Tax Exempt Executive Compensation Issues

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Tax Exempt Executive Compensation Issues

Recently there has been a great deal of focus on the Internal Revenue Service’s Exempt Organizations group (EO Group). Many of our clients and friends are directors of tax-exempt organizations. We would like to remind them that the EO also is continuing to focus on executive compensation of tax exempt organizations. In fact, in the EO’s 2013 Work Plan they called out a focus on the transparency of total executive compensation and the disclosures in Form 990. So let’s briefly review the key steps Directors should follow to establish and maintain appropriate executive pay and avoid the imposition of excise taxes under the IRS intermediate sanctions rules under Section 4958.

The intermediate sanctions regulations make it clear that independent directors of tax-exempt organizations can protect their organization and themselves by establishing and maintaining defensible rationales for their compensation programs and following good governance practices. The key concern that tax-exempt organizations should address is establishing a “rebuttable presumption” of reasonableness of compensation. To do so, the regulations require the following three key criteria:

  1. Approval of executive compensation must be done by an Independent Board or a designated committee (the Committee).
  2. The Committee should review comparable and appropriate compensation data as part of the decision-making process.
  3. The final decision and the rationale for such must be documented by the Committee.

As a Director, here are the 4 key topics that you need to be concerned with regarding executive compensation:

A. Define and document your executive compensation strategy, including:

  1. Your pay for performance philosophy
  2. Market definition (targeted market position, peer group, appropriate data sources)
  3. Executive benefits and perquisites approach

B. Define and document the role of the Committee

  1. Comprised of Independent Directors
  2. Elements of pay to be reviewed – “total compensation”
  3. Timing of compensation reviews
  4. Outside advice to be considered

C. Thoroughly document the Committee’s decision process and outcomes, including:

    1. Date of the decision
    2. Members present / voting results
    3. Terms of the compensation / benefits decided
    4. Outside advice and details of market / comparable data used
    5. Rationale for decisions made

D. Total compensation – your process should include:

    1. Review and understand existing and proposed employment contracts
    2. Cash compensation – base salary and bonus
    3. Executive perquisites and benefits
    4. Severance arrangements

To summarize, given what’s at stake, it is important that tax exempt organizations establish and follow a thorough and transparent governance process for executive compensation decisions. Compensation Committees frequently engage an independent compensation consultant with the expertise to synthesize complex data into simple, actionable advice for Committee members’ use.

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Benefits of Pay For Performance Compensation Plans

Why wouldn’t every company implement an effective Pay For Performance plan?

This is a concept that is an integral part of the American dream; the harder you work, the more money you make. For many of us, how well we are compensated for the job we do plays a major role in how we define ourselves. It also determines our motivation to improve our performance – or not. By definition, incentive compensation payouts are based on achievement of a predetermined set of objectives, milestones, or targets in order to motivate employees and align their actions with a company’s goals. If the results are achieved, then there’s a payout. Pay-for-performance plans are common in sales force compensation packages as well as in bonus programs for top executives. So if incentive plans are successful in these areas, when should they be applied to a broader range of employees? In my work with clients, and in my ongoing compensation research, I am actually seeing the trend of expanded pay-for-performance plans due to the many benefits a well-designed plan can deliver.

Pros of Adopting a “Pay For Performance” Mindset

Align employee’s actions with the interests of the company. What aspect of the business do you need to improve? Customer service? Productivity? Business processes? A pay-for performance plan is an excellent way to focus your employee’s actions on the areas that need attention. They are a tool that can be used to shine a spotlight on key company priorities and business drivers.

Attract and Retain Talent. A critical business objective for every company, well-designed pay-for-performance plans help companies compete for the talent they need and communicate company priorities and critical business objectives to employees.

Give employees a stake in the company’s success. Obviously employees realize that performing their job well helps the company do well, but the company’s success can be too far removed from the daily activity of the employee to be a motivating factor. A pay-for- performance plan can bring the interests of the employee closer to the interest of the company.

