performed.

The unfortunate firestorm that followed public disclosure of the pay arrangement, however, resulted in a major drop in contributions, with resulting cuts to member agencies, damage to trust in the board of directors, and a costly legal settlement with the terminated director.  This example illustrates why it is so important for those charged with governance of exempt organizations to consider stakeholder perspectives in determining executive pay levels and the peril that may result when oversight doesn’t meet public expectations.

Governing boards of exempt organizations have the formidable task of balancing stewardship of public support with the equally worthy duty to attract and retain the level of management talent needed to maximize mission performance.  And this must be accomplished against the attraction of more lucrative pay levels in the for-profit sector.

Executive compensation has been a hot-button governance issue for exempt organizations in recent years, so much so that the Internal Revenue Service began collecting detailed information about executive pay and how it is determined with the introduction of the revised Form 990 in 2008.

This article seeks to offer practical guidance on the process for determining “reasonable compensation.”  Through a review of key provisions of Section 4958 of the Internal Revenue Code, discussion of some important findings from a recent IRS study, and some observations regarding the governance environment, those in positions of oversight should take away a refreshed perspective on this important issue.


Congress has long been concerned about financial abuses between exempt organizations and those who control them.  Until the 1996 enactment of the intermediate sanction rules of Section 4958, the IRS had no way to curtail such abuses short of the death blow of revocation of tax-exempt status.

Section 4958 imposes penalties in the form of excise taxes as a result of an excess benefit received by certain organization insiders, termed “disqualified persons.”  A disqualified person is someone in a position to exercise substantial influence over the affairs of the organization, such as an officer, director, key employee, family member of such a person, and certain related entities.

The excess benefit rules apply to organizations exempt under Section 501(c)(3) and 501(c)(4), except for private foundations which are subject to self-dealing rules under Section 4941.  Special definitions and rules apply to entities classified as a Section 509(a)(3) supporting organization and donor advised funds.

Wile the term “excess benefit” is most frequently associated with compensation, it generally applies whenever there is an economic benefit provided to an insider that exceeds the fair market value of consideration received by the organization in exchange.  Other common transactions with insiders where an excess benefit may arise include the sale or lease of property, loans, and use of organization property.

When an excess benefit transaction takes place, it must be corrected by returning the benefit, and to the extent possible, restoring the organization to the same position it would be in had the excess benefit not occurred.  A disqualified person who receives an excess benefit from an excess benefit transaction is liable for payment of an excise tax equal to 25% of the excess benefit received.  Further, if the transaction isn’t corrected timely, a second penalty is imposed on such a disqualified person, equal to 200% of the excess benefit.

An excise tax equal to 10% is also imposed on any organization manager, including a volunteer board member, who knowingly and willingly takes part in an arrangement resulting in an excess benefit.  Participating organization managers are jointly and severally liable for payment of such tax, up to an aggregate maximum of $10,000 with respect to any one excess benefit transaction.

Reasonable Compensation

Reasonable compensation is the standard for the valuation of services to be used in applying the excess benefit rules.  The reasonable value of services is the amount that would ordinarily be paid for like services by like enterprises (whether taxable or tax-exempt) under like circumstances.  Section 162 standards apply in determining the reasonableness of compensation.  The rate at which any deferred compensation accrues is taken into account as well.  Treas. Reg. § 53.4958-4 (b)(ii).

Rebuttable Presumption

The Regulations under Section 4958 provide a procedure that may create a rebuttable presumption that compensation paid to an insider represents a reasonable exchange of value.  If the steps described below are properly followed, the burden of proof shifts to the IRS to show that an excess benefit has occurred.  The required steps are: 

1)    The compensation arrangement must be approved in advance by an authorized body* of the organization (i.e. the board of directors or, to the extent permitted by state law, a board committee or other party authorized to act on its behalf) which is composed of individuals who do not have a conflict of interest concerning the transaction 

2)    Prior to making its determination, the authorized body obtains and relies upon appropriate data as to comparability  

3)    The authorized body adequately and timely documents the basis for its determination concurrently with making that determination (by the next board meeting or 60 days after final action is taken, whichever is later)

*While the Regulations permit compensation decisions to be made by a duly “authorized body” of the board for purposes of the rebuttable presumption standard, it is nevertheless prudent that the full board vote on all executive compensation matters.

The documentation of the authorized body must include: 

  • The terms of the transaction that was approved and the date it was approved
  • The members of the authorized body who were present during debate on the transaction that was approved and those who voted on it
  • The comparability data obtained and relied upon by the authorized body and how the data was obtained
  • Any actions taken with respect to consideration of the transaction by anyone who is otherwise a member of the authorized body but who had a conflict of interest with respect to the transaction

Regarding comparable compensation data, the Regulations also provide that in general, relevant information includes, but is not limited to:  

  • Compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions
  • The availability of similar services in the geographic area of the organization
  • Current compensation surveys compiled by independent firms
  • Actual written offers from similar institutions competing for the services of the disqualified person

Safe Harbor for Small Organizations 

For organizations with annual gross receipts of less than $1 million, including contributions, the authorized body will be considered to have appropriate data as to comparability if it has data on compensation paid by three comparable organizations in the same or similar communities for similar services.  In determining eligibility for this provision, the organization may average its gross receipts for the 3 preceding taxable years.  Also, an organization that controls, or is controlled by, another organization must combine gross receipts for this purpose.

