Executive Compensation Best Practices

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As tax-exempt organizations operated for charitable purposes, nonprofits are expected by the public to adopt reasonable compensation and avoid high salaries or benefits, though there are differences of opinion on what constitutes high salaries.

The Principles and Practices for Nonprofit Excellence are based on the fundamental values of quality, responsibility and accountability and provides guidance on how to approach compensation. The Principles and Practices suggest that a nonprofit board of directors or its designees “set compensation for the organization’s executive director and stay informed of compensation levels for other key personnel.” Board leadership and involvement in this process allows nonprofits to better fulfill their duty of care in management of financial resources and additionally help safeguard against excessive compensation and financial mismanagement.

Legal Authority

The hallmark of any nonprofit organization is the mission it sets out to accomplish, not its financial activity. In fact, attainment of IRS 501(c)(3) status requires that “no part of the [organization’s] net earnings . . . inures to the benefit of any private shareholder or individual.” The prohibition on private inurnment does not necessitate volunteer only nonprofit organizations. Because nonprofits that provide a public service that is reflected in a preferential 501(c)(3) tax status, transparency and compensation scrutiny is often heightened.

While no individual or group of individuals may profit from net organizational earning, a charity may nonetheless pay “reasonable compensation for services rendered.” Treas. Reg. § 53.4958-6. The IRS and the state of Minnesota do not require organizations to follow a particular process to determine reasonable compensation. In Minnesota, nonprofit Boards are given authority to fix compensation, usually via articles or bylaws. M.S.A. § 317A.211.

While the IRS does not require organizations to follow a particular process, the 990 disclosure requirement appears to be modeled on the “rebuttable presumption test” established in Internal Revenue Code and Treasury Regulations. As the IRS explained,

Under this test, compensation payments are presumed to be reasonable if the compensation arrangement is approved in advance by an authorized body composed entirely of individuals who do not have a conflict of interest with respect to the arrangement, the authorized body obtained and relied upon appropriate data as to comparability prior to making its determination, and the authorized body adequately documented the bases for its determination concurrently with making the determination Treas. Reg. § 53.4958-6 (2009).

990 Disclosure

In a February 2008 IRS publication, the Service noted that it has observed “significant errors or omissions” in executive compensation reporting on the IRS Form 990. The IRS recommends that “organizations should take steps to ensure accurate and complete compensation reporting on these forms…Executive compensation continues to be a focus point in our examination program.”

The 990 inquires in Part VI, Section B, 15: Did the process for determining compensation of the following persons include a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision:

  1. The organization’s CEO, Executive Director, or top management official?
  2. Other officers or key employees of the organization? Describe the process in Schedule O.

Additionally, Part VII and Schedule J solicits compensation information for certain officers, directors, trustees, key employees and highest compensated employees.

Organizations would be prudent to adopt compensation procedures and provide a narrative of those procedures in Schedule O, based on each part of the question 15 inquiry as emphasized above.

Procedure Insight

In this case, the IRS has given filers insight on what they are looking for in compensation policies through the stem of the 990 Inquiry and the Treasury Regulation on which the inquiry is modeled. The process for setting executive compensation may generally be thought of in the following steps in order to be presumed reasonable. 
Advance approval by authorized independent body

  • Authorized body:
    • Organization’s governing body, board of directors;
    • Board committee established to determine compensation; or
    • Other parties authorized by the board to act on its behalf by following specified procedures
  • The use for the word “independent” is synonymous with the requirement that the body setting compensation is free of conflict of interest. Treasury Regulation § 53.4958-6(c)(iii) outlines persons with conflicts and therefore not eligible to be apart of the authorized body. These persons generally include:
    • Persons who exert great influence as a board member, but also would economically benefit from the compensation arrangement;
    • The person with the ultimate responsibility for implementing decisions of the board (executive director, CEO, COO, president, etc.);
    • The person who has the ultimate responsibility for managing the finances of the organization (treasurers, associate directors, CFO, etc.);
    • Family members of executive employee;
    • Persons not in an employment relationship with executive employee;
    • Persons who does not receive payment or other compensation approved by executive employee;
    • Persons who have no material financial interest that would be impacted by compensation arrangement; and
    • Persons who does not engage in mutually beneficial compensation arrangement with executive employee.
      See Treas. Reg. § 53.4958-3 for descriptive definition and examples.
  • Comparability data
    • Reasonable compensation arrangement. The value of services is the amount that would ordinarily be paid for like services by similar organizations under similar circumstances. Compensation arrangements contemplate the aggregate economic benefits provided to a person including:
      • All cash and noncash compensation
      • Salary, fees, bonuses, severance payments, etc.
      • Payment of liability insurance premiums
      • See exhaustive list in Treas. Reg. § 53.4958-4(b)(1)(ii).
    • Relevant comparison information
      • Compensation levels paid by similarly situated organizations – taxable and tax-exempt, for functionally comparable positions
      • Availability of similar services in geographic area of applicable tax-exempt organization
      • Current compensation surveys compiled by independent firms
      • Actual written offers from similar institutions competing for the services of the executive
  • Documented decision
    • Adequate documentation generally includes:
      • Compensation terms approved and date of approval
      • Board members present during compensation arrangement discussions and corresponding vote
      • Comparability data obtained and used and how data was obtained
      • Actions by a non-independent Board member with respect to the compensation arrangement.
    • Additionally, if the compensation arrangement is higher or lower than the range of comparability data, the authorized body must record the basis for its determination.
    • Concurrent documentation requires records are prepared within 60 dates of final action on compensation arrangement or in advance of the next meeting of authorized body. Records must be reviewed and approved by the authorized body as reasonable, accurate and complete within a reasonable time of receipt.

Once an organization fulfills the outlined steps, the IRS may rebut the presumption that an amount of compensation is reasonable only if it puts forth sufficient contrary evidence to rebut the probative value of the comparability data relied upon.