Compensation for CEOs and Senior Staff in the New Fiscal Year: Establishing "Reasonableness"

As the new fiscal year begins, many nonprofit boards will establish new compensation levels for their CEOs and senior management staff. When doing so, it is important to remember that the Internal Revenue Code (IRC) sets forth the criteria for determining who is a member of senior management, and also provides that a nonprofit organization cannot pay more than "reasonable" compensation to CEOs and senior management. If an organization pays excessive compensation, the employee who receives the excess payment must return it to the organization, and the employee and the board members who authorize it will be subject to penalty taxes on the amount of excess pay.

To avoid the penalty tax on any payment intended as compensation, the nonprofit organization must report the payment as compensation on its federal tax forms, or have the employee do so, unless the nonprofit reasonably believed that the payment was exempt from tax.

To avoid harsh penalties for paying excess compensation, the board should follow the IRC's "safe harbor" procedure for establishing the presumption that the compensation is reasonable. If the organization follows the three steps below, the IRS will have the burden of proving in court that the compensation is unreasonable.  

The board (or a committee of the board) must approve the amount of compensation in advance. When approving the compensation, no director should have a conflict of interest. Any board member with a conflict of interest must disclose it to the other directors, and directors with conflicts may not participate in the vote or discussions of management compensation.

A conflict of interest exists if:   

•     A director is participating in, or economically benefiting from, the compensation arrangement being voted on, or the director has a family member (which includes spouses, parents, siblings and their spouses, children and their spouses, and grandparents, great-grandparents, grandchildren, and great-grandchildren and their spouses) benefiting from the compensation arrangement;
•     A director is an employee subject to the direction or control of a member of management whose compensation is being voted on;
•     A director receives compensation or other payments that must be approved by a member of management whose compensation is being voted on;
•     A director has a material financial interest that would be affected by the compensation package being voted on; or
•     A director votes on a compensation package for a member of management, and that member of management has approved, or will approve, a transaction providing economic benefits to the director.    

The board (or committee) must make use of comparability data that shows how much similar organizations are paying employees with similar job titles, expertise, and experience to determine that the compensation is reasonable. Comparability data is appropriate if it provides the board with sufficient information to determine if the compensation arrangement, in its entirety, is reasonable when compared to what other organizations pay. The board should consider:   

• The actual compensation paid by similarly situated for-profit and nonprofit organizations for comparable positions;
• Whether or not there is a ready supply of qualified prospective applicants in the area;
• Current compensation surveys compiled by independent firms; and  
• Actual written offers from similar institutions competing for the services of the senior manager.   

To obtain comparability data, the organization may hire a compensation consultant to review the organization's compensation structure, or may purchase compensation comparability data from organizations that provide technical assistance to other nonprofits or from human resource companies that compile that information for a fee. The organization can also use publicly available information on Web sites such as GuideStar to determine what comparable organizations are paying their employees. Organizations with less than $1 million in revenue should rely on at least three comparable organizations. Larger organizations will typically rely on 5-10 organizations.   

• The board must have a clear understanding of which organizations qualify as "peers" for purposes of making comparisons. A peer organization should be similar in size and mission, and should be located in the area where the organization is located. For example, if the organization is located in the metro-D.C. area, the peer organizations should be located in that area. If there is not a ready supply of people to perform similar services in the immediate geographic area in which the nonprofit is located, the organization may look at similar organizations in a larger geographic area and adjust its determination of comparability accordingly.
• Peer organizations may be different for different positions. For example, a health care organization would typically recruit medical staff from other health care organizations, and would look at those in developing a peer group. At the same time, the health care organization may need to recruit a CFO from other types of nonprofits, and may want to base the comparison on those groups.   

The decision-making process must be properly documented. The decision-making process must be documented in written or electronic form, such as through written minutes or an e-mail summary of the meeting at which the compensation is approved. The documentation must note:   

• The terms of the compensation package and the date it was approved;
• The members of the board (or committee) present when the compensation package was debated, and those who voted on