Federal tax regulations provide a “rebuttable presumption of reasonableness” for compensation arrangements that satisfy three requirements. If all of the following are met, it’s up to the IRS to show that compensation was nonetheless unreasonable.
Compensation generally must be set in advance by the board of directors or a subcommittee composed of board members. It’s critical that none of the participants have a conflict of interest regarding the arrangement. For example, neither the executive nor a subordinate of the executive can participate in the compensation decision.
The authorized body also must rely on appropriate comparability data prior to making its compensation determination. The data can be derived from industry surveys, documented compensation of individuals in similar positions in similar organizations, expert compensation studies or other comparable data about reasonable compensation for the position. If the organization’s average gross annual receipts are less than $1 million, it only needs compensation data for three similar positions in similar communities. The regulations don’t specify the requisite number of comparables for larger organizations.
Keep in mind that similar job titles don’t necessarily mean similar jobs. When evaluating comparability data, the positions must have comparable duties, not just titles.
What’s more, the authorized body must adequately document the basis for its compensation decision while making that determination. This requirement is often overlooked. Documentation must include terms of the arrangement and the date it was approved, members of the body who were present during debate on the arrangement and those who voted on it, comparability data that was relied on and how it was obtained, and any actions by a member with a conflict of interest.
You must prepare the documentation before the later of the next meeting of the authorized body or 60 days after the body’s final actions. The group also must approve the documentation within a reasonable time after preparation.