In light of the heightened interest of the I.R.S., Congress, state regulators, and the media in executive compensation, as well as heightened penalties, exempt organizations should strongly consider increasing the amount of time and attention they devote to investigating, deliberating, documenting, and reporting executive compensation.
Table of contents
- Practices and Procedures in Setting Nonprofit Executive Compensation
- 1. Create a Compensation Committee.
- 2. Employ the Rebuttable Presumption Safeharbor Procedures.
- 3. Adopt Comprehensive Conflicts of Interest Policy.
- 4. Adopt a Compensation Policy.
- 5. Use Appropriate Comparability Data.
- 6. Assess All Components of Executive Compensation Relative to Comparable Organizations
- 7. Have CEO’s and Directors’ Compensation Approved by the Full Board
Practices and Procedures in Setting Nonprofit Executive Compensation
To facilitate the careful review that is demanded, tax-exempt organizations that employ an executive staff should consider implementing the following practices and procedures:
1. Create a Compensation Committee.
A dedicated committee is in a better position than the full board of directors to devote the time and attention that executive compensation matters require. To guide the Compensation Committee and to establish its legal authority (as required under the rebuttable presumption, safe-harbor procedures), the Compensation Committee should operate pursuant to detailed bylaw provisions, resolutions, or a written charter adopted by the full board of directors (or trustees).
The legal restrictions in this area are designed, in part, to create tension between the board and the executive staff around executive compensation. Management should not control the compensation setting process even indirectly. Ideally, the Compensation Committee’s Charter should authorize the Committee to select, hire and work with advisors directly, outside the presence of management.
2. Employ the Rebuttable Presumption Safeharbor Procedures.
A tax-exempt organization making a decision regarding compensation of a disqualified person must adequately document the basis for its determination. For 501(c)(3) public charities (and social welfare organizations) the procedure, if carefully followed, shifts the burden of proof to the IRS to prove the unreasonableness of the compensation package. For other tax-exempt organizations, the procedure serves as a good roadmap for adequately documenting compensation decisions.
To adequately document the decision for purposes of the rebuttable presumption process, the records of the governing body must state the terms of the compensation package that were approved, the date it was approved, the members of the governing body who were present during the debate on the compensation arrangement that was approved and those who voted to approve or reject it.
The documentation should also note the comparability data obtained and relied upon by the governing body, how it was obtained, and the actions taken with respect to any member of the governing body who had a conflict of interest with respect to the compensation decision.
Additionally, the governing body must record the basis for its determination whenever it decides that reasonable compensation is higher or lower than the range of comparable data received.
The documentation must be made concurrently with the determination of the compensation arrangement. Records must be prepared by the next meeting or within 60 days of the governing body and must be reviewed and approved by the governing body as reasonable, accurate, and complete within a reasonable time thereafter.
3. Adopt Comprehensive Conflicts of Interest Policy.
All exempt organizations should by now have adopted a Conflict of Interest Policy. A Conflict of Interest Policy is a de facto I.R.S. requirement for public charities now that Forms 990 and 1023 ask whether an organization has a Conflict of Interest Policy and require an explanation for those that do not.
If a member of the governing body is found to have a conflict of interest, the rebuttable presumption safe-harbor procedure requires that the tax-exempt organization take steps to address the conflict and record those steps in its meeting minutes.
Such steps could involve the member with the conflict not participating further in any decision making related to the matter creating the conflict (and leaving the meeting room during discussions and votes on the matter) or stepping down from the governing body.
Another option is for the tax-exempt organization to end a business relationship with a business in which the member has a conflict. The situation could also be addressed by utilizing a process in which the tax-exempt organization generates disinterested bids or hires a consultant to examine the terms of the relationship and in light of the analysis determines that the terms of the compensation arrangement are fair and reasonable.
4. Adopt a Compensation Policy.
To increase consistency in setting compensation, tax-exempt organizations should consider creating a Compensation Policy. A Compensation Policy should serve as a long-term policy on executive compensation. It should articulate how the organization links pay to performance, strategy, values, and mission.
It should specify comparable peer groups, target market position with respect to salary, long and short-term incentives that the organization offers, total cash compensation, standard benefits, and any executive benefits and perquisites.
5. Use Appropriate Comparability Data.
Compensation must be commensurate with the duties and responsibilities of the person being compensated. Reasonable compensation is the amount that would ordinarily be paid for like services by like enterprises, whether taxable or tax-exempt, under like circumstances.
In order to satisfy the rebuttable presumption safe-harbor procedure, the authorized body of the tax-exempt organization must rely on comparability data to make its determination regarding compensation issues.
