There are countless stories in the media of nonprofit excessive compensation. In fact, nonprofit excessive executive compensation is often cited as evidence of widespread corruption in the nonprofit field. The reality, though, is that most nonprofit directors are not receiving exorbitant salaries. Most nonprofits compensate their executives within the appropriate range for organizations of their size and the region of the country they are located in. 

Nonetheless, due to the media attention that this issue receives, many board members and donors are extremely concerned about this perceived crisis. Funders, regulators, and the IRS have also taken action to curtail high salaries in the nonprofit sector by instituting numerous penalties and accountability measures. As a result, nonprofits must approach executive compensation with a strong focus on compliance.

Compensation Rate Factors

There are numerous factors that are considered when coming up with a salary range for nonprofit executives. Search committees take into consideration both the financial realities of the organization as well as the characteristics of the candidates or existing executives when determining whether individuals are compensated in the 10^th percentile range or the top 90^th percentile. Some of the administrative and financial considerations include, but are not limited to, the organization’s cash flow, the potential sustainability of the salary range, and the organization’s salary benchmarks. With respect to the candidate, search committees consider the skills, years of experience, technical expertise, cultural alignment with the organization, fundraising abilities, and track record. For more information on how to set salary ranges to go to Nonprofit Compensation Systems Part 2: Formal Structures and Communication Systems.

Compensation is a Compliance Issue

With respect to executive compensation, though, making sure that you have a systematic and evidence-based approach to setting compensation is a compliance issue. The IRS uses a two-prong test to determine whether compensation is reasonable: “1) an amount test, focusing on the reasonableness of the total amount paid; and 2) a purpose test, examining the services for which the compensation was paid.” 

It is also important to note that the IRS considers compensation to be more than just the salary. The following is a list of some of the items that can be considered to be part of a full compensation package: 

• Salary or wages; 
• Contributions to pension and profit-sharing plans; 
• Unpaid deferred compensation; 
• Payment of personal expenses;
• Rents, royalties, or fees; and
• Personal use of the organization’s property or facilities. 

For a full listing of all types of compensation, go directly to the 990 that nonprofits must file, pages 34-36.

In the event that the IRS questions how the organization came up with a salary range for an executive or an employee, you should be able to produce the records documenting your research process. If there were special accommodations made for this person, like additional vacation days or a special bonus, the documentation justifying this action should be part of the permanent record. The IRS will consider the following twelve factors when examining reasonable compensation cases: 

1. The nature of the employee’s duties; 
2. The employee’s background and experience; 
3. The employee’s knowledge of the business; 
4. The size of the business; 
5. The employee’s contribution to the profit making; 
6. The time devoted by the employee to the business; 
7. The economic conditions in general and locally; 
8. The character and amount of responsibility of the employee; 
9. The time of year when compensation is determined; 
10. The relationship of shareholder-officer’s compensation to stock holdings; 
11. Whether the alleged compensation is in reality, in whole or in part, payment for a business or assets acquired; and 
12. The amount paid by similar size businesses in the same area to equally qualified employees for similar services. 

For more information, click here. 

Excessive Executive Compensation Penalties:

In the rare event, there is a finding by the IRS, the penalties for nonprofit excessive executive compensation are significant for the organization, the board members, and the individual executive director. The organization could risk losing its tax-exempt status or receive substantial fines, which are known as excess benefit transaction excise taxes. The overpayment must also be paid back by the executive director with interest. The IRS can make the ED pay an excise tax equal to 25% of the overpayment. If the ED fails to repay the amount above what the IRS determines is appropriate to correct the excess benefit transaction within the taxable period, an additional excise tax equal to 200 percent of the excess benefit is imposed. 

For the board members that approved the compensation or existing board members who were not involved in the original decision, but have not taken action to correct the problem, they may be required to pay an excise tax equal to 10% of the overpayment, which does not exceed $20,000. 

Tax Cuts and Jobs Act Excise Tax

A 21% excise tax that equals the corporate tax rate is also now imposed on nonprofits that compensate employees above $1 million dollars in annual remuneration or who receive parachute payments. This is classified as nonprofit excessive compensation according to the Tax Cuts and Jobs Act (TCJA), even if it is appropriate for the budget of the organization. There are some exceptions for employees that provide medical or veterinary services who can exempt portions of their pay related to these services. Distributions from certain tax-qualified retirement plans are excluded from this law, but other vested amounts, such as those under 457(b) deferred compensation plans, may be included.

IRS Annual Compensation Review

Nonetheless, the IRS conducts a compensation review when it examines the 990 forms nonprofits have to file annually. In part II of Schedule J, nonprofits must disclose various types of compensation. The organization must also specify how compensation was determined: 

• Compensation committee, 
• Independent compensation consultant, 
• Form 900 of other organizations, 
• Written employment contract, 
• Compensation survey or study, and/ or 
• Approval by the board or compensation committee.

Organizations that report excess benefit transactions must provide further detailed information on the nature of the excess benefit transaction under Form 990 Schedule L.

Conflict of Interest Policies

Organizations should also adopt conflict of interest policies for the executive director and board members. This issue may appear to not be related to nonprofit excessive executive compensation. However, adopting and following the procedures of a conflict of interest policy can prevent improper private benefits, including excessive compensation, before they occur. A good policy clearly articulates the procedure for disclosing the conflict, and what constitutes a conflict, and requires a vote to determine how to address the issue, if at all.

As always, with any financial, tax, or legal issues the organization is facing, particularly as it pertains to compliance, it is always best to seek counsel to ensure your organization is in compliance. 

For more information on nonprofit compensation, please click on Part 1 and Part 2.

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