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The stakes can be enormous. To attract highly qualified executives, employees, and board members, not-for-profit organizations must offer competitive compensation packages.

But take it too far, and you could run afoul of the IRS’ reasonable compensation rules.

The IRS can impose significant penalties, referred to as intermediate sanctions, on those it considers excessively compensated. These penalties can also be levied against the board members and managers within your organization who approved the compensation. In other words, they can be held personally liable. As a last resort, the IRS could revoke your organization’s tax-exempt status.

In testimony before the U.S. Senate, IRS Commissioner Mark Everson stated that “The issues of governance and executive compensation are closely intertwined. We are concerned that the governing boards of tax-exempt organizations are not, in all cases, exercising sufficient diligence as they set up compensation for the leadership of the organizations.”

In a recently published discussion draft of good governance practices, entitled Good Governance Practices for 501(c)(3) Organizations, the IRS recommends the following compensation practices:

“A successful charity pays no more than reasonable compensation for services rendered. Charities should generally not compensate persons for service on the board of directors except to reimburse direct expenses of such service. Director compensation should be allowed only when determined appropriate by a committee composed of persons who are not compensated by the charity and have no financial interest in the determination.

“Charities may pay reasonable compensation for services provided by officers and staff. In determining reasonable compensation, a charity may wish to rely on the rebuttable presumption test of section 4958 of the Internal Revenue Code…”

Safe Harbor for Reasonable Compensation
If you implement standard compensation practices that satisfy the IRS’ rebuttable presumption test, thereby creating a safe harbor, it becomes the responsibility of the IRS to prove that your compensation is excessive before it can assess penalties.

You create a rebuttable presumption of reasonable compensation by creating an authorized body–for example, a board of directors or compensation committee comprised of individuals with no conflicts of interest. That authorized body must implement and oversee three practices mandated by the IRS. These practices require that your organization do the following:

  Establish appropriate compensation guidelines based on relevant data for comparable organizations before compensation agreements are approved.

  Approve in advance all compensation agreements for executives, board members, or others in a position to exercise substantial influence over your operations (collectively referred to as disqualified persons).

  Thoroughly and concurrently document the basis for all compensation determinations.

If your organization has gross receipts of less than one million dollars, the most efficient approach to establishing the reasonableness of your compensation may simply be to reference the compensation paid by at least three comparable organizations. If your organization is larger, you could elect to rely on a more detailed analysis or refer to a compensation study performed by a qualified third party.

To assist you, Guidestar has published a Nonprofit Compensation Report, available for purchase online. Locally, United Way of King County has recently published its 2007 Wage & Benefit Survey [link updated for 2011 survey], available for purchase online.

Unfortunately, according to a recent IRS study, nearly half of the organizations involved in the study had not even attempted to institute all three of the practices required to establish a rebuttable position of reasonable compensation.

Definition of Compensation
The IRS defines compensation for this purpose as “all forms of cash and non-cash payments provided in exchange for services, including salary and wages, bonuses, severance payments, deferred payments, retirement benefits, fringe benefits, and other financial arrangements or transactions such as personal vehicles, meals, housing, personal and family educational benefits, below-market loans, payment of personal or family travel, entertainment, and personal use of the organization’s property.”

IRS Sanctions for Excessive Compensation
Under the intermediate sanctions regulations, if the IRS finds that your executives, board members, and other disqualified persons have been excessively compensated, they can impose the following penalties:

  The person receiving the excessive compensation can be charged a 25 percent excise tax levied on the amount of each excess-benefit transaction. If the person does not return the excess benefit to your organization within a specified time period, there is an additional excise tax imposed at 200 percent of the excess benefit.

  Your organization’s board members and managers can be charged an excise tax equal to 10 percent of the excess benefit, up to a maximum of $10,000 per excess benefit transaction. The tax can only be imposed on persons found to have knowingly and willfully participated in the transaction. However, board members who approve budgets have a fiduciary responsibility to understand those budgets. They could be considered to have knowingly and willfully participated in an excess benefit transaction if the budget includes excessive compensation for the organization’s executives.

Implementing Best Practices

As part of your organization’s best-practices implementation, consider the following recommendations:

  Establish a committee (or other authorized body) and a formal process to determine reasonable compensation for your organization’s executives, board members, and all other disqualified persons. The committee could also be responsible for establishing and monitoring formal processes governing expense reporting and any transactions with related parties.

  Implement the three practices, outlined above, that are necessary to establish a rebuttable presumption of reasonable compensation.

  Remain current regarding recent (and anticipated) changes to the reporting requirements for IRS Form 990 that require additional disclosure. A recent IRS study found significant confusion with regard to these reporting requirements within the not-for-profit community—including inaccurate and incomplete reporting of such things as loans to officers and directors.