Appropriate data includes compensation levels paid by similarly situated organizations, both tax-exempt and taxable, for comparable positions. The positions compared must constitute like services, the enterprises compared must constitute like enterprises and the surrounding circumstances must constitute like circumstances.
In comparing an individual’s compensation to another individual’s compensation, the comparison must be based on substantially similar duties and responsibilities. The I.R.S. has stated that the key is comparing duties and responsibilities, a functional comparison, and not the job title. To determine whether the individual’s compensation is commensurate with others in the same position and thus reasonable, the I.R.S. considers, among other factors:
- the individual’s duties and responsibilities;
- the number of employees the individual manages;
- the size of the budget or assets the individual manages;
- the number of hours worked;
- whether the job is national or local in scope; and
- whether the individual manages multiple functions or departments.
Comparisons of enterprises need to be based on entities of similar size. Indicators of size include the number of employees, number of persons served by the organization, budget, and revenues.
Additionally, the comparables should come from the same industry so as to best match the individual’s duties and responsibilities. For example, the director of a private elementary school is not necessarily comparable to the director of a four-year university.
Tax-exempt organizations can look to both the for-profit and non-profit sectors to determine reasonable compensation. However, exclusive reliance on for-profit comparables is not advisable.
The I.R.S. has stated that exclusive reliance on for-profit data will likely draw increased scrutiny and may lead to the tax-exempt organization not being able to rely on the rebuttable presumption of reasonableness.
The only time that the exclusive use of for-profit data is appropriate is where there are no appropriate non-profit comparables in the tax-exempt organization’s market or where the tax-exempt organization can show that tax-exempt and for-profit entities compete for the same pool of specialized talent.
Compensation packages being compared must consist of a similar mix of compensation items. All forms of compensation must be properly aggregated and accounted for and included in total compensation. The organization should also use comparables from the same geographic area where possible.
The availability of similar services in the geographic area of the organization is relevant to determining the appropriate level of compensation. If there are no comparables in the geographic area, the tax-exempt organization can go outside of that geographic area for comparables but must make appropriate cost-of-living adjustments.
Number of Comparables
Small organizations trying to meet the requirements of the rebuttable presumption of reasonableness must use at least three comparables in the same or similar communities for similar services. This includes organizations with annual gross receipts of less than $1 million.
There is no specific number of comparables required for larger organizations to satisfy the rebuttable presumption safe harbor procedure, although the inference is that such an organization needs more than three comparables.
Where compensation should fall within the range of comparables
There are no hard and fast rules for where an organization’s compensation should fall within the range of comparables. The I.R.S. says that it is less likely to scrutinize compensation that is at or below the fiftieth percentile for the relevant market.
As far as compensation paid above the fiftieth percentile, an organization will need evidence to show that the compensation that it awards is reasonable and justify why such compensation is greater than the compensation of comparable organizations. Higher compensation may be warranted in situations where, for example,
- the executive receiving the higher compensation has special knowledge, experience, or relationships that would be difficult to replace;
- the executive has received competing offers at that level or other special circumstances;
- such as where the executive has special qualifications relevant to recovering from mismanagement or to grow into new and different areas.
In each of these situations, the organization may need to compensate a person outside of the range of what would be the median for comparable organizations.
6. Assess All Components of Executive Compensation Relative to Comparable Organizations
It is important to ensure that total compensation is reasonable rather than comparing salary and various perquisites in isolation. Unless the Compensation Committee has taken care to assess the reasonableness of total compensation, their review will not significantly protect the tax-exempt organization or the board from penalties. All financial benefits (other than de minimus fringe benefits) must be included in the analysis and reported as compensation.
7. Have CEO’s and Directors’ Compensation Approved by the Full Board
It is prudent to have the full board of directors approve the CEO’s compensation package. Some boards reserve the right to approve other executive’s compensation, others delegate that task to the Compensation Committee or to the CEO (within pre-established limits).
Also, the full board of directors should approve any compensation paid to directors or trustees and should base its decision on the certified opinion of an independent compensation consultant due to the inherent conflict of interest. This is a requirement under some states’ non-profit corporation laws.
Ellis Carter is a nonprofit lawyer with Caritas Law Group, P.C. licensed to practice in Washington and Arizona. Ellis advises nonprofit and socially responsible businesses on corporate, tax, and fundraising regulations nationwide. Ellis also advises donors with regard to major gifts. To schedule a consultation with Ellis, call 602-456-0071 or email us through our contact form.