How Nonprofits Can Structure Executive Compensation to Meet IRS Standards
Summary:
Nonprofits can support reasonable executive compensation through independent approval, appropriate market comparisons, and timely written records. The IRS reviews the full economic package and the board’s decision-making procedure in comparison with the compliance requirements of the Intermediate Sanctions Act. A well-documented framework protects charitable resources, reinforces board accountability, and supports public trust.
Executive compensation can draw attention from donors, employees, regulators, and future board members. An appropriate salary commensurate with the executive’s experience may also be scrutinized by the IRS. The IRS reviews how the board reached its decision; therefore, an informal approval, thin market research, or incomplete minutes – each non-compliant with the mandatory Intermediate Sanctions Act process — can leave a nonprofit unable to support a compensation package that was approved in good faith and subject the executives as well as the board members to potentially significant penalties and excise taxes.
Fair Value for Services Provided
The IRS evaluates whether total compensation reflects what comparable organizations would pay for similar services under similar circumstances. That review includes salary, bonuses, allowances, insurance premiums, retirement contributions, deferred compensation, and other economic benefits.
Section 4958 of the U.S. Tax Code (the “Intermediate Sanctions Act”) addresses excess benefit transactions involving people who hold substantial influence over a nonprofit. These individuals can include executive directors, chief financial officers, directors, and certain family members, among others. An excessive benefit may trigger a 25% excise tax for the recipient, repayment to the nonprofit, and an additional 200% tax when correction doesn’t occur within the applicable period. Managers and/or board members who knowingly approve the transaction may also face a personal excise tax.
Three Steps That Can Support Reasonableness
A nonprofit can establish a rebuttable presumption of reasonableness through three connected steps.
First, an independent, unconflicted board or compensation committee approves the package in advance. Anyone with a financial or personal conflict should disclose it, recuse themselves, and depart during deliberation and voting.
Second, the approving body reviews reliable comparability data. Relevant sources may include compensation reports or surveys, compensation reported by similar organizations, competing salary offers, or an independent consultant’s analysis. The comparison should account for geography, budget, staff size, position, duties, and organizational scope.
Third, the board creates a written record of the decision. Minutes should identify the approved terms, approval date, participants, recusals, data reviewed, and the rationale supporting the final amount approved. IRS instructions also require nonprofits to report which compensation-setting methods they used.
Board Oversight Builds Trust
Compensation may become an issue when a board relies on personal impressions, outdated surveys, or data from organizations that bear little resemblance to its own. Delayed minutes can create another gap, especially when the written record does not identify conflicts, data sources, or the full compensation package.
This executive compensation process and the decisions made belong at the board level for oversight. Independent committee review protects the organization, supports fair treatment of leadership, and gives donors and stakeholders greater confidence in how charitable resources are managed.
A Process That Supports the Mission
A compensation review with a legal team that supports your mission brings governance, transparency, and IRS compliance into one coordinated decision. Asiatico Law PLLC helps nonprofit boards evaluate executive compensation procedures and related governance practices to ensure compliance. Learn more by calling 214-570-0700.
Nonprofit Executive Compensation FAQ
What qualifies as reasonable compensation?
Reasonable compensation reflects what comparable organizations would pay for similar services under similar circumstances. The IRS considers the full economic package, including salary, incentives, benefits, and deferred compensation.
Who is considered a disqualified person?
A disqualified person is an individual who exercised substantial influence over the organization during the five years before the transaction. Senior executives, directors, and certain family members may fall within this category.
What documentation should the board retain?
The record should include approved compensation terms, approval dates, participating members, recusals, comparability sources, and the board’s rationale. The organization should prepare the minutes within the period required by Treasury regulations.
