Compensation Issues for School Heads Reviewed and Updated for NAIS by Howard Silver and Margaret de Lisser, Hogan Lovells U.S. L.L.P. Compensation provided to School Heads continues to receive scrutiny, coming in such forms as Congressional hearings, mandatory disclosure of certain compensation packages, and the IRS ever-evolving positions on the tax treatment of certain types of compensation. This increased scrutiny extends well beyond base salary to the various types of fringe benefits and deferred compensation that heads often receive. To help your school provide benefits to heads at a reasonable level, and, in the process, without generating an income tax liability for the employee, NAIS and NBOA offer the following series of questions and answers about certain types of benefits and tax concerns they may raise. Please note that this publication provides neither a comprehensive description of all relevant tax rules nor a complete listing of all possible benefits; rather, this publication focuses on benefits that are either popular or problematic. Tax-Exempt Status and Intermediate Sanctions The principal concern in setting head compensation is that overall compensation be reasonable: the head should receive an adequate but not excessive reward for his or her efforts. A school providing excessive compensation risks losing its tax-exempt status. This draconian penalty, however, is rarely invoked by the IRS; instead, overcompensated heads and the school administrators who approved the excessive compensation risk excise tax liability under the intermediate sanctions regime. A summary of the intermediate sanctions rules follows. What are intermediate sanctions? Intermediate sanctions impose a 25% excise tax on any disqualified person (that is, on any individual properly viewed as an insider under these rules), such as the head, who 1
is in a position to exercise substantial influence over the school) receiving an excess benefit (more than fair market value or reasonable compensation) from the school. If the excess benefit is not repaid or otherwise restored to the school within a certain amount of time, the disqualified person is subject to an additional 200% tax. A tax of up to 10% or $20,000, whichever is less, is also imposed on any school manager (officer, director, or trustee) who knowingly and willfully approves (or fails to vote against) the excess benefit arrangement. Are all heads disqualified persons for intermediate sanctions purposes? Yes. By regulatory definition, individuals who implement decisions of the school s board or who otherwise supervise the management, administration, or operation of the school, are automatically categorized as disqualified persons. Voting members of the school s board and individuals who manage school finances (such as a treasurer or business officer) also fall within the class of automatic disqualified persons. What about the head s family? The head s family members (spouse, ancestors, siblings, and descendants and their spouses) are also categorized as disqualified persons. Similarly, the class of automatic disqualified persons includes entities (corporations, partnerships, trusts, or estates) in which the head directly or indirectly holds a 35% interest. It is essential, then, that your school carefully reviews benefits provided to those family members or entities to ensure that they are reasonable. What is an excess benefit transaction? An excess benefit transaction is any transaction, compensation arrangement, or the like in which the school provides a disqualified person such as a head with an economic benefit having a value greater than that of the consideration the school receives in return. An excess benefit can result from a direct transaction between the school and the disqualified person or from an indirect transaction between the disqualified person and an intermediary or an entity controlled by the school. What types of compensation can create an excess benefit transaction? Salary, fees, bonuses, severance payments, vested deferred or non-cash compensation, certain liability insurance premiums or indemnification payments, and certain fringe benefits will generate an excess benefit transaction if, in the aggregate, they provide the head with unreasonable compensation. Section 132 fringe benefits, such as schoolprovided equipment and qualified transportation or parking, specifically are not taken into account under the intermediate sanctions regulations. Reimbursements paid 2
pursuant to a Section 62 accountable plan are similarly excluded by regulation. Many of the most popular fringes, however, including on-campus meals and housing, educational assistance programs, and tuition remission plans, must be included in determining whether the head s overall compensation constitutes an excess benefit transaction. How can my school protect against intermediate sanctions? Your school may establish a rebuttable presumption that the head s compensation is reasonable and therefore does not provide an excess benefit under the intermediate sanctions rules by following a three-step safe harbor procedure. First, the compensation package (including benefits as noted above) or other economic transaction must be approved by your school s governing board or a committee (or other delegate) thereof that is entirely independent of the disqualified person being