What the IRS Expects in a Rebuttable Presumption Package

If you serve on a nonprofit board or advise one on compensation, you need to understand the rebuttable presumption of reasonableness. It’s the single most important legal protection against intermediate sanctions under IRC §4958, and it’s surprisingly straightforward to satisfy.

What are intermediate sanctions?

When the IRS determines that a nonprofit paid “excess compensation” to a disqualified person (anyone who exercised substantial influence over the organization’s affairs at any point during the prior five years — including senior executives, key board members, and their family members or controlled entities), it can impose excise taxes — on the individual who received the compensation and, in some cases, on the managers who approved it.

The penalties under 26 U.S.C. §4958 are steep:

• 25% initial tax on the excess benefit amount, paid by the disqualified person who received it (§4958(a)(1))
• 200% additional tax on the disqualified person if the excess benefit is not corrected within the taxable period (§4958(b))
• 10% tax on each organization manager who knowingly approved the transaction, capped at $20,000 per transaction (§4958(a)(2))

These aren’t theoretical. The IRS actively enforces them.

The three requirements

Under Treasury Regulation 26 CFR 53.4958-6, a compensation arrangement is presumed reasonable if the organization satisfies three conditions:

1. Approval by an independent body

The compensation must be approved by an authorized body — the board of directors, a committee of the board, or another body authorized under state law — composed entirely of individuals who do not have a conflict of interest with respect to the transaction (§53.4958-6(a)(1)).

In practice, this means the executive whose pay is being set should not vote on or participate in the deliberation. Family members and business partners of the executive should also recuse themselves. Many organizations use a dedicated compensation committee for exactly this reason.

2. Comparability data

Before making its decision, the authorized body must obtain and rely on “appropriate data as to comparability” (§53.4958-6(a)(2)). The regulation specifically recognizes:

• Compensation paid by similarly situated organizations (both taxable and tax-exempt) for functionally comparable positions
• Independent compensation surveys compiled by recognized firms
• Actual written offers from competing employers

For organizations with annual gross receipts under $1 million, the regulation provides a safe harbor: comparability data from three comparable organizations in the same or similar communities for similar services is sufficient (§53.4958-6(c)(2)(ii)).

3. Concurrent documentation

The authorized body must document its decision and the basis for it “before the later of the next meeting of the authorized body or 60 days after the final actions of the authorized body” (§53.4958-6(c)(3)). The documentation must include:

• The terms of the compensation arrangement and the date of approval
• The members of the body present and those who voted
• The comparability data obtained and relied upon, and how it was obtained
• Any actions taken by a member with a conflict of interest (e.g., recusal)
• If compensation exceeds the range of comparability data: the basis for the determination that the amount was reasonable

What the presumption actually does

When all three requirements are met, the IRS may rebut the presumption only if it “develops sufficient contrary evidence to rebut the probative value of the comparability data relied upon by the authorized body.” In other words, the burden of proof shifts to the IRS. Instead of your organization having to prove its compensation was reasonable, the IRS must prove it was unreasonable.

Without the presumption, the organization bears the burden. Having the presumption in place makes it far less likely that a reasonable compensation arrangement will be challenged at all.

Common pitfalls

• Using the right data, but not documenting that you used it — The board pulled comparability data but didn’t record it in the minutes. The regulation requires contemporaneous documentation, not a retroactive memo.
• Failing to exclude conflicted members — Even one conflicted participant in the vote can undermine the independence requirement under §53.4958-6(a)(1).
• Relying on a single data point — One organization’s pay isn’t comparability data. You need a genuine peer group analysis.
• Setting compensation above the range without justification — The regulation explicitly requires documentation of the basis when pay exceeds the comparability range.