Senate Finance Committee Considers Changes in Governance reporting Requirements and Intermediate Sanctions Rules on Compensation

The Senate Finance Committee has just completed debate of its version of health reform legislation, America's Healthy Future Act. During the bill's mark-up, Senator Charles Grassley (R-IA), Ranking Member of the Committee, offered two amendments to the legislation that are significant to tax-exempt institutions of higher education. These legislative proposals pertain to the obligation to complete governance questions on the IRS' new Form 990 and the legal protection available to tax-exempts that follow an IRS-approved process for demonstrating that compensation is reasonable. While Senator Grassley ultimately pulled both amendments and they were not voted upon by the Committee, he has indicated that he is reserving the right to bring them back in future tax legislation. It does not appear at present that these amendments will resurface in any of the health reform bills now before the Congress.

The first legislative amendment proposed by Senator Grassley was intended to ensure that tax-exempt organizations fully report governance information on Form 990 as part of their annual reporting requirements to the Internal Revenue Service. As AGB has previously reported,1 the primary focus of the Internal Revenue Service's new Form 990 is transparency about governance and operations. Key questions on the new form cover topics such as relationships between directors, conflicts of interest and whistleblower policies, and executive compensation review procedures. In the IRS' view, while asking these questions (with the implicit approval of affirmative responses) does not mandate that particular governance practices be adopted in order to comply with the law, the IRS nevertheless has the right to ask these questions in order to achieve maximum transparency regarding nonprofit governance. The IRS believes it has the general authority to ask these questions under a catch-all provision of the Internal Revenue Code that gives broad authority to the Secretary of the Treasury to request additional information. Senator Grassley is concerned that there have been real or threatened challenges regarding the IRS' authority to obtain this information. The proposed amendment would protect the IRS from what Senator Grassley labeled "wasteful legal challenges" by adding language to the Internal Revenue Code to make clear that the IRS may require governance and management information be reported in annual filings.

The second amendment proposed by Senator Grassley would remove a safe harbor available to tax-exempt organizations with respect to proving that compensation of executives is at reasonable levels. Under the common law, a legal process for securing the "rebuttable presumption of reasonableness" provides a defense that governing boards and management have properly determined reasonable compensation for purposes of complying with the Internal Revenue Code's prohibition of excessive compensation by tax-exempt organizations. This process consists of review of compensation by an independent board or board committee; obtaining and relying upon objective evidence that the compensation is reasonable; and recording the results of this process in the records of the organization. The rebuttable presumption is well established in IRS regulations and this process is specifically queried about in the new Form 990. The IRS uses its "intermediate sanctions" rules to enforce these provisions by requiring repayment of excess benefits and applying a substantial excise tax on the individuals who are overcompensated by the exempt organization. The Senator is apparently concerned that excessive compensation is occurring in exempt organizations as a result of their use of the shield of the rebuttable presumption. In his statement in support of the amendment, Senator Grassley alleged that the IRS' recent study of executive compensation showed that compensation was very high even though most all of the organizations had complied with the rebuttable presumption procedures. He further alleged that Committee staff had encountered abuse of the rebuttable presumption procedures in the tax-exempt sector and that the safe harbor was used to justify paying compensation comparable to that earned by executives in the for-profit world, even when they had nothing in common with the tax-exempt organization. The amendment as proposed would remove the safe harbor aspects of the rebuttable presumption while retaining its due diligence requirements. In other words, exempt organizations would still be required to go through the three steps, but this would not provide any legal protection for them with regard to demonstrating that the compensation at issue was reasonable in nature. The Senator cited a 2005 report of the Joint Committee on Taxation, as well as the June 2005 report of the Panel on Nonprofit Sector, as making a similar recommendation.

Analysis

With respect to the amendment giving the IRS legal authority to require governance information on the Form 990, this change would not appear to have much impact on the practices of higher education institutions. Those institutions that are required to file the Form 990 are, in AGB's experience, being fully compliant in their responses on the governance questions, even in cases in which the institution follows different governance practices than those asked about in the Form 990. AGB feels strongly that while the IRS has the legal authority to inquire about governance practices on the Form 990, these questions should not establish de facto requirements for good governance procedures. AGB and other nonprofit governance-related organizations have done extensive work in this area and will continue to advocate to the IRS for consideration of a broad range of good governance prractices in their review.

As for the removal of the rebuttable presumption safe harbor, this may have greater impact on the higher education sector.; However, AGB does not believe that passage of such a measure would result in a significant change in the governance practices of colleges and universities. As noted, the due diligence process of independent board review, relying on comparables, and reporting the information in the organization's records would be retained as a requirement under the law, and indeed represents a good governance practice for board oversight of executive compensation. Moreover, the IRS specifically inquires whether organizations follow these processes in the new Form 990. Typically, the rebuttable presumption only has utility in challenges under the immediate sanctions rules and in litigation. These challenges, while important, are infrequent.

AGB believes that colleges and universities should continue to follow the rebuttable presumption process. Should the IRS become more aggressive in challenging compensation as a result of colleges and universities losing the protection of the rebuttable presumption, this process will nonetheless put these institutions in the best position to mount a defense of their executive compensation. Combined with the new transparency regarding compensation that is a hallmark of the new Form 990, boards will be able to amply demonstrate that their compensation review process is an effective one.

AGB will continue to monitor the future proffering and passage of these proposed amendments. Stay tuned for further developments.

1Trusteeship, Thomas K. Hyatt, "New Form 990 Will Follow Your Functions," January/February 2008; Thomas K. Hyatt, "Show Me What I'm Looking For: A Trustee's Guide to Reviewing the New IRS Form 990," July/August 2009.

October 12, 2009