compensated or otherwise involved in the economic transaction, so that no members of the board or committee (or their delegates) have a conflict of interest (including family, employment, or other financial relationships with the head). Second, the board or committee must rely on comparable data (including independent appraisals, written offers, and independent compensation surveys of functionally comparable positions at similarly situated schools) to determine whether the compensation or other economic transaction is reasonable. Finally, the board or committee (or their delegates) must adequately and timely document the basis for its decision in minutes or other records that describe (i) the terms of the compensation package or economic transaction and date of approval, (ii) the individuals who were present during the discussion of and/or vote on the compensation package or other economic transaction, (iii) the source and substance of the data relied upon, (iv) the actions taken with respect to any conflicts of interest (e.g., recusal of a board member with such a conflict), and (v) if the approved compensation or other economic transaction is above or below the comparables, the reason for the discrepancy. Establishment of the rebuttable presumption does not automatically mean that compensation paid is reasonable (i.e., not excessive), but it does shift the procedural burden of proof as to reasonableness from the school and head, on the one hand, to the IRS, on the other hand. Given the highly factual nature of these determinations, this shift in the burden of proof can be significant. Can bonuses be included in the safe harbor review? Yes, in certain cases. If the bonus is subject to an upper limit (e.g., up to $10,000 or 10% of base salary), the board or committee can obtain safe harbor protection for the bonus if 3
they find that the maximum amount (in addition to all other included compensation) is reasonable. If the bonus is entirely discretionary, however, it cannot be shielded by the safe harbor procedure until the dollar amount or formula for determining the dollar amount becomes fixed. What if my school doesn t, or can t, follow the safe harbor procedure? If head compensation is not or cannot be approved in accordance with the safe harbor procedure, an excess benefit transaction will not necessarily occur; your school and the head simply will not enjoy the procedural benefit of the rebuttable presumption. As noted above, absent the rebuttable presumption of reasonableness, the procedural burden will be on the disqualified person and the school to affirmatively demonstrate that the compensation or other economic transaction involving the school is reasonable. They will not be able to require the IRS to first establish that such compensation or other transaction was unreasonable and provided an excess benefit. Because the safe harbor rule only shifts the burden of proof on a procedural basis, even where the safe harbor has been put in place it is still possible that the IRS will be able to establish that head compensation or other economic transactions between the school and its head have resulted in unreasonable compensation. In these circumstances, the IRS would find an excess benefit transaction, and the excess benefit would be subject to intermediate sanctions excise taxes. In any event, the revised Form 990 (at Part VI.B of the core form) now asks an organization if its process for determining senior management compensation includes the steps that, in effect, establish the rebuttable presumption; and, if so, to describe the process. While not an affirmative requirement, an organization that does not answer this question in the affirmative may be at some greater risk (albeit, an unquantifiable one) for an IRS audit of its return. Fringe Benefits In addition to ensuring that the head s overall compensation, including fringe benefits, does not generate an intermediate sanctions excise tax, your school will also want to ensure that those fringes are provided free of income tax whenever possible. The tax-free requirements for a number of the most popular benefits are summarized below. For a more detailed description of the tax treatment of various fringe benefits, see The Tax Treatment of Employee Fringe Benefits, available from NAIS. 4
Can my school provide housing to the head (and family) on a tax-free basis? Yes, if four requirements are met. First, the housing must be located on school premises, which generally means on the main campus. Second, the housing must be provided for the convenience of the school -- that is, for a substantial business reason other than to provide the head with additional pay. Third, the school must require the head to live in the housing as a condition of employment, to enable him or her to properly perform his or her duties (e.g., if the head is required to be available for duty at all times or if he or she could not perform his or her duties unless such housing is furnished). Finally, the housing must be provided in-kind. Housing provided by the employer-school will not qualify for tax-free treatment if the head is given the option to receive additional compensation in lieu of housing. What if my school doesn t, or can t, meet the four requirements for on-campus housing? In that case, the head (and family) may still enjoy tax-free housing located