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Trusteeship Magazine

Preparing for an IRS Audit of Executive Compensation Decisions

By Raymond Cotton
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In October 2008, the Internal Revenue Service chose 400 public and private colleges and universities to participate in a “compliance project” that examined, among other areas, their respective executive compensation packages. Responses were made by 387 institutions, with the 13 institutions failing to respond being designated for further examination. Among those that did respond, the IRS chose a subset to audit based upon their responses.

Accordingly, we are seeing more audits of presidential compensation packages than has been the case in past years. Since boards of trustees make the final determination regarding such matters, they need to take the lead in ensuring adherence to decision- making practices that are approved by the IRS and that comport with best practices.

In 1996, Congress added section 4958 to the Internal Revenue Code, commonly referred to as “Intermediate Sanctions.” Previously, the IRS was limited in what actions it could take if a nonprofit institution overpaid its CEO (or, in IRS parlance, granted that CEO an “excess benefit”). The IRS could remove the organization’s tax exemption or do nothing at all. Today, the IRS can fine both the board that approved the excess benefit and the recipient thereof, and compel the executive who received the payment in question to return the “excess amount.”

Once the IRS notifies an institution that it will be subject to an audit, the college should retain both a trusted accounting firm and a qualified legal team to respond to the IRS’s inquiries and, ultimately, to its assertions/demands. The IRS may send a team to the campus to conduct a review of (typically) hundreds of files and possibly to interview both administrative staff and trustees themselves. For these reasons, the board should follow closely the provisions of Intermediate Sanctions which provide “safe harbor” protections for the board and the president. These steps include the following:

  1. The board, which typically does not have professional expertise in nonprofit compensation matters, should retain an independent consultant with experience in analyzing compensation for presidents and senior administrators in higher education.
  2. The board should direct the consultant to conduct a comparable compensation study for the purpose of obtaining information about the current marketplace regarding presidents of similar colleges. It is essential that the board’s decisions in this area be based upon current marketplace data.
  3. The board (or its designated compensation committee) should review and discuss the report with the consultant to make sure that members fully understand the data presented and its implications for their institution. The minutes from meetings addressing executive compensation should reflect not only the review of comparable data, but also concerns relating to the decisionmaking process, such as performance assessment and any conflicts of interest within the board on the proposed comp package (in which case, such member of the board should refrain from participation in any voting or discussions of this process).
  4. After these steps, the board or the compensation committee is in a position to make decisions as to the president’s package and can address the following elements: 1) base salary; 2) deferred compensation; 3) bonuses (if any); and 4) other matters such as presidential housing, spousal compensation, or tuition for children, etc.

All of the above recommended documentation and the report of the compensation consultant should be kept in a safe place in the event of an IRS audit so that the institution can claim the safe-harbor protections of Intermediate Sanctions law.

In the event that a college is already subject to an audit prior to instituting these measures, it is important that steps are taken to limit exposure. College and university audits are very different from other examinations conducted by the IRS. For that reason, the IRS auditors themselves may not be familiar with the appropriate compensation data, and boards should be armed with the necessary expertise to respond to assertions of the IRS and should maintain that the audit be limited to the tax years in question.

As in all matters undertaken by the board, adhering to best practices is highly advised.



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