What should a nonprofit pay its chief executive?
The board of directors is responsible for hiring, and establishing the compensation (salary and benefits) of the executive director/CEO by identifying compensation that is "reasonable and not excessive," but that also is attractive enough to retain the best possible talent to lead the organization. The recommended process for determining the appropriate compensation is to conduct a review of what similarly-sized peer organizations, in the same geographic location, offer their senior leaders. Nonprofits filing IRS Form 990 must describe the process they use to approve executive compensation as part of the nonprofit’s responses on the annual return, IRS Form 990, Section VI, Part B, line 15.
What is "reasonable" compensation according to the IRS?
The IRS recommends that charitable nonprofits follows its three-step process to determine that compensation is “reasonable and not excessive.”
In order to protect your nonprofit and its board members from potential intermediate sanctions (penalties), your nonprofit should be aware of the three-step process promoted by the IRS (in instructions to the Form 990).
Three-step process to determine appropriate compensation
- The board should arrange for an "independent body" (which means that the person receiving the compensation should not be part of the review process) to conduct a "comparability review." Many nonprofits task a "compensation committee," or use their executive committee, or another sub-group/task force of board members, for this purpose.
- The independent body should take a look at "comparable" salary and benefits data, such as data available from salary and benefit surveys, to learn what employers of a similar budget size that are located in the same, or a similar geographic region, pay their senior leaders. Ideally, the comparison will include data from other nonprofits of a similar mission focus.
- The board/independent body that is conducting the review should document who was involved and the process used to conduct the review, as well as the disposition of the full board's decision to approve the executive director's compensation (minutes of a meeting are fine for this). The documentation should demonstrate that the board took the comparable data into consideration when it approved the compensation.
- 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. ("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).
- Adopting a written policy that requires the full board to approve the compensation (salary AND benefits) is a recommended practice.
- 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). Nonprofits filing the Form 990 must describe the process on Schedule O.
- Having a robust conflict of interest policy is another important aspect of ensuring fair and reasonable compensation, as well as transparency in financial transactions.
- 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. See instructions to IRS Form 990, pages 31-32.
- 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.
- 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).
- 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.
- Sources for comparable data include survey reports or studies from state associations of nonprofits or other sources, including outside compensation consultants. 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.
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.
- Compensation policy (sample) (Public Counsel Law Center)
- Performance appraisal process for CEO (Joyaux Associates)
- Evaluating the Executive Director - Your role as a Board Member (First Nonprofit Foundation)
- Setting nonprofit executive compensation and the role of the compensation committee (Charity Lawyer Blog)
- Quick tips for setting nonprofit executive compensation (Charity Lawyer Blog)
- Sample CEO self-evaluation tool (National Council of Nonprofits)
- What You Need to Know about Nonprofit Executive Compensation (GuideStar)
- Establishing CEO compensation (GuideStar/Venable LLP)
- Compensation strategies are shared in a two-part best practice series on nonprofit compensation in the NonprofitLaw Blog.
- 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.
- IRS Form 990, and instructions to Form 990
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)