on, or in the proximity of, the school s campus if he or she pays rent (for a year) equal to at least 5% of the fair market value of the housing. My school wants to purchase a house, or to make a down payment or regular mortgage payments, for the head. Is that taxable? Yes. Any school-provided housing that does not meet the requirements noted above, or for which the head does not pay rent, is taxable. If the head is given an ownership interest in the house, the full value of that interest is considered taxable compensation. Can my school make a tax-free loan to the head? Yes, if the loan falls into any of three categories: (i) the loan does not exceed $10,000; (ii) the loan qualifies as an employee relocation mortgage loan and is used to purchase a new residence; or (iii) the loan qualifies as an employee relocation bridge loan made while the sale of the head s prior residence is pending (and payable in full within 15 days of such sale). If the loan does not fall into one of these categories, the head will be taxed on the difference between the applicable federal interest rate and the actual interest rate (if any) paid by the head. An alumnus donated a beach house to my school. Will the head be taxed if he or she uses it as a weekend retreat? Yes, unless the head is using the beach house for school purposes (for instance, to host prospective donors or a working session for the board). Personal use of the premises must either be treated as taxable compensation or paid for by the head. 5
Can my school provide on-campus meals to the head (and family) free of tax? Yes, so long as those meals are provided for the school s convenience that is, for a substantial business reason (for example, to provide students and faculty with informal access to the head in the dining hall). Alternatively, the school may reimburse the head s meal expenses if he or she must work unusually early or late hours to adequately fulfill his or her responsibilities (e.g., prolonged hours during alumni reunions). What about school-provided transportation -- is that taxable? No, as long as school-owned vehicles are used primarily for school purposes (e.g., visiting donors) and only incidentally for personal purposes. Non-incidental personal use, such as use of a school car for weekend getaways or for day-to-day commuting, is taxable unless the head reimburses the school for the personal use. If instead the head uses his or her own car to perform school duties, he or she may be reimbursed for that use on a tax-free basis. In addition, for 2013, a school may provide tax-free up to a maximum of $490 per month, which includes up to $245 per month worth of combined transit passes and commuter van services and up to $245 worth of parking near the school or near a train station or other location from which the employee commutes by mass transit or car-pool. A school may also provide tax-free reimbursement for bicycle commuting expenses (including reasonable expenses for the purchase and repair of a bicycle, bicycle improvements, and bicycle storage) of up to $20 per qualified bicycle commuting month. A qualified bicycle commuting month is any month in which the employee regularly uses a bicycle for a substantial portion of his or her commute to the school and does not receive a transit pass, commuter van services, or parking benefits. When can my school cover the head s travel expenses on a tax-free basis? The school may cover the cost of the head s business travel, either directly or by providing cash advances or reimbursements for properly documented expenses. Nonbusiness travel expenses, including additional costs incurred if the head tacks on a day or two of vacation at the end of a business trip, are taxable if paid by the school. Additional travel costs for family travel are generally subject to tax unless the family s presence served school purposes -- for example, if the head s spouse made a presentation to donors at a fundraising event. What kind of educational expenses can my school provide to the head free of tax? The school may provide up to $5,250 free of tax to cover the cost of tuition, books, and fees for the head. This benefit cannot be limited to highly compensated employees. If the educational activities are significantly related to the head s duties (e.g., attending a 6
seminar on recent legal developments affecting schools), the school may cover the head s full costs (including meals, lodging, and transportation), regardless of the type of education or the dollar amount of the expenses. What about educational benefits for the head s family? The school may also provide the head and his or her spouse and children, free of tax, tuition reduction at the school itself or tuition remission at another educational institution for education at the undergraduate level or below (with the exception of certain graduate students who are teaching or research assistants). This benefit also cannot be restricted to highly compensated employees. There is no legal limit on the dollar value of this benefit; however, the school may wish to impose an upper limit on a per-employee basis to ensure that an excessive amount of tuition is not waived in any one year. Because these educational benefits must be included in the intermediate sanctions analysis, an upper limit may serve to protect the head from excise taxes as well. Can my school