One answer: Because the the IRS Form 990 asks 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?" (Form 990, Section VI, Part B, line 15) Nonprofits filing the Form 990 must describe the process on Schedule O.
Protect your nonprofit by following the IRS 3-step process: Nonprofits that follow the IRS 3-step process are generally able to take advantage of what the IRS refers to as a "rebuttable presumption" that the compensation is reasonable, thereby protecting the nonprofit and the board members from sanctions that can result from a finding by the IRS that the compensation was not reasonable. See 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 (March 2007).
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. Boards that engage in an annual process of reviewing and approving the compensation of the executive director/CEO (and certain highly paid "key" employees as defined by the IRS) and that document this process in the minutes of board meeting(s), will be protecting their nonprofit (and themselves). An annual review also ensures that the nonprofit is acting in a transparent manner because through the process the full board will 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.
Policy for setting nonprofit executive compensation: 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); (2) use of "comparability data," and (3) documentation (usually through minutes of the meeting) of the board's consideration and approval of the compensation. (See link to sample policy below.)
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.
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