Executive compensation at nonprofits is a hot-button issue right now as the IRS has begun ramping up oversight and enforcement. This is partly in response to some high-profile instances where executives working at nonprofit organizations received excessive salaries in relation to the size of the organization or the region of the country.
Now is a good time to take a look at your organization’s executive compensation policies. If the IRS determines that your executive compensation is excessive, you could be subject to fines or even loss of your tax-exempt status. Also, executives must repay excess compensation with interest and may also have to pay an excise tax of 25 percent of the excess amount.
Is Your Executive Compensation Reasonable?
The key question to ask is whether your executive compensation package is “reasonable.” The IRS defines reasonable compensation as “the value that would ordinarily be paid for like services by like enterprises under like circumstances.”
The IRS looks at several factors when determining the reasonableness of nonprofit executives’ compensation. These factors are weighted differently, depending on specific circumstances:
- The executive’s job description and nature of duties
- The organization’s size
- How much education or experience is required for the job
- Average compensation for similar positions at other nonprofits in the same area
- How many hours the executive works
- The organization’s overall budget
When determining whether a nonprofit executive’s compensation is reasonable, the IRS will consider the reasonableness of the total compensation amount and the services for which the compensation was paid. In addition to base salary, the following are also considered part of an executive’s total compensation package:
- Pension and profit-sharing plan contributions
- Personal use of the organization’s facilities
- Unpaid deferred compensation
- Payment of personal expenses
- Rents, royalties, and fees
Be Sure to Use Arms-Length Procedures
Smaller organizations where employees wear many different hats can sometimes get tripped up here. In effect, executives shouldn’t have a say in the size of their own compensation packages.
For example, suppose the president of the board is also the salaried executive director of a nonprofit organization. In this scenario, the individual should refrain from any board discussions about his or her compensation. Also, no board member voting on the executive’s compensation should have any relation to him or her.
Not following arms-length procedures when creating compensation packages can be costly. The IRS could classify an executive compensation package as an excess benefit transaction, especially if the total package is considered unreasonable. Intermediate sanction penalties could then be levied against board members for allowing financial transactions that unfairly benefit insiders.
Similarly, it’s also a good idea to adopt conflict of interest policies for nonprofit board members and executive directors. This can help prevent the payment of improper private benefits before they occur, including excessive executive compensation. Effective conflict of interest policies detail what constitutes a conflict of interest and spell out the procedures for disclosing potential conflicts.
Disclosing Executive Compensation
Nonprofit organizations disclose various types of compensation paid, including executive compensation, on Form 990, which is filed annually. Here, the organization must specify how it determined compensation—for example, by a compensation committee, independent compensation consultant, compensation survey, or board approval.
Note that if an executive’s compensation exceeds a certain amount, Schedule J must be filed with Form 990. Schedule J lists the executive’s base pay, bonus and incentive compensation, deferred compensation and non-taxable benefits such as health insurance, educational assistance, life and disability insurance, dependent care assistance and adoption assistance. In addition, it asks questions like whether the executive flies first class.
It’s smart to reexamine your compensation practices given how closely the IRS is watching this issue and the potential consequences of paying excessive compensation to executives.
Contact our Nonprofit Group if you have any questions about structuring your compensation packages.
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