pay the head s country club dues on a tax-free basis? Generally, no. School-subsidized dues or membership fees for social clubs, such as country clubs, are taxable except to the extent that the head can demonstrate that the membership is used for school purposes (for instance, to meet with the parents of prospective students). All personal use is taxable. In contrast, the school may pay for the head s membership in professional associations or in civic or public service organizations (such as the local Lions Club) free of tax. Non-Qualified Deferred Compensation Fringe benefits are not the only type of compensation that raises potential tax issues. Nonqualified deferred compensation, often referred to as a 457 plan, can provide tax-deferred benefits to heads and other top administrators above and beyond that permitted under standard 401(k) or 403(b) plans -- but only if certain requirements are met. What do we mean by non-qualified deferred compensation arrangements? Any arrangement which results in deferring income for income tax purposes is a deferred compensation arrangement. Qualified deferred compensation arrangements are retirement plans such as 403(b), 401(k), and pension plans which are regulated by very strict requirements (e.g., amount deferred, nondiscrimination, etc.). Generally, any other type of deferred compensation plan is a non-qualified deferred compensation arrangement. 7
Why is there special treatment for non-qualified arrangements sponsored by tax-exempt organizations? Taxable entities deduct compensation in connection with calculating their taxable income. If a taxable entity permits an executive to defer compensation, its current taxable income is increased since it cannot deduct the executive compensation until received by the executive. Since tax-exempt organizations aren t concerned about the timing of tax deductions for compensation paid to its executives, there is no incentive to restrict the amount of compensation deferred or the payout methods. To address this difference, the government enacted Section 457 of the Internal Revenue Code, which regulates non-qualified deferred compensation programs sponsored by tax-exempt organizations. What are the most common non-qualified deferred compensation arrangements for taxexempt organizations? The most common programs are 457(b) plans ( eligible plans ) and 457(f) plans ( ineligible plans ). What is an eligible plan? An eligible plan is somewhat similar to 401(k) and 403(b) plans. That is, a participant can reduce current compensation and contribute that amount to the plan. Nongovernmental tax-exempt organizations must limit participation in these plans to the top hat group. This means that only the highly compensated management employees may participate in eligible plans or else certain ERISA requirements will apply (e.g., eligibility, vesting, etc.). Prior to recent changes in the law, contributions to these plans were reduced by contributions to 403(b) and/or 401(k) plans; thus, eligible plans were of little use. Now that contributions are not reduced by contributions to those other plans, many tax-exempt organizations are offering eligible plans to their top hat employees. Unlike either a 403(b) or a 401(k) plan, amounts held in an eligible plan are subject to the tax-exempt s creditors. What are the contribution limitations of an eligible plan? A participant s pre-tax elective deferrals plus any contributions made by the tax-exempt employer (e.g., matching contributions) cannot exceed the lesser of 100% of the participant s compensation or the annual limit. For the 2013 year, this annual limit is $17,500. Also, in the case of a plan maintained by a governmental tax-exempt organization, the plan may permit catch-up contributions for participants age 50 or 8
greater (generally $5,500 in 2013 or a separate provision allowing increased deferrals during the three years prior to retirement). This age 50 catch-up contribution is not available to a participant under a non-governmental 457(b) plan. When are amounts in an eligible plan taxed? Generally, participants are taxed on their accounts when the amounts are made available to them. This is generally upon separation of service (e.g., termination, retirement, etc.). What is a 457(f) or ineligible plan? Since the amounts that can be deferred under qualified retirement plans (e.g., 403(b) plans) or eligible plans are limited, tax-exempt employers may establish other 457 plans to which a highly paid executive can defer compensation. Generally, an ineligible plan is any deferred compensation plan that does not satisfy the eligible plan rules (e.g., amounts contributed in excess of the eligible plan contribution limits). The most important difference between an eligible plan and an ineligible plan is that amounts deferred into an ineligible plan are taxed to the participant when no longer subject to a substantial risk of forfeiture. At the moment the deferred compensation is not subject to this risk (that is, at the moment the deferred compensation vests), it becomes taxable. What is a substantial risk of forfeiture? A substantial risk of forfeiture exists when the executive s rights to the compensation are conditioned on the future performance of substantial services. A substantial risk of forfeiture must impose a significant limitation or duty that will require a meaningful