Perhaps you’ve seen news mentions of some not-for-profit executives who were being paid excessive salaries in relation to the size of their organization or out of sync with comparable salaries in their region. As a result, the IRS is increasing its oversight and enforcement of executive compensation.
Not-for-profits should evaluate their executive compensation policies. Those that are found to pay excessive compensation could be subject to fines – or even the withdraw of tax-exempt status. In addition, executives may be required to repay their excess compensation with interest, plus an excise tax of 21 percent of the excess amount.
Is Your Executive Compensation Reasonable?
The key question to ask is whether your executive compensation package is “reasonable.” The IRS defines reasonable compensation as “the value that would ordinarily be paid for like services by like enterprises under like circumstances.”
The IRS looks at several factors when determining the reasonableness of not-for-profit executives’ compensation. These factors are weighted differently, depending on specific circumstances:
- The executive’s job description and nature of duties
- The organization’s size
- How much education or experience is required for the job
- Average compensation for similar positions at other not-for-profits in the same area
- How many hours the executive works
- The organization’s overall budget
When determining whether a not-for-profit executive’s compensation is reasonable, the IRS will consider the reasonableness of the total compensation amount and the services for which the compensation was paid. In addition to base salary, the following are also considered part of an executive’s total compensation package:
- Pension and profit-sharing plan contributions
- Personal use of the organization’s facilities
- Unpaid deferred compensation
- Payment of personal expenses
- Rents, royalties, and fees
Be Sure to Use Arms-Length Procedures
Smaller organizations where employees have many different roles can sometimes create problems in determining compensation. In effect, executives shouldn’t have a say in the size of their own compensation packages.
For example, if the president of the not-for-profit board is also the salaried executive director of the organization, they should not be part of any board discussions about his or her compensation. In addition, no board members voting on the executive’s compensation should have any relation to the executive.
Not following arms-length procedures when creating compensation packages can be costly. The IRS could classify an executive compensation package as an excess benefit transaction, especially if the total package is considered unreasonable. Intermediate sanction penalties could then be levied against board members for allowing financial transactions that unfairly benefit insiders.
Similarly, it’s a good idea to adopt conflict of interest policies for not-for-profit board members and executive directors. This can help prevent the payment of improper private benefits before they occur, including excessive executive compensation. Effective conflict of interest policies detail what constitutes a conflict of interest and spell out the procedures for disclosing potential conflicts.
The National Council of Nonprofits advises not-for-profit organizations to take the following steps to help ensure that executive compensation isn’t excessive:
- Get your board of directors involved in creating executive compensation packages.
- Compare your organization’s compensation to those of executives at similarly sized organizations in your area that perform similar types of work.
- Document your compensation review process, including the names of everyone who participated in the compensation committee and the specific data they reviewed.
The Excess Nonprofit Compensation Tax
Section 4960 of the Tax Cuts and Jobs Act added a 21 percent excise tax on excess compensation paid to not-for-profit executives earning more than $1 million, as well as excess parachute payments to covered executives. Section 4960 defines covered employees as any not-for-profit employees who:
- Are among the five highest-compensated employees in the organization for the tax year.
- Were covered employees for any preceding tax year beginning after December 31, 2016.
- Each common-law employer, whether this is the not-for-profit organization or a related entity, must pay its share of excise tax based on its proportional share of remuneration paid to the covered employee.
Disclosing Executive Compensation
Not-for-profit organizations disclose various types of compensation paid, including executive compensation, on Form 990, which is filed annually. Here, the organization must specify how it determined compensation—for example, by a compensation committee, independent compensation consultant, compensation survey, or board approval.
Note that if an executive’s compensation exceeds a certain amount, Schedule J must be filed with Form 990. Schedule J lists the executive’s base pay, bonus and incentive compensation, deferred compensation and non-taxable benefits such as health insurance, educational assistance, life and disability insurance, dependent care assistance and adoption assistance. In addition, it asks questions like whether the executive flies first class.
When considering executive compensation, the adage “it’s better to be safe than sorry” is especially relevant.
Dembo Jones professionals have vast experience working with organizations in evaluating and crafting appropriate compensation packages. We’re here to help.