In recent months, the Internal Revenue Service has publicly announced that it intends to audit as many as 2,000 nonprofit organizations. It has not divulged what percentage of those audits will involve colleges and universities, but I believe it is safe to conclude that they will not be excluded from this massive IRS effort. And one of the things the auditors will be looking at is presidential compensation.
I believe that the high levels of compensation paid to presidents of especially large universities can usually be justified by the magnitude of their responsibilities, the complexity of the job, and the specific challenges faced by those institutions.
The question is, Will the IRS agree?
Many presidents of colleges and universities in the United States are, in my opinion, underpaid. In particular, I would point to the presidents of community colleges, some of whom have responsibility for upwards of 50,000 students, and earn less than $200,000 a year. Indeed, many earn less than $150,000. I would submit that, in our economy, there is no other set of organizations as large and complex as these where the CEO's receive such relatively low levels of compensation.
Likewise at many small liberal-arts colleges, you will often see presidents who earn between $100,000 and $200,000 a year, even with 10 or more years experience.
At the other end of the spectrum are the major research universities like the University of Pennsylvania, a $3.6-billion-a-year enterprise that paid its immediate past president, Judith Rodin, approximately $890,000 in the 2002 fiscal year. If her successor, Amy Gutmann, the former provost of Princeton University, received an increase over that amount when she was recruited, then perhaps she is now being paid close to $1-million a year in total compensation.
IRS auditors will be taking a close look at the Form 990, which all private colleges and universities and nonprofit foundations are required to file. The 990 is an informational return, since those organizations are exempt from paying federal income taxes. The form should contain and report all direct and deferred compensation that is part of the president's package.
There is no doubt that the IRS will be examining the Form 990's and looking at those institutions whose CEO's receive especially high levels of compensation.
A confluence of societal events appears to be exerting upward pressure on the levels of compensation that trustees feel they are being required to offer in order to attract (and retain) the best possible presidents for their institutions.
The first of those trends is reflected in a study that was published by the American Association of Community Colleges in 2002. The study predicted that in the next six years, approximately 45 percent of community-college presidents would be retiring. So far, not only have the projections held true, but the association reports that it has also seen significant numbers of vice presidents retiring as well.
My own observations and discussions with academic administrators lead me to conclude that many four-year institutions are already, or will be soon, experiencing approximately the same levels of retirements as community colleges. We are already seeing an imbalance between the growing demand for successful presidents with proven track records and their limited supply.
Where will all of the new presidents come from? Will the new generation of leaders be as qualified as their predecessors? Will this presumably "younger generation" demand higher levels of compensation than their predecessors did?
At the same time, compensation for corporate CEO's continues to grow. One study by a graduate student in management at the University of California at Los Angeles determined that, on average, in 2000, presidents of elite universities received about 5 percent of the average total compensation earned by CEO's of companies in the S&P 500.
Of course, everyone in higher education knows that people who become college or university presidents do not begin their careers with the primary goal of maximizing their incomes.
However, when there is such a huge gulf between the compensation of for-profit CEO's and that of nonprofit CEO's, one can expect a migration of highly talented administrators to occur from the nonprofit sector to the for-profit one, simply because they receive offers that they cannot refuse.
Some trustees who serve on the compensation committees of their boards have asked me whether it is permitted, or even appropriate, for them to consider compensation levels in the for-profit sector when setting their president's pay.
According to that UCLA study, leading a large university is one of the most difficult jobs in America, comparable in complexity to leading a major corporation. And, since the IRS itself advises that it is permissible for nonprofit compensation committees to take into account salaries and other kinds of compensation paid to the CEO's of for-profit entities that are approximately the same size and complexity as their university, one must conclude that it is appropriate.
But that is simply a very general bit of compensation guidance offered by the government. The IRS has a lot more to say on the subject, in new regulations for enforcing the law on executive compensation at tax-exempt organizations and in guidance to its agents on how to interpret the regulations. Those documents offer important guidelines for the trustees who determine presidential pay at nonprofit institutions.
The regulations and guidance deal with Section 4958 of the Internal Revenue Code -- also known as "intermediate sanctions" -- which provides that the IRS can impose a penalty or tax on both an overpaid CEO and on the individual board members who approved the excessive payment.
Before Congress passed Section 4958, if the IRS was displeased with the amount of compensation being paid to a nonprofit CEO, it had two options: It could do nothing, or it could revoke the tax-exempt status of the organization.
Since the IRS was extremely reluctant to revoke an organization's tax-exempt status, more often than not it simply did nothing.
With the enactment of Section 4958, matters have changed considerably. Now that the IRS has published final regulations to implement the intermediate-sanctions provisions, trustees and those who advise them have some guidance on how to avoid being penalized.
Without getting into too many technicalities here, an acceptable procedure for a board to follow would be as follows:
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A governing board should appoint an independent committee or subcommittee made up of three to five trustees who do not have a conflict of interest with the president, to review and establish the president's compensation.
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That committee would be well advised to seek the advice of an experienced, outside, independent expert, who in turn should base his or her recommendations on current compensation data from institutions of similar size and complexity.
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Using data supplied to it by the outside consultant, the committee should review the president's compensation periodically. Then, using their best judgment, the members of the committee or the full board should set the president's pay.
According to IRS regulations under Section 4958, if such a procedure is followed, and if the IRS later challenges the board's decisions in an investigation or audit, the burden of proof would shift from the university to the IRS to show that the compensation is excessive.
That gives the board a significant advantage. Moreover, although the IRS regulations are relatively new, there is not yet a single case on record of the IRS even challenging a compensation decision that was based upon the above-described process.
The vast majority of trustees come to their positions for one reason and one reason only -- to benefit their college or university.
As university presidents continue retiring in the coming years, boards will be faced with the great challenge of finding qualified and experienced administrators for their presidencies. Bidding contests for the best talent can be expected. Increases in current levels of presidential compensation can also be expected.
At the same time, trustees, as fiduciaries of their institutions, must exercise prudence in setting compensation levels. It is exceedingly important for all boards, at both private and public institutions, to consider creating a compensation committee with an expertise in this area.
Boards at public universities ought to view establishing such a committee as a "best practice." At private universities, such committees can help the board, the president, and the university itself comply with the IRS guidelines and prevent legal problems from developing in the first place.
