Reasonable Compensation for Executives in Tax-Exempt Organizations

December 9, 2010

Recently, I had the privilege of becoming a preferred consultant for the Nonprofit Resource Network (NRN). The mission of the NRN is to enhance the effectiveness of local nonprofit organizations in carrying out their own missions. In addition to holding a number of educational seminars and networking events in or near Lancaster County, the NRN provides hands-on counseling to help nonprofits achieve long-term financial stability. As a preferred consultant, I was given the opportunity to write an article for the new resource section of their website. I am posting the article on the Lancaster Law Blog to benefit our readers as well. I would also encourage everyone to check out the Nonprofit Resource Network website for additional information pertaining to nonprofits.

It probably goes without saying that effective leadership is an essential component to the performance of non-profit organizations. In order to successfully pursue their tax exempt purposes, it is essential for non-profits to seek out and hire quality executives to run the show. 

The problem is that in a free market economy, tax exempt organizations are competing with for-profit businesses in the same talent pool. Although the salary a for-profit business can offer is generally limited only by that company’s budget, non-profits can lose their tax exempt status or face intermediate sanctions if the salaries they pay are excessive. Therefore, it is important for non-profits to familiarize themselves with the rules regarding reasonable compensation. 

In general, the compensation awarded to non-profit executives should reflect that of an arms-length transaction between two unrelated parties and should be based on the fair market value of services being rendered. Non-profits should ask themselves: "what is the pay scale for comparable skills on the open market?"

An increase in risk or danger to an employee can be taken into account. On the open market, those hazards would tend to increase compensation. An example of such a risk would be frequent required travel to areas afflicted with disease, poverty, malnutrition or war. On the other hand, there is a social expectation attached to many non-profit organizations that employees who believe in the mission of the organization will be willing to work for less. This is especially true for organizations that rely primarily on public donations.

There are three other things to consider. First, compensation should not be based on the relationship of the employee to the organization. For example, an individual should not be given higher compensation because he is the nephew of an important donor. Second, compensation comes in more forms than only money. Non-profits also need to be careful about benefits, in-kind payments of goods, bonuses, deferred compensation, insurance premium payments, taxes, revenue sharing, vacations, use of property and other items of value.

Finally, to make things easier, the IRS has provided a safe harbor that, when applicable, creates a rebuttable presumption that the compensation is reasonable. In general, there are three requirements:

  1. The compensation, along with any related terms or conditions, must be approved by disinterested members of the board or a similar body authorized to approve such compensation.
  2. The authorized body must accumulate sufficient data regarding similar compensation paid by similar organizations for comparable services. There are various resources, such as local Chambers of Commerce, that can be of assistance.
  3. The authorized body must document in detail the basis for its determination at the time that the decision is made. This can be done with a unanimous resolution or can be recorded in detail in the written minutes of an official meeting.

Ultimately, the goal is to level the playing field for potential candidates and treat them equally. Compensation should not be based on favoritism or other factors not relevant to the skill set and job requirements of the specific opening.

Most nonprofit organization have personnel who are well versed in the requirements to maintain tax-exempt status; however, it is always advisable to ask questions to clarify issues that arise. Consulting with an attorney who has experience dealing with tax-exempt organizations will allow you to be confident that your decisions will not jeopardize the organization. 

For more information on compensation issues and other compliance issues relevant to tax exempt organizations please see IRS Publication 557.