Cost control. Although not as important as the factors mentioned above, one cannot ignore that pay-for-performance plan mitigate financial risk for the company. Since these plans are tied to performance, they are effective cost control mechanisms. In addition, pay-for-performance payouts are not added to base pay, and thus don’t generate the compound growth of fixed-costs that base pay increases do.

Con’s

Given all of those potential benefits, why wouldn’t every company implement an effective pay-for-performance plan? As with any powerful tool, pay-for-performance plans have a learning curve and require regular maintenance. If misapplied, they can do more harm than good. Employers need to be sure the plan does not end up demoralizing the employees. So, whether you are implementing a pay-for-performance plan for the first time, or trying to improve the effectiveness of an existing plan, make sure to be mindful of the above caveats when executing your pay-for-performance plan.

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9 Critical Steps for Successful Pay For Performance Compensation Plans

Follow these nine steps to find pay for performance success.

At this point, most company executives agree that pay-for-performance plans are an effective tool not only to align the employee’s behavior with the company’s goals, but also to attract and retain the best talent. The question is, if they are so great, why doesn’t everyone have an element of incentive payment plans as part of the package they offer to employees? The short answer is that as with any powerful tool pay-for-performance plans have a learning curve, they require regular maintenance, and if they are misapplied it can do more harm than good. So whether you are implementing a pay-for-performance plan for the first time, or trying to improve the effectiveness of an existing plan, consider these nine critical steps for a successful pay for performance plan:

1) Understand the company’s overall business strategy. You must gain a deep understanding of the strategic context that the plan is intended to support. Review the company’s mission, business goals and objectives, the HR strategy, and the compensation philosophy. They are the foundation of the company’s management framework that the incentive compensation plan will need to align with and reinforce.

2) Identify root causes of poor performance. What is driving the need for improved performance, teamwork, or employee engagement? Challenge whether you only have a pay problem, or are there other factors that need to be addressed?

3) Identify the company’s key strategic objectives. Specifically, what do you want to improve: customer satisfaction, productivity, quality, new products or process improvement? Assign different weights to these objectives based on impact, importance, and your degree of confidence in your ability to measure results.

4) Create an integrated set of financial and strategic objectives. The goals must reflect a balance of financial results and the key business drivers. Set a range of financial and strategic performance levels and commensurate reward levels. Provide payout opportunities that are consistent with the value of the performance and meaningful to employees.

5) Define clear objectives for employees. Participants must have a clear line of sight to the goal. They must understand the actionable measures that they can impact that determine revenues, costs, productivity, or profits.

6) Communicate the objectives. Notify employees of expectations early in your goal-setting process. Allow time for managers and employees to align business unit, team, and individual objectives with company objectives.

7) Prepare to remain engaged. Expect this to be an ongoing and iterative process. Refresh your plan each year based on business conditions and updated goals and objectives. If this is your first pay-for-performance plan, start out by piloting a plan in a segment of your business.

8) Communicate with employees on all aspects of performance. Use the pay-for-performance plan as one component of your ongoing communications with employees. Provide ongoing feedback to all participants. Use progress updates, recognition for both small and large wins, and other reinforcements for results achieved.

9) Finally, remember the plan is not an end unto itself. A pay-for-performance plan is just one part of a company’s management framework. The more these programs and systems are synchronized and integrated, the greater the likelihood that the company’s overall vision and business goals will be achieved. Consequently the more closely aligned a pay-for-performance plan is with the management framework, the more successful it can be in providing strategic support for achieving your company’s synchronized goals and objectives.

So, whether you are implementing a pay-for-performance plan for the first time, or trying to improve the effectiveness of an existing plan,  read more about how to properly design and execute a compensation system in my article written for the Maryland Association of Certified Public Accountants monthly publication, Statement.

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Pay and Performance Alignment: Compensation Committee’s Ongoing Essential Role

A compensation committee’s essential ongoing role boils down to ensuring the alignment of pay with performance.

