Executive Compensation Policies

Why Have a Written Policy for the Compensation of Nonprofit Executives?

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.)

• Definitions matter: Compensation includes salary and benefits, such as insurance, a car, housing allowance, or other fringe benefits, that should be included in the calculation of total annual compensation.
• During the process of board approval of the compensation of the executive director/CEO it is essential to have comparable data in order to comply with the expectations for good governance reflected on the Form 990 (see Part VI, Section B, line 15). One method is to obtain compensation surveys or studies from outside compensation consultants for this purpose. The Internal Revenue Service will look to the independence of any compensation consultant used, and the quality of any study, survey, or other data, used to establish executive compensation.
• Comparable data is compensation data from "similarly qualified," "functionally comparable," and similarly situated nonprofits (in the same or a nearby geographic area, of similar budget size, and in a similiar or the same sub-sector).
• Example: it would not be comparable to compare the compensation of a CEO of a large urban hospital or university to the CEO of a rural day care center.

Practice Tip

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 18-23, and read 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.

Tools for boards

• Review a sample policy for board approval of compensation prepared as an illustration for small nonprofits by the National Council of Nonprofits.
• Easy-to-understand legal discussion about setting nonprofit executive compensation and the role of the compensation committee posted on Charity Lawyer Blog -- and quick tips for setting nonprofit compensation.
• Compensation strategies are shared in a two-part best practice series on nonprofit compensation in the NonprofitLaw Blog.
• Musings from Blue Avocado on What to Pay the Executive Director.
• Read a white paper from the DC Bar about the “rebuttable presumption” and how following the IRS process for approving compensation helps boards protect their nonprofit from allegations that compensation is “too high” or unreasonable.
• Attend a virtual seminar, hosted by Columbia Law School during which leading tax-exempt lawyers,who specialize in executive compensation, provide guidance to state charity regulators on the process a nonprofit board might use to establish that compensation is reasonable.

Resources:

I.R.S., Governance and Related Topics - 501(c)(3) Organizations 3-4 (2008), "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."

IRS Report on Exempt Organizations Executive Compensation Compliance Project--Parts I and II (March 2007)

IRS Form 990, and instructions to Form 990