Louis E. Michelson, A Professional Corporation

Beginning in February, 2010, the IRS is conducting its first Employment Tax National Research Project since 1984. For the first time, this project will include audits of exempt organizations. Of the 6,000 companies to be audited, some 500 audits of exempt organizations should be expected.

The IRS will be focusing on four employment tax compliance initiatives in 2010: (1) classification of workers as employees or independent contractors, (2) reasonableness of executive compensation, (3) tax treatment of employee reimbursements, and (4) tax treatment of fringe benefits.

These employment audits present additional risks for charitable organizations because IRS agents may consider other employment-related tax issues unique to charities. It would not be unusual for IRS agents auditing compensation at exempt organizations to inquire about the reasonableness of compensation. This might trigger scrutiny of the economic benefits being paid to executives, which includes payment of wages, as well as use of property, foregone interest on loans, deferred compensation, etc., all of which are intended to be treated as compensation. If unreasonable in the aggregate, the compensation can give rise to excess benefit transactions.

The automatic excess benefit transaction rules might also be at issue for employee expense reimbursements. If an employee’s expenses are reimbursed, but does not do so accordance with an accountable plan and there is no contemporaneous documentation that the parties intended to treat the benefits as compensation, the benefits may give rise to automatic excess benefits (whether or not the benefits were reasonable).

Workers can correct excess benefit transactions by repaying any excess benefits, but could be liable for penalties and interest on the excess benefits received. The IRS may also assess the charitable organization’s managers with penalties. Benefits that were incorrectly treated for tax purposes might result in additional income taxes to the worker and give rise to related payroll tax obligations for the exempt organization.

Charitable organizations should consider conducting an internal review of their compensation practices. It is also prudent to review expense reimbursement policies and procedures to ensure that the organization’s reimbursement arrangements qualify as accountable plans.