Where the use of an outside compensation consultant may not be cost effective or determined to be necessary, informal inquiries made to similarly situated organizations or sufficiently categorized data from published compensation surveys may provide appropriate comparative data.  Such findings may be further supported by localized occupational wage estimates from the U.S. Bureau of Labor Statistics website and from publicly available IRS Forms 990 of similarly situated organizations.

Colleges and Universities Compliance Project (CUCP)

A compliance study that included executive compensation issues pertaining to colleges and Universities was initiated in 2008 by the IRS Exempt Organizations Division.  The IRS issued its final report in April 2013.

Detailed questionnaires were sent to 400 randomly-selected colleges and universities. The IRS subsequently selected 34 of the 400 institutions for examination because their questionnaire responses and Form 990 reporting indicated potential noncompliance in the areas of unrelated business income and executive compensation.  The executive compensation component of the examinations focused mainly on compliance with section 4958.

The CUCP report stated that although most private colleges and universities examined attempted to meet the rebuttable presumption standard, about 20% of them failed to do so because of problems with their comparability data including:

  • Institutions that were not similarly situated to the school relying on the data, based on at least one of the following factors:  location, endowment size, revenues, total net assets, number of students, and selectivity
  • Compensation studies neither documented the selection criteria for the schools included nor explained why those schools were deemed comparable to the school relying on the study
  • Compensation surveys that did not specify whether amounts reported included only salary or included other types of compensation to equal total compensation, as required by section 4958

The final report concluded, in relevant part, that the IRS intends to “ensure, through education and examinations, that tax-exempt organizations are aware of the importance of using appropriate comparability data when setting compensation.”

Practical Implications

Although institutions of higher learning were the subject of the IRS project, there are lessons to be drawn by the exempt sector as a whole for setting executive compensation.  Actions to consider include:

  • Define and rank criteria for identifying similarly situated organizations and document it in advance of the search; don’t leave it to the IRS or another potentially adverse interest, such as local media, to infer the rationale employed if compensation is later scrutinized
  • Document why particular comparative metrics or qualitative criteria were selected, including factors given more weight as well as mitigating reasons for factors given less weight
  • Break it down.  Reasonable compensation is the sum of its separately valued components; e.g. cash salary, health benefits, retirement plan contributions, use of property, etc.
  • If an outside compensation consultant is used, don’t act on the consultant’s recommendations before verifying that such issues are documented in reports provided to the compensation setting body

Setting compensation is not exact science.  Reasonable compensation is drawn from a range of independently supportable value.  The process should take a “bottom up” approach.  Resist the temptation to reverse-engineer current pay structure

Additionally, compensation should be paid or accrued ratably as earned, so that amounts reported on Form 990 represent remuneration for services performed in the year reported.  Reporting back pay or catch-up retirement contributions, for example, as expense of a single year may lead to not only an excess benefit problem, but the type of crisis described earlier.

Assessing the Governance Environment

Here are some questions to consider about the governance environment as it relates to determining compensation:

  • Is the compensation setting body independent of subject employees, as well as any consultants relied upon, both in fact and in appearance?
  • Is a compensation committee ad hoc or standing? If standing, is there prescribed member turnover?
  • Does comparability information from outside consultants or other sources flow directly to the authorized body or is it filtered by management?
  • Are the key reasons underlying compensation decisions documented in pithy and unambiguous language?
  • Is the full board apprised of the work of a separate compensation setting body?
  • Does the full board vote on compensation decisions?
  • Aside from legitimate privacy issues, what is the board’s comfort level with public disclosure of its process, tools employed, and reasoning in establishing pay for executive staff?
  • What is the board’s attitude toward posting executive pay levels on the organization website in advance of filing IRS Form 990?
  • The “$10 smell test” – How might John Q. Public, with the means to contribute $10 to the organization, and being adequately informed, react to current executive pay levels?


The process of setting reasonable compensation should be driven by a quest for the exercise of due diligence and adequate public transparency.  Congress has provided standards, practical guidance, and deterrence against abuse through the enactment of IRC Section 4958.  But in the end, there is no substitute for the collective prudence of an independent and engaged governing body.  The IRS and public stakeholders expect the same.

The author wishes to thank Donald A. Wells, Don Wells Consulting, Inc., Hillsborough, NC, a nationally recognized nonprofit leadership consultant, for reviewing the article.

About the Author

Through The Micah Project, Dennis Walsh, CPA serves as a volunteer consultant to religious workers and exempt organizations, focusing on financial management, legal compliance, and organizational development. A graduate of the University of Wisconsin, he completed the Duke University certificate program in nonprofit management and is a member of the North Carolina Association of CPAs and the American Institute of CPAs.

Dennis is the author of “Legal & Tax Issues for North Carolina Nonprofits” and has written for various nonprofit publications. He actively volunteers with the Guilford Nonprofit Consortium, the Not-for-Profit Committee of the NCACPA, and for the accounting assistance program of the North Carolina Center for Nonprofits.

Mr. Walsh can be reached at

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