The nonprofit sector relies on strong leadership to fulfill its mission and ensure long-term sustainability. One of the most important responsibilities of a nonprofit board of directors is to establish fair and reasonable compensation for the executive director or CEO. Compensation must strike a balance between attracting and retaining top talent while ensuring compliance with legal and regulatory requirements.
The Board’s Role in Executive Compensation
The board of directors is responsible for hiring and setting the salary and benefits of the nonprofit’s executive leadership. This must be done in a way that is reasonable and not excessive, aligning with the organization’s mission and available financial resources.
A well-structured executive compensation process includes:
- Conducting an independent review of compensation.
- Comparing salaries to similarly sized organizations in the same geographic location.
- Documenting the process to create a rebuttable presumption of reasonableness in case of IRS scrutiny.
- Ensuring the compensation package is competitive enough to attract and retain skilled executives.
Compliance with IRS Regulations
To maintain tax-exempt status, nonprofits must adhere to IRS guidelines on executive compensation. This involves:
1.) Using an Independent Review Body: The board or a designated compensation committee should conduct a review, excluding the executive director from the decision-making process.
2.) Using Comparable Data: Compensation should be benchmarked against similar organizations in terms of size, mission, and location.
3.) Documenting the Process: Meeting minutes should record the compensation discussion and the basis for decisions.
Nonprofits filing IRS Form 990 must disclose their executive compensation approval process in Part VI, Section B, Line 15, Schedule J, Part 1, Question 3, and provide details on Schedule O.
Best Practices for Establishing Executive Compensation
To ensure fairness and transparency, nonprofit boards should:
- Conduct Annual Reviews: Regularly evaluate executive performance and compensation.
- Leverage External Resources: Use salary surveys from state nonprofit associations, consultants, and platforms like Candid.
- Develop a Compensation Philosophy: Define guiding principles that align with the nonprofit’s mission and values.
- Account for Total Compensation: Beyond salary, factor in benefits like health insurance, retirement plans, bonuses, and other perks.
Executive Evaluation and Performance Metrics
Boards should integrate compensation discussions with executive performance evaluations. A formal annual review should include:
- Progress toward strategic goals.
- Leadership effectiveness.
- Financial and operational achievements.
- Staff and stakeholder feedback.
Setting performance-based incentives can further align executive compensation with organizational success.
Avoiding Pitfalls and Legal Risks
Failure to properly manage executive compensation can lead to:
1.) IRS Regulations and Federal Penalties
- Excess Benefit Transactions (IRC Section 4958):
- Nonprofit board members have a fiduciary duty to ensure that compensation is reasonable.
- If compensation exceeds what is deemed reasonable, it is considered an “excess benefit transaction.”
- The IRS may impose excise taxes on the excess amount. For individuals, the tax can be up to 200% of the excess benefit if it is determined that they knowingly approved the transaction.
- Personal Liability:
- Board members who participate in or authorize such transactions may be held personally liable for the excess benefits received by the nonprofit.
2.) State-Level Oversight
- Attorney General Investigations:
- Many states have oversight mechanisms for nonprofits.
- State attorneys general can investigate complaints or irregularities regarding compensation practices.
- Findings of excessive compensation could lead to civil penalties, mandatory corrective actions, or even removal from the board.
3.) Organizational Consequences
- Risk to Tax-Exempt Status:
- Nonprofit organizations must operate within IRS guidelines.
- Persistently excessive compensation can jeopardize the organization’s tax-exempt status, which in turn affects funding, grants, and overall operations.
- Reputational Damage:
- Public disclosure of excessive compensation can lead to negative publicity, reduced donor confidence, and potential loss of funding.
- Internal Remedies:
- The executive may be required to return the excess compensation or adjust future compensation packages to align with reasonable market standards.
Executive compensation is the most reviewed information within an organization’s 990 and continues to come under scrutiny. NY States now repealed Executive Order 38 put limits on executive compensation by NY State funded organizations and Suffolk County, NY attempted to pass regulations that would have disallowed contracting by the County with nonprofits that paid executive compensation in excess of $250,000. This makes it exceedingly important for organizations to have proper controls surrounding executive compensation in place.
A nonprofit board’s role in setting executive compensation is crucial for financial sustainability, regulatory compliance, and leadership retention. By following a structured, transparent process and prioritizing fairness, boards can ensure that their executive leaders are adequately compensated while staying aligned with the organization’s mission and ethical standards.
Implementing best practices, maintaining documentation, and seeking external expertise when necessary will help nonprofits make informed decisions and avoid potential risks. Ultimately, well-compensated leadership contributes to the success and long-term impact of the organization.
Iwona Sornat, CPA
Manager
Iwona is a Manager in Cerini & Associates’ audit and consulting practice, and she has more than 10 years of experience in providing various audit, review, accounting services to nonprofit, for-profit and government clients. Iwona has a strong background of financial statement and audit experience, including all aspects of grant compliance and single audit testing (Uniform Guidance). Iwona’s technical knowledge and experience allows her to provide effective and efficient audit service to her clients.