An organization is entitled to tax-exempt status under Section 501(c)(3) provided that it is organized and operated exclusively for religious, charitable, scientific testing, public safety, literary, or educational purposes. In addition, no part of the net earnings of the organization may inure to the benefit of any private shareholder or individual.
Simply put, a tax-exempt organization may receive its status only to the extent that there are no gains to any private individual outside of a fair market value exchange. This means nonprofits cannot pay unreasonable compensation.
A nonprofit’s board of directors is responsible for establishing the compensation (salary and benefits) for the chief executive (typically referred to as either the Executive Director, the CEO, or the President). Although the IRS does not provide specific dollar amounts or an acceptable range of compensation levels, they stipulate that compensation must be reasonable and not excessive.“Reasonable” is defined as the value that would ordinarily be paid for like services by like enterprises under like circumstances.
From an organizational point of view, the compensation also needs to be attractive enough to retain the best possible talent to lead the organization.
Compensation Inclusions of Nonprofit Executives
It’s important to remember that compensation includes all items provided by an exempt organization in exchange for the performance of services, including:
- All forms of cash and noncash compensation
- Payment of liability insurance
- Taxable fringe benefits
- Forgone interest on loans
However, there are five exceptions to the rule. These items are disregarded in the reasonable compensation analysis:
- Nontaxable fringe benefits
- Benefits to volunteers
- Benefits to members or donors
- Benefits to a charitable beneficiary
- Benefits to a governmental unit
Excess Benefit Transactions Apply to Executive Compensation
Treasury Regulations Section 4958 regulates excess benefit transactions with respect to tax-exempt organizations.
What is an excess benefit transaction?
An excess benefit transaction is a transaction in which a tax-exempt organization provides an economic benefit to a disqualified person, and the value of that economic benefit exceeds the value of consideration for the disqualified person’s good or service. Excess benefit transactions result in excise taxes for the exempt organization’s managers (any officer, director, trustee, or key employees) and the disqualified person receiving the excess benefit.
Disqualified persons are, in essence, the organization’s insiders (officers, directors, trustees, or another party with significant influence over the organization and their close family members and businesses).
How much is the excise tax for excess benefits?
An excise tax equal to 25% of the excess benefit is imposed on each excess benefit transaction between an exempt organization and a disqualified person. The disqualified person who received the excess benefit is liable for the tax. If the excess benefit is not corrected within the tax period, the IRS imposes an additional excise tax equal to 200% of the excess benefit.
An excise tax equal to 10% of the excess benefit may be imposed on managers who approved the transaction. The manager’s tax is imposed if:
- The 25% tax is imposed on the disqualified person
- The manager knowingly participated in the transaction
- The manager’s participation was willful and not due to reasonable cause
Recently, the IRS publicized a rule where executives who earn more than $1,000,000 are also taxed. Any employee earning at least $1,000,000 is subject to a 21% tax regardless of the reasonableness of the compensation.
Recommended practices and procedures for setting the compensation of nonprofit executives
Nonprofits should strongly consider increasing the amount of time and attention they devote to investigating, deliberating, documenting, and reporting executive compensation. In order to facilitate a careful review, nonprofits that employ an executive staff should consider implementing the following practices and procedures:
- Create a compensation committee
- Employ the rebuttable presumption safe harbor procedures
- Adopt a comprehensive conflict of interest policy
- Adopt a compensation policy
- Use appropriate comparability data
- Assess all components of executive compensation relative to comparable organizations
- Have Chief Executive Officers’ and Directors’ compensation approved by full board
For more in depth information – download our helpful guide, Best Practices for Setting the Compensation of Nonprofit Executives, including a free Compensation Review Checklist and Compensation Committee Charter
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.