IRS Rules on Reasonable Compensation for Executive Directors

Create a rebuttable presumption of reasonable compensation with the IRS by following these procedures.

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The IRS has established procedures for approving transactions with directors and key employees that, if followed, create a “rebuttable presumption” that the transaction in question was reasonable and therefore not an excess benefit transaction. This means that the IRS must presume that the transaction passes muster if you follow the IRS-recommended procedures. In addition, sanctions cannot be imposed on your nonprofit's managers if these procedures are followed. The IRS can still challenge what your nonprofit did, but it must come up with its own evidence showing that your board acted improperly. As a practical matter, the IRS will rarely make such an effort. To be effective, you must implement these procedures before you enter into the transaction with the director or employee.

Your nonprofit would be wise to use these procedures to establish the compensation of its keep employees and directors. The IRS-recommended procedures consist of the following:

Prior Approval by Authorized Body

The person's compensation must be approved in advance by an "authorized body." This can be the entire board of directors, a committee of the board, or other person or persons authorized by the board to act on its behalf. Thus, it is not necessary to have the full board approve the transaction. It can be approved by a committee appointed for the purpose by the board. Such a committee, usually called an executive committee, usually consists of at least two board members. However, a committee of only one member is acceptable to the IRS if permitted under your state's nonprofit corporation law. If permitted by your state's nonprofit corporation law, an independent committee consisting of non-board members can also be authorized by the board to approve such transactions--for example, a committee consisting of the executive director and chief financial officer.

No Conflicts of Interest

Whoever reviews and approves the compensation--whether the full board or a committee--may not have any conflicts of interest. Any person with a conflict of interest should not participate in the deliberations or vote on the issue. No person voting on the transaction should be:

  • a member of the director or employee's family
  • in a position to benefit financially if the transaction is approved or disapproved
  • an employee of the nonprofit who works under the DP’s direction
  • an employee of the nonprofit whose compensation is subject to approval by the director or employee, or
  • involved in any financial transaction with the nonprofit that has been, or will be, subject to the director or employee's approval.

The director or employee may be present to answer questions during disclosure of all the relevant facts, but should leave the room during the vote and not otherwise participate in the discussion or meeting.

Use of Data to Back Up Decisions

The board or other authorizing body should look at and rely on hard data about how much directors or employees with similar skills in similar positions are paid by other nonprofits. A massive amount of compensation data is available without having to pay a high-priced consultant. Some of it is free, while much is available for purchase for from anywhere from $50 to $1,000 or more.

If your nonprofit earns less than one million dollars per year (including donations), all that is required is compensation data for three similar positions in similar communities. This data may be obtained by any means, including documented phone calls. In determining whether the one million dollar threshold is met, a nonprofit may average its gross annual receipts over the prior three tax years. For larger organizations, there is no set number of comparables required—presumably there should be more than three.

Often this data will reveal a broad range of pay for a certain type of position. The IRS shouldn’t complain if your nonprofit pays a director or employee an amount that is average or below the average that is paid for similar work at comparable organizations. At the same time, a compensation package that is more than average will not necessarily be viewed as unreasonable by the IRS. It all depends on the circumstances. For example, a higher than average salary may be reasonable because the nonprofit is located in an area with a high cost of living or because the person involved has performed exceptionally well.

Adequate and Timely Documentation

The authorizing body's decision must be adequately and timely documented. If the authorizing body is the board of directors, this would normally consist of written board minutes. If an executive committee or independent committee served as the authorizing body, it should prepare its own minutes or report. The documentation must contain:

  • the compensating terms and the date approved
  • the names and titles of all those who were present during the debate on the transaction and those who voted on it
  • the data that was relied on by the authorizing body and how it was obtained—this data can be attached or referenced in the minutes (or other documentation) but should be available for later review, and
  • a detailed explanation of how any potential conflicts of interest on the authorizing body were handled.

The documentation must be prepared before the later of the next meeting of the authorizing body or 60 days after the body's final action on the matter. In addition, the body must approve the documentation within a reasonable time after it has been prepared. In most cases, this would be taken care of in the normal course of business by preparing minutes of the meeting that include all the required information and then approving those minutes at the next board or committee meeting.

To learn more about following IRS rules on nonprofits, see Nolo's book, Every Nonprofit's Tax Guide.

May 2013

by: , J.D.

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