Executive Compensation Governance, Compliance with IRS Guidelines, and Establishing the “Rebuttable Presumption of Reasonableness”
From a regulatory perspective it is imperative that an organizational process be established, followed, and adequately documented. Upon audit, if a paper trail cannot be found or followed, it will likely be viewed by the IRS as having never occurred.
Boards (and Committees thereof) need to take advantage of the opportunity to design a well structured decision-making process not only meeting legal and regulatory obligations but to ensure that public trust is maintained, appropriate outcomes are achieved, and allowing for greater transparency. This process is the best protection for the Board. It enables the Board to shift the burden of proof, communicate a “good faith” effort toward compliance, and the intended application of sound business judgment even if the outcomes were to be challenged by a regulatory body.
Establishing an Executive Compensation Committee
A Committee should be formally established according to a codified charter addressing the mission and purpose of the Committee, By-laws (if applicable), authority/purview, membership appointment and expertise, accountability, meeting frequency, documentation requirements and responsibilities.
It is essential the organization develop a companion document setting out an Executive Compensation Philosophy, which would be an additional tool for guiding the Committee through deliberations and maintains consistency as membership evolves. Such items contained in a Compensation Philosophy include, but are not limited to, targeted market placement for various levels of executive experience, factors to be considered when addressing extenuating circumstances, the relationship between fixed and variable compensation, etc.
Conflict-Free Committee
When dealing with compensation a Committee must be free from conflicts ensuring the Committee includes proper talent to deal with the issues relative to the Committee’s purview. Most organizations, as a part of their governance processes, have Board members complete, sign, and date a Conflict of Interest Policy annually in order to deal with potential conflicts.
A well-documented process begins with establishing a conflict free Committee or providing an explanation of how conflicted persons will be handled during the decision making process. Prior to each executive compensation cycle the completed forms are cross-referenced with the rules governing disqualified persons to ensure each member of the Committee is not conflicted (within the meaning of IRC §4958). (See Sample Disqualified Persons Policy)
Comparability Data
Comparability data must be obtained from similarly situated organizations for functionally comparable positions. To satisfy this requirement a methodology must be developed to determine which factors, regulatory and otherwise, will be used to determine the comparative market group representing appropriate cross section of organizations. Job function must be properly aggregated and matched to the data through a combination of methods including a thorough analysis of job descriptions, management & corporate organizational charts, and discussions with executive management associates (if necessary). Positions with anomalies requiring premiums, discounts, blends, etc. must be properly substantiated and accounted for.
Once the appropriate market comparative group has been identified be sure to aggregate all forms of compensation so that total compensation is being considered. This includes making the Committee aware of current and future liabilities such as expenses, cell phones, spouse travel, loan forgiveness, severance payouts, deferred compensation, and short-term and long-term variable compensation opportunities, and all contractual obligations. In addition, not only should the cost be reviewed and approved but the policies that govern discharging and reporting items like expense reimbursement, spousal travel, loan forgiveness, tax-gross-ups, and automobiles, etc. should be understood clearly.
Meeting Documentation
Minutes are crucial to the establishment of the rebuttable presumption and are frequently part of IRS document requests. The requirements of the Minutes, where brevity once prevailed have shifted dramatically.
Regulations dictate a myriad of information to record, and best practices have shown, including (in addition to synopsizing Committee deliberations and discussions), members present/absent, those voting and abstaining, terms of the arrangement, date of approval, market comparability data relied on by the Committee and a description of how it was obtained, actions taken by any member of the Committee who had a conflict of interest with respect to that particular compensation arrangement, and, if compensation is below or above the range of comparability data, a description of the Committee’s rationale for the variance (e.g., scope of duties, prior services, change in FTE status), benefit impact (relative to the market) and reporting treatment.
Moreover and often missed, the minutes must be approved the later of 60 days following the meeting or the next meeting.
Form 990 Reporting
The process does not end when the meeting adjourns. The IRS uses the Form 990 as a tool for compliance checks and examinations. It is crucial to ensure that compensation and benefits are submitted correctly and figures reconcile with individual Form W-2. If not, it is recommended that explanations be provided.
Educating the Board
It is important that the full Board be informed of the steps the Committee has taken to ensure that legal requirements are met, how the Executive Compensation Program operates, and the promises and arrangements made and their cost. The organization does not want its Board members to be ill prepared if faced with a question in the Community regarding Executive Pay. We feel it is important to review the process with the Board in an open and honest manner and allow the Board to ask questions.
Communicating to the Public & the Media
Oftentimes we hear about a local newspaper(s) reporting compensation and the awkward circumstances it can create for the Board members and executives living in the community. In addition to educating the Board, the organization should be ready to address requests by media outlets on these sensitive topics.
Like so many areas in the organization, a communication strategy should be developed which compiles the necessary information and presents in a clear and concise way. Generally speaking, these steps include identifying someone within the public relations department to carry the message that is supported and substantiated by Form 990 information, consultants’ reports, market comparisons, an explanation of the process followed, and the provision of community benefit, which is now part of the Form 990.
Executive Compensation Programs evolve as organizations do and it is important that these issues, including the procedures and practices that support the program be reviewed regularly to assess whether the original intentions of the program’s elements and compensatory offerings continue to support their intended aims, otherwise revision may be appropriate or even necessary.