effort on the part of the executive to fulfill. The deferral will only work if there is a true risk that the executive could lose the benefit by not fulfilling his obligations under the agreement. For example, a risk of forfeiture might include a requirement that the executive work until a specified date or retirement, death, or disability. If the executive terminates prior to one of these dates, he or she forfeits 100% of the deferred amounts. Are there ways around the substantial risk of forfeiture rules? Generally, amounts deferred in excess of the eligible plan rules are subject to the risk of forfeiture rules. However, certain plans are not subject to these rules; for example, bona fide severance plans. Unfortunately, these other plans have not been well defined. A severance plan will only pay a benefit on account of involuntary termination of employment (usually, without cause), and in some cases for constructive termination. Also, some organizations have used certain insurance arrangements and discounted options to provide benefits which they believe may not be subject to the 457 rules. 9
Recently, the IRS has announced certain positions with regard to these plans which may affect the use of these arrangements. Certainly, you should seek the advice of competent tax and legal counsel whenever establishing 457 plans. Are there other restrictions on a 457(f) or "ineligible plan"? Yes. Section 409A of the Internal Revenue Code provides additional restrictions that apply to a 457(f) plan or agreement. Section 409A is an overlay of rules that applies to non-qualified deferred compensation of taxable and non-taxable entities. (Eligible deferred compensation plans or 457(b) plans are exempt from Section 409A.) Otherwise tax-deferred amounts under non-qualified deferred compensation plans that fail to satisfy the requirements of Section 409A become immediately taxable and subject to a 20% excise tax. In the past, some institutions have permitted a "rolling risk of forfeiture" under which the affected participants were permitted to elect to push out the time of vesting, provided the election was made well in advance of the otherwise upcoming vesting date. Rolling risks of forfeiture are not recognized as valid deferrals under Section 409A, and plans or agreements permitting these additional deferrals risk subjecting the participant to the severe tax consequences of Section 409A. Again, institutions should seek the advice of qualified outside counsel in these circumstances, and it makes eminent sense to review your deferred compensation programs generally for compliance with Section 409A. What are some common mistakes made by tax-exempt organizations when establishing eligible plans and ineligible plans? There are many common errors including: subjecting a retiring executive to immediate taxation on the entire value of the compensation deferred under an eligible deferred compensation plan even though paid out in installments over a period of years (e.g., executive will be paid 10 years of payments of $50,000 each at retirement, but is taxed immediately at retirement on the value of those 10 years of payments); o Failing to consider payroll withholding taxes (e.g., FICA, etc.); o Subjecting an executive to immediate taxation on current amounts deferred by failing to provide a substantial risk of forfeiture (e.g., the agreement does not effectively provide the risk, and the executive is immediately taxed on amounts contributed each year). 10
How do tax-exempt organizations avoid these problems? Both eligible and ineligible plans should be established and maintained using professionals experienced in tax-exempt compensation matters. Many professionals do not practice in this area and are not as familiar with the requirements. In particular, the IRS announced in June 2013 that it will be undertaking a compliance project directed at eligible plans, which will increase scrutiny of existing and new eligible plans in 2013 and 2014. Conclusion With careful planning, your school can provide an attractive benefits package to your head at a minimal tax cost -- and without jeopardizing the school s exempt status or incurring intermediate sanctions penalties. NAIS and NBOA encourage you to use the information contained in this publication as a starting point for conversations with your school s tax advisor about the details of the benefits package you offer. * * * * * To assure compliance with IRS standards of professional practice, Hogan Lovells U.S. L.L.P. discloses to you that any federal tax advice in this communication was not intended or written to be used, and cannot be used, for the purpose of avoiding federal tax penalties; and, if used to promote, market, or recommend any transaction, investment or matter, the advice was written to support the promotion or marketing of the transaction or matters addressed. Taxpayers should seek advice, based on their particular circumstances, from an independent tax advisor. About NAIS Legal Advisories NAIS provides legal advisories to NAIS member schools as a way to highlight key issues and to help them stay in legal compliance and operating in best practice. NAIS legal advisories are intended for general educational use only and should not be construed as or relied upon in place of advice from counsel. Find a full suite of legal advisories at www.nais.org. 11