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Nonprofit Executive Compensation: 3 IRS Requirements

February 09, 2016

Nonprofit executives receiving excess compensation and their board of directors could be at risk for significant penalties.

Do you think any of your organization’s executives are being paid in excess? Excess compensation continues to be a focus area for the IRS because nonprofit executives may be able to increase or have significant influence on their compensation. This is a major risk to an organization because not only is the nonprofit executive liable for the excise tax on excess compensation, but those who approved the compensation may also be held liable.

What is considered excessive?

In order to determine what is excessive we have to understand what is reasonable. Reasonable compensation is defined by Reg. 1.162-7(b)(3) as the amount that would ordinarily be paid for like services by like organizations in like circumstances.

Thus, the concept has two prongs:

  1. An amount test, focusing on the reasonableness of the total amount paid; and
  2. A purpose test, examining the services for which the compensation was paid.

What is included in compensation?

Compensation includes salary, assets and/or property transferred, deferred compensation, benefits, etc. Many organizations provide deferred compensation packages to retiring executive directors but do not factor this into their compensation studies which in turn could cause an excess compensation issue.

Does your compensation arrangement pass?

Compensation arrangements that satisfy three IRS requirements are eligible for a “rebuttable presumption of reasonableness” provided by federal tax regulations. If the IRS deems that compensation at your nonprofit is excessive but you have met the following requirements, it will be hard for them to penalize your organization.

1.) Approval in Advance by an Authorized Body (or Board of Directors). The terms of the compensation arrangement must be approved in advance by the Board of the organization or by an entity it controls. An authorized body is the organization’s governing body (i.e. board of directors, board of trustees, or an executive committee) that is reviewing and making the decision on the compensation arrangements. The authorized body must be composed entirely of individuals who do not have a conflict of interest for the compensation arrangement or the property transfer.

If any member of your decision making body meets any of the following criteria, he/she has a conflict of interest:

  • Is a disqualified person participating in or benefiting financially from a compensation arrangement,
  • Is related to person #1,
  • Receives compensation or other payments subject to approval by #1,
  • Is in an employment relationship under the direction or control of #1,
  • Holds a material financial interest affected by a compensation agreement, or
  • Authorizes any transaction which provides benefits to #1 in exchange for benefits for his/herself.

2. ) Reliance on Comparable Data.

  • Compensation levels paid are similar to other like organizations for similar functional positions.
  • Compensation surveys used are compiled by an independent firm
  • The availability of similar organizations in the geographic area.
  • A Small organization is considered to have appropriate comparable data if they have compensation data by three comparable Organizations in the same or similar communities.
  • Property transfers must have current independent appraisals of the value and offers received as part of a competing and open bidding process.

3.) Documentation. The board of directors must document the results and decisions and the records must include:

  • Terms of the transaction approved and the date approved.
  • Members of the authorized body present during the debate and those who voted.
  • The comparability data relied on and how it was obtained.
  • Actions taken by a member of the authorized body who had a conflict of interest in the transaction.
  • Basis for determination that compensation was reasonable when there is a difference from the range of comparable data obtained.

In order to maintain your 501(c)(3) tax exempt status, you need to ensure that your organization’s decision making body is complying with the above IRS regulations. IRS scrutiny is tough when it comes to evaluating nonprofit executive compensation, so be aware of any conflicts of interest in your organization, and make sure that all compensation decisions are approved and documented.

Questions about your executives and if their salaries are appropriate? Contact any member of our Not-for-Profit Services Team.

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