The strategic needs of any company are many and complex. These needs include developing leaders, balancing performance and retention needs, and creating and maintaining a performance culture. Board compensation committees play an essential role in addressing these needs.

Many compensation committees have significantly improved their performance in response to all of the compensation committee governance requirements and guidance promulgated by legal, regulatory and shareholder advocacy groups over the past decade. Whether publicly or privately held, for-profit or not-for-profit — responsible compensation committees are following the principles and rules found in “Say on Pay”, “Intermediate Sanctions”, “ISS” and “Sarbanes Oxley”. In our compensation consulting work with clients in and around Baltimore, Maryland, we’ve seen significant improvements in compensation committee process and compliance. We see compensation committees giving appropriate consideration but not slavish deference to “best practices”, “competitive practice” or “market data”.  These committees focus on what your business needs, recognize the unique challenges and situations facing their organization and consider alternative pay strategies in light of the organization’s strategy and under the known facts and circumstances.

In our opinion the compensation committee’s essential ongoing role boils down to ensuring the alignment of pay with performance. The basic question is whether or not the amount paid to an employee is appropriate in light of company, unit and individual performance. Committees now perform more in-depth analyses to examine this relationship, and record the rationale and the results of their pay decisions.

We see compensation committees using healthy doses of common sense in analyzing the pay-and-performance relationships. Designs and decisions typically look at the broad context by taking into account factors including specific performance against goals, the state of the economy, industry trends, the total compensation package, changed circumstances and how they were handled, and owner and employee perspectives.

Committees are focused on adopting balanced compensation program designs to ensure a meaningful pay-performance alignment. Balanced programs reinforce the pay-performance relationship and promote appropriate risk management. A well-balanced total compensation program should typically incorporate the following features:

  • Include both short and long-term performance
  • Consider both absolute (targeted) and relative (compared to peers/industry) performance
  • Include a balanced portfolio of performance measures (e.g. financial, operational, strategic, risk)
  • Consider company, team/division/function and individual performance
  • Balance of formulaic and qualitative performance metrics

We also see committees improving of their understanding of program designs by reviewing modeling of the program results under various performance levels, and by closer monitoring of results. By “stress testing” proposed compensation designs companies and committees can be proactive in both the design of programs and explaining the rationale for the rewards that result from these programs. As part of the process, they ask themselves the following questions:

  • What is the range of total compensation that could result from our programs under various performance scenarios?
  • What are the upside/downside values if both short and long-term incentive plans pay out at threshold and max performance?
  • What is the impact of different stock price assumptions over the next several on total realized value of compensation?
  • How is compensation affected under different risk scenarios such as changes in interest rates, asset quality, stock market, or customer retention?
  • Can we document a meaningful link between pay and performance relative to our decisions over time?
  • Can we relate compensation received by executives to company performance relative to peers/industry over multiple years?
  • Are levels of ownership sufficient to ensure executives, employees and board members interests are aligned with shareholders? Do our executives and board members hold and retain stock over the long-term?

With this type of due diligence we see committees significantly increasing the likelihood of achieving a proper relationship between pay-performance, addressing shareholder and regulatory concerns, and implementing programs that help the company attract and retain the talent needed to ensure the company’s long-term survival and success.

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Why Hire a Compensation Consultant?

Compensation consultants add value to all organizations in 3 main ways:

  • Keeping pay levels and benefits packages competitive
  • Updating incentive mechanisms to appropriately reward performance and stay current
  • Improving internal equity and consistency across employee classes and levels

Companies of all sizes from SMB to enterprise, effectively use compensation consultants in many different types of circumstances. For example, when:

  • A CEO or a Board that wants to assess whether top executives are paid appropriately, or how much to offer a key recruit
  • A CEO or Board has begun work on a merger, acquisition or other significant corporate event like succession planning and wants to address pay for the executive team
  • A management team has a desire to develop a performance-based compensation plan across the enterprise
  • A company has grown to a point where they need to put some structure around their compensation practices