Executive Compensation in the Tax-Exempt World

Abstract

Whether nonprofit organizations provide charity, education or health care, entities that are organized and operated under Section 501(c)(3) of the Internal Revenue Code must be mindful of specific tax rules that do not apply to private or public companies when structuring compensation arrangements to attract, motivate and retain executive-level talent. For example, Section 457 of the Code places unique restrictions on the compensation programs sponsored by tax-exempt entities. Congress believed these restrictions were necessary because the usual tension created by a public or private company’s desire to recognize a current compensation deduction and an employee’s desire to defer tax on compensation does not exist with tax-exempt entities. Additionally, the Code regulates whether tax-exempt organizations pay reasonable compensation through the operation of the excess benefit transaction (or intermediate sanction) rules. This article examines the restrictive tax provisions of Section 457 and of the excess benefit transaction rules, which both create a challenging environment for tax-exempt entities when they compete with taxable entities for executive-level talent.