Nonprofit Executive Compensation

While charitable organizations are permitted to arrange executive compensation agreements, "unreasonable" compensation to a disqualified person will be considered an excess benefit, subjecting the disqualified person and members of management who approved the transaction to penalties under section 4958 of the Internal Revenue Code known as "intermediate sanctions."

The IRS uses the term "disqualified person" to describe "any person [including a corporation] who was, at any time during the five-year period ending on the date of [the] transaction, in a position to exercise substantial influence over the affairs of the organization." For example, voting board members, officers, directors, staff members with ultimate decision-making authority, and highly compensated employees are considered disqualified persons.

Any payment determined unreasonable by the IRS must be corrected. Not only will the payment have to be returned by the disqualified person, the disqualified person will pay a penalty of 25% of the excess benefit (an additional 200% may be imposed if not paid within 90 days), and members knowingly involved in the excess benefit transaction may be subject to a penalty of 10% of the excess benefit. Even if the charitable organization that granted the excess benefit transaction no longer exists, the disqualified person is still required to correct the excess benefit, generally paying the amount to another 501(c)(3) organization in accordance with the original charitable organization's dissolution clause.

Other than the general standard that the compensation should be what is ordinarily paid for like services, by like enterprises, under like circumstances, the IRS has yet to establish more detailed instructions for calculating reasonable compensation. Therefore, it is extremely important organizations exercise their best efforts to execute reasonable compensation agreements.

In its report, "Strengthening Transparency Governance Accountability of Charitable Organizations," the Panel on the Nonprofit Sector recommends charitable organizations to approach the required Form 990 or 990 PF filing as an opportunity to undertake a full review of its organizational and governing instruments, key financial transactions, and compensation policies and practices at least once every five years.

Furthermore, the Panel highlights that the executives of charitable organizations have some responsibility in preventing an excess benefit transaction from occurring. The governing board or other authorized body approving the compensation should be accountable for the process used in the overall determination of reasonableness. They should not shift the burden to the IRS of demonstrating the compensation is excessive.

The Panel also strongly encourages charitable organizations to adopt a requirement that the board of directors approve CEO compensation annually prior to the payment of the new compensation level as part of their bylaws or governing documents. For example, if the board elects to exercise a multi-year CEO contract in which compensation is increased periodically or upon meeting specific performance measures, the board should institute a regular process for reviewing whether these terms have been met. Even if the board designates a separate committee for CEO compensation and performance review, the Panel suggests that the committee's report regarding its findings and recommendations should be subject to the full board's approval.

While public charity managers may rely on professional advice (i.e. certified public accountants or accounting firms with relevant tax law expertise, and independent appraisers or compensation consultants qualified to make such valuations), the use of professional consultants for compensation purposes is still relatively new to the charitable sector. Therefore, the Panel recommends using an independent consultant who will report directly to the board or its compensation committee. Regardless if the CEO is responsible for hiring other staff of the organization, the boards or designated compensation committee should always have a stake in the process by reviewing the overall compensation program of the various positions.

It is important to note that section 4958 provides an additional remedy available to the IRS and therefore, an organization may still be liable to have its tax-exempt status revoked for the excess private benefit. Therefore, with the limited information currently available, an organization's safest bet is to err on the side of caution and make a best efforts attempt to use the safe harbor provision of the rebuttable presumption outlined on the IRS website as a model for determining reasonable compensation.

To learn more about the rebuttable presumption procedure, see "Rebuttable Presumption Procedure is Key to Easy Intermediate Sanctions Compliance" by Steven T. Miller, Director Exempt Organizations, IRS.

The Panel on the Nonprofit Sector's report, "Strengthening Transparency Governance Accountability of Charitable Organizations" is available here.

Here are links to additional information on this subject:

"How Officers and Directors of Nonprofits Can Stay Out of Trouble Under the Excess Benefit Rules" by Lisa Nachmias Davis, Esq.

Council for Advancement and Support of Education's overview on Intermediate Sanctions and Timothy L. Theitje's "A Guide for Managers of Institutionally Related Foundations" – both available here.

Lisa A. Runquist's article on general nonprofit director liability issues in "To Serve or Not to Serve: The Benefits and Hazards of Lawyers Serving on Nonprofit Boards."

– Emily Chan