Inadequately Documented Executive Expenses – What’s the Harm?

The Straight Scoop and Practical Suggestions

In recent years, actual and perceived abuses in the area of executive expenses and “perks” have been among the leading causes of stricter federal tax laws governing nonprofit organizations and greater scrutiny by the Internal Revenue Service of the practices of nonprofit organizations in the United States. Many organizations struggle with this area of compliance. For purposes of this article, we use the term “executive expenses” to refer to expenses incurred by the leaders of a nonprofit organization that could appear to be personal in nature if not properly documented as business expenses. Common examples include, but are not limited to, expenses for travel, meals, hospitality, gifts, supplies, club memberships, and other types of expenditures.

Adequacy of documentation for federal tax law compliance – “accountable plan” rules

Under federal tax law, documentation for travel, meals, hospitality, and similar expenses must include the nature of the business activity conducted, the people involved in the activity, and the places at which the activity was conducted. Payment of such expenses incurred by nonprofit executives must be made pursuant to an “accountable plan.” (An accountable plan is one wherein such expenses are properly substantiated in a timely manner by documentation as required by the Internal Revenue Code and related Regulations.) If executive expenses are not properly substantiated in a timely manner, they are required to either be repaid by the individual who incurred them or treated as taxable compensation to that individual.

Implications of not following the accountable plan rules

If executive expenses are incurred and not properly substantiated in a timely manner, and if the expenses are not either repaid by the executive or treated as taxable compensation to him/her, the payment of such expenses by the nonprofit organization may constitute “automatic excess benefit transactions” under federal tax law. Excess benefit transactions are prohibited. Federal sanctions for excess benefit transactions generally include a requirement that the person receiving the “benefits” (inadequately documented executive expenses) return the full amount of any such expenses to the organization and pay an initial penalty tax of 25% of the “excess benefit amount” (the amount of the inadequately documented expenses). If the excess benefit transaction is not corrected in a timely manner, an additional penalty tax of 200% can apply to the person who incurred the expenses. Officials who knowingly approve such transactions may be subject to personal penalties as well.

Practical options for employers addressing inadequately documented executive expenses

A nonprofit organization faced with inadequately documented executive expenses generally has two options in order to avoid excess benefit transactions related to inadequately documented expenses:

  1. The organization may treat the inadequately documented expenses as taxable compensation to the individual. This option is only practical, however, if the amounts and frequency of inadequately documented expenses are low. Under federal tax law, total compensation for a nonprofit organization leader must be “reasonable.” Treating inadequately documented executive expenses as taxable compensation effectively results in a compensation increase for the person whose expenses are not adequately documented. Accordingly, such an approach may not be an effective deterrent against incurring personal expenses, since the only effect to the individual is that he or she may be taxed on the additional compensation. Additionally, increases in compensation must generally be approved by appropriate authorities within an organization. Further, a nonprofit organization must ensure that total compensation for its leaders (including inadequately documented expenses treated as compensation) meets the reasonableness requirements of the law.
  2. The nonprofit organization may deduct the inadequately documented expenses from the individual’s pay. This option avoids the effect of creating a de facto pay increase and may be a more effective disincentive, since the person’s actual pay is reduced dollar-for-dollar by the amount of the inadequately documented expenses.

Obviously, neither option is favorable, and the ideal approach is to avoid this scenario.

Example

Consider the following scenario. A CEO of a nonprofit organization regularly travels to conferences and events to promote the organization. The CEO uses a corporate credit card when conducting business-related travel. At the end of each month, the organization’s accounting office is presented the corporate credit card bill for payment. The CEO does not provide the accounting department with adequate documentation meeting the accountable plan requirements related to the expenses. Assume the undocumented expenses for the month total $5,000. The organization is faced with only two practical options that are in compliance with the law:

  1. Treat the undocumented expenses as additional taxable compensation to the CEO. (Note, however, that the impact of such treatment on the overall reasonableness of the CEO’s compensation must be considered, along with the organization’s policy for compensation-setting.)
  2. Reduce the executive’s actual paycheck in the subsequent month by $5,000 (i.e., take a deduction from the executive’s pay representing “repayment” to the organization of the undocumented expenses).

Frustrations of Executives with Expense Documentation – Practical Suggestions

We understand that busy executives can find the expense documentation requirements of federal tax law  burdensome and frustrating. At the same time, failure to comply with them can result in very severe penalties being assessed against the executive personally, in addition to a requirement that the executive repay the expenses to the organization. Accordingly, nonprofit executives should develop practical, workable systems that allow them to provide the necessary documentation in a timely manner. If the executive has an administrative assistant or equivalent, the assistant is often familiar with the executive’s calendar and appointments and can often provide the required documentation. Technology (software/applications) can also aid compliance in this area. For example, some newer applications allow an executive to take a snapshot of a receipt with his/her cell phone and jot a few notes that provide the required documentation in a very efficient manner. Whatever the method, nonprofit leaders should make the effort to avoid the potentially severe penalties that can apply to inadequately documented executive expenses.

This publication is for general informational and educational purposes only, and does not constitute legal, accounting, tax, financial, or other professional advice. It is not a substitute for professional advice. For permission to reprint, please contact us.  © 2024 Batts Morrison Wales & Lee, P.A.  All rights reserved.
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