One answer is because charitable nonprofits always should be able to justify that the compensation received by the executive director/CEO and other staff is reasonable, and not excessive. Adopting a written policy about "executive compensation" and following it helps ensure that a nonprofit is following the guidelines outlined by the IRS, and responds to the desire for financial transparency. A related goal of a compensation policy is to ensure that your nonprofit is paying ENOUGH to attract and retain the most highly qualified and talented employees.
Legal Background: The IRS Form 990 asks charitable nonprofits about the process used to approve the compensation of the executive director/CEO (and certain other key employees): "Did the process for determining compensation of the following persons include a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision?" (See IRS Form 990, Section VI, Part B, line 15.) Nonprofits filing the Form 990 must describe the process on Schedule O.
Ensuring that the board has approved "reasonable and not excessive" compensation for the executive director/CEO is one of the fiduciary responsibilities of every nonprofit board. (As in -- "Are the assets of this nonprofit being used prudently and to advance the mission?") Boards that engage in an annual process of reviewing and approving the compensation of the executive director/CEO and that document this process in the minutes of board meeting(s), will be protecting their nonprofit (and themselves). The written policy should require the full board to approve the compensation (salary AND benefits). A committee, such as the executive committee or a compensation committee, or a task force, can review comparable salaries/benefits and make a recommendation but the full board should be aware how much the executive director/CEO is being paid by the nonprofit. Having a robust conflict of interests policy is another important aspect of ensuring fair and reasonable compensation, as well as transparency in financial transactions.
Defining what is "reasonable" requires a comparison. Protect your nonprofit and its board members from potential penalties by following the IRS 3-step process below: As described by the IRS in the Form 990 and instructions to the Form 990, the review process must include three elements: (1) review by an independent body (such as a compensation committee or the executive committee, as long as no one on the review body is employed by the nonprofit); (2) use of "comparability data," such as salary surveys, that provide data from nonprofits of similar mission focus, budget size, and geographic region, and (3) documentation (usually through minutes of the meeting) of the board's consideration and approval of the compensation. Sample policy. (Source: Section 4958 of the Internal Revenue Code and Treasury Regulation section of 53.4958-6 and The IRS Report on Exempt Organizations Executive Compensation Compliance Project Parts I and II.)
The process boards should use to review comparability data and approve the compensation and benefits of the executive director/CEO is explained in more detail in the instructions to the IRS Form 990 (see pages 23-34, specifically the explanation for Line 15).
The instructions to Form 990 include a glossary of terms and a table that shows precisely how and where to report the many types of "other compensation" that should be included in total compensation.
"Charities should generally not compensate persons for service on the board of directors except to reimburse direct expenses of such service. ... Charities may pay reasonable compensation for services provided by officers and staff. In determining reasonable compensation, a charity may wish to rely on the rebuttable presumption test of section 4958 of the Internal Revenue Code and Treasury Regulation section of 53.4958-6."
- Source: IRS publication Governance and Related Topics - 501(c)(3) Organizations (2008)
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