How Nonprofits Should Set Executive Compensation
Founder and Managing Attorney
Can a Nonprofit Pay Its Executives?
Yes. Nonprofits can, and often must, pay competitive salaries to attract and retain qualified executive leadership. The legal requirement is not that compensation be low, but that it be "reasonable" and not constitute a private benefit or an excess-benefit transaction. For help building the board oversight processes that support these decisions, see our nonprofit governance counsel.
What Is Reasonable Compensation?
The IRS defines reasonable compensation as the value that would ordinarily be paid for like services by like enterprises under like circumstances. It accounts for the executive's duties, experience, the size of the organization, its budget, and geographic location. Total compensation includes salary, bonuses, benefits, deferred compensation, and any other perks.
Who Should Approve Executive Compensation?
Executive compensation should be approved by an independent body, typically the full Board of Directors or an authorized compensation committee. The individual whose compensation is being determined must not participate in the final discussion or vote regarding their own pay.
Using Comparable Compensation Data
To establish that compensation is reasonable, the board must rely on appropriate comparability data. This might include salary surveys of similar nonprofits, compensation data from publicly available Form 990s of peer organizations, or a formal compensation study conducted by an independent firm.
Conflicts of Interest and Independent Approval
A robust conflict-of-interest policy is essential. Any board member with a financial or familial relationship to the executive must disclose the conflict and recuse themselves from the compensation approval process to ensure independence.
Documenting Compensation Decisions
The board must contemporaneously document the compensation decision. The meeting minutes should record:
- The terms of the approved compensation.
- The date it was approved.
- The members of the board or committee who were present and how they voted.
- The comparability data relied upon and how it was obtained.
- Any actions taken regarding conflicts of interest.
The Rebuttable Presumption Process
By following three specific steps, a nonprofit can establish a "rebuttable presumption of reasonableness" under IRS rules, shifting the burden of proof to the IRS if compensation is challenged:
- Approval by an authorized, independent body.
- Reliance on appropriate comparability data.
- Adequate and contemporaneous documentation.
Understanding Excess-Benefit Transactions
If the IRS determines that an executive received unreasonable compensation, it is considered an "excess benefit transaction." This can result in severe intermediate sanctions (excise taxes) levied personally against the executive receiving the excess benefit, and potentially against the board members who knowingly approved it.
Compensation, Bonuses, and Benefits
All forms of compensation must be aggregated when determining reasonableness. This includes base salary, performance bonuses, health benefits, retirement contributions, housing allowances, and vehicle use. Bonuses should be tied to measurable, pre-established performance goals that advance the nonprofit's mission.
Founder Compensation
Founders transitioning to paid executive roles face heightened scrutiny. Their compensation must be approved strictly by independent board members, without the founder exercising undue influence over the decision. The standard of reasonableness applies equally to founders.
Compensation Review and Board Oversight
Executive compensation should be reviewed annually. The board should conduct a formal performance review of the executive director or CEO, assess whether the current compensation remains reasonable using updated comparability data, and formally approve the compensation package for the upcoming year.
Common Compensation-Approval Mistakes
- Allowing the executive to set their own salary or vote on it.
- Failing to gather objective comparability data.
- Approving compensation without documenting the process in the minutes.
- Ignoring the value of benefits and perks in the total compensation calculation.
- Basing bonuses on a percentage of the nonprofit's gross revenue (which can jeopardize tax-exempt status).
When Legal Guidance May Be Appropriate
Legal counsel can be valuable when structuring complex compensation packages, drafting executive employment agreements, establishing a formal compensation committee, navigating founder transitions, or ensuring the rebuttable presumption process is properly documented to protect both the executive and the board.