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Incentive Compensation in a Not-for-Profit Environment

March 29, 2013

How not-for-profit organizations can utilize alternative methods to increase efficiency.

Many believe that any form of incentive compensation in a not-for-profit organization is inappropriate or worse, against the law. This is totally not true. As a matter of fact, in 2002 the IRS published an Information Letter (INFO 2002-0021) that listed the 12 factors that it considers in determining whether an incentive compensation agreement is OK or a violation of prohibited private inurement.

Before we get to the IRS factors, we should consider whether incentive compensation is appropriate to the task at hand whether that is in a for-profit or not-for-profit environment. There are many who believe that linking compensation directly to performance is a process with diminishing results. These people believe that intrinsic motivation, where performance of the task is its own reward, when coupled with a fair level of compensation is best. This blog is not for debating that topic. There is plenty of material out there if you want to delve more deeply into the behavioral ramifications of each type of program.

In a not-for-profit organization, one would think that intrinsic motivation is natural since the organization is mission oriented and achieving the mission is usually a rewarding experience. (Is that really any different from any other business? Wasn’t Steve Jobs thrilled that people liked his products?) Even if you do believe that not-for-profit work is more intrinsically rewarding, this does not mean that there are not some situations in which an incentive compensation financial reward would not be in the best interest of the organization.

For example: In an organization that has a clinical counseling component, it is often a challenge for the organization to avoid excessive missed counseling appointments. When a client fails to show for their scheduled appointment, the organization does not realize the third-party payment that is linked to that counseling session while still incurring costs relating to the counselor and the physical space that goes unused. In such a situation, it is entirely appropriate to incent the clinician to devise procedures that will result in reduced no-shows.

Reduced no-shows are in the best interest of the people being counseled as well as the organization. What can be wrong with a program that encourages the clinician to help achieve that goal? Claiming that the clinician should not need a financial incentive to reduce no-shows is an admirable theoretical position that should not be adhered to while the programmatic and financial results suffer.

Of course, I have also seen some companies that had so many financial incentives that some employees felt they should be tipped for holding the door open for a fellow employee.

The IRS has said the following in regard to incentive compensation at not-for-profit organizations.

The incentive compensation agreement should:

  1. Be approved by the board of directors or compensation committee with a conflict of interest policy;
  2. Result in total compensation that is reasonable;
  3. Be utilized only where there is an arm’s length relationship between the employer and the employee rather than where there is impermissible participation by the employee in management and control of the employer;
  4. Have a ceiling on the amount the employee can earn;
  5. Consider data that measures quality of service to the employer’s constituents;
  6. Accomplish a charitable purpose, such as keeping expenses within budgeted amounts if the compensation amount is based on net revenue;
  7. Serve a legitimate business purpose, such as achieving efficiency or economy of operations;
  8. Provide rewards based on services actually performed by the employee rather than rewards based on the employer’s performance in an area where the employee performs no significant functions.

The incentive compensation agreement should not:

  1. Have the potential for reducing charitable services provided by the employer;
  2. Transform the employer’s principal activity into a joint venture between it and the employee or subcontractor;
  3. Serve as a device to distribute the employer’s profits to the person or persons who control it;
  4. Result in abuse or unwarranted benefits because prices or operating costs don’t compare favorably with those of similar organizations.

Remember, all not-for-profit organizations are a business with a mission to be accomplished. Use every tool available to you to achieve your goals. Do you have incentive compensation plans? What are some of the challenges you have faced?.

As one of the largest CPA firms in Boston, KLR is unique because they service over 220 not-for-profit organizations with compliance and consulting services. We have extensive experience helping Nonprofit organizations regarding boards, and board responsibilities, charitable contributions, taxes and 990 filing requirements. The KLR Nonprofit team is active in our local community and not-for-profit organizations, visit our Facebook page to see photos from our latest volunteer event.

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