The Real Rules Around Executive Compensation
Updated: Sep 17, 2019
Issue in Brief
Non-profit organizations are required by law to pay only "reasonable compensation" to their executives and penalties can be imposed on the organization, or board members.
This comprehensive, direct guide is designed to bring you flexibility, and get you back to focusing on the mission ASAP. It is written for board members, executives, and advisers at any 501(c)3 organization.
This guide is based on information from top experts, IRS publications, and the law itself and lays out what's allowed, best practices, and gives simple steps to achieve compliance. For typical organizations, those include that you:
Get market data
Form a compensation committee
Document the decision in meeting minutes
As a disclaimer, this article is for informational purposes only and isn't tax or legal advice.
Why this Matters
IRS agents recommended $21 million in penalties for excessive executive pay in 2007, and always look at executive compensation in audits.
We've researched the topic deeply and spoken with expert advisors. We believe this is the most comprehensive, and easiest to use guide to compliance on setting executive compensation out there.
Board Members: You’re Held Responsible
Setting fair compensation is part of being a good leader and using resources responsibly. But beyond that, excise taxes may be levied personally against board members who make the decision (If you're worried about this, you can get D&O insurance). Loss of nonprofit status can happen if you run afoul of this rule.
CEOs, EDs, and Others: Understand Your Board & Negotiate Fair Compensation
If you're a leader in an organization, this can give you insight into your board’s decision-making process and limitations for setting your compensation. This can help you understand why your board is doing what it's doing, and give you insight into negotiating your compensation.
What’s Not in This Guide: This is Just About the Rules
This guide covers the rules and guidelines. The following issues are important, but left for you to consider:
Impact: Most importantly, your executive compensation matters a lot for impact because choosing an executive or retaining a really good one is really important. It also matters as an expense which could be used otherwise to help your exempt purpose.
Public Image: Executive compensation is often in the news. This guide doesn't address that issue - we think you know your donors best, and you can decide how to set compensation they'd understand.
Donor Interest: About 40% of donors are interested in executive compensation. That information is available to them, now more than ever, with more public data released from the IRS, and the success of services like GuideStar and Charity Navigator.
This section covers the strict rules and helpful guidelines set forth by the IRS.
Reasonable Compensation is Just That
According to the IRS, pay at nonprofits must be reasonable.
“Reasonable compensation is the value that would ordinarily be paid for like services by like enterprises under like circumstances. Reasonableness is determined based on all the facts and circumstances.”
-From the IRS, here
In short the concept is:
Pay fair market value, based on what others are paying, but also
Make a thoughtful decision, considering all relevant factors
While these are the limits on what’s allowed, they leave a lot open to interpretation. The rest of this guide lays out more concrete guidelines and clear, practical steps you can take to stay compliant.
Ok, But What Does that Really Mean? Guidelines for Safe Harbor.
The IRS sets out many guidelines for reasonable compensation, and how you make the decision.
How you run your organization is up to you, but the following are best practices that can grant you a safe harbor, meaning you're more likely to be in compliance, and you can worry less.
In addition, these guidelines are not just for the IRS. These procedures also help ensure that your organization is using its resources responsibly, that executive compensation isn't excessive, and is decided upon fairly. These issues go beyond the scope of this guide, though.
To get the safe harbor, what matters is what information you use to make it, who makes the decision, and, of course, you need to document it when it happens.
1. What: To determine fair market value, you should look at data on comparable organizations. There are many ways to fulfill this requirement. That data can come from surveys, form 990s, phone calls, market studies, or written offers.
Consider written offers from other organizations if you have them
You can sometimes acquire surveys from your state nonprofit association
For additional confidence, you can hire a consultant to do a review or custom market study.
In any case, organizations of a similar size, in a similar location/market, and organizations that do similar types of work.
How much information is considered appropriate and adequate depends on the size of your organization...
...for most cases, we recommend our market summary report, based on all the most recent available form 990s filed electronically with the IRS, available on nonprofitfairpay.com.
...for smaller organizations (<$1 million/year) the safe harbor is specifically defined as a minimum of calling 3 similar organizations in the area, and documenting the phone calls. The phone call needs to cover compensation, the job description, and qualifications of the candidate. We can help you identify similar organizations. You can call leaders of similar organizations, to find out about their compensation for similar roles. Be sure to document those calls, as described here.
If you’re still unsure what fits you, feel free to contact us, or talk to your tax advisor, legal council, or the IRS.
2. Who: Compensation must be set by an independent body. Usually this is a compensation committee, composed of board members excluding the executive director and family members. For unusual cases, it may be another independent group, such as a compensation consultant.
This group should take into account all the facts and circumstances around compensation.
Qualifications of a candidate include formal qualifications such as job history, education, and skills, but also things like soft skills, connection and contacts, and other intangibles.
3. When you go through the decision process, document it. You need to document the decision and how it was made, in your meeting minutes, within (60 days). Document
the date, terms of the transaction
who was present and how they voted
anything done by anyone with a conflict of interest
the basis for the decision
If you do those 3 things, then you should meet IRS guidelines for safe harbor. While there are no perfectly hard and fast rules for meeting this, if you do qualify, note that the IRS has never challenged the presumption of reasonableness established by the safe harbor in court.
Keeping Compensation Current: Stay in Step with the Market
The IRS gives some guidance on setting compensation from year to year. In particular, if not much has changed, you can just look at what few things have changed, including the market trends, and make adjustments. After a couple years, though, you'll need to dig in deeper again.
Best Practice: Set a Compensation Policy
Although not required for the IRS safe harbor, the IRS does ask organizations to report whether they have a formal executive compensation policy. About half of all organizations have one.
A formal pay policy can also show donors you're committed to fair pay. This is considered best practices, and is reportable to the IRS. A sample policy is here.
Reasonable Compensation Checklist
Level 1 – Set Pay Your Own Way (At Your Own Risk)
□ We believe we’re paying reasonably, based on all the facts and circumstances, and adequate information about the market for similar services from similar organizations.
Level 2 – Safe Harbor (Recommended)
Note that the IRS has never challenged the presumption of reasonableness established by safe harbor in court.
□ We used data to make our decision
For smaller organizations ( less than $1 million per year): 3 documented phone calls to similar organizations in your market is considered adequate for the safe harbor. You can contact us for help identifying similar organizations.
For larger organizations: more care and detail is expected.
□ Surveys or reports (*our report) – reportable to the IRS
□ Form 990 info (*included in our report) – reportable to the IRS
□ Written offers of employment – reportable to the IRS
□ Phone calls with leaders at similar organizations – reportable to the IRS
□ The decision makers were independent – reportable to the IRS
□ Didn’t include the people being paid AND
□ Didn’t include family members of the people being paid
□ When we decided, we documented it
Level 3 – Best Practices
□ We have a formal executive pay policy – reportable to the IRS
□ We’ve hired a compensation consultant, if needed – reportable to the IRS
If you would like additional assurance, have an unusual situation, or would just like an independent voice in the room, it is common practice to hire a consultant to review your compensation and give an opinion - reportable to the IRS. You can work with us, or look one up.
It is also recommended that you consult your accountant and attorney on the subject. This guide is for informational purposes only. It is not legal nor tax advice.
Have More Questions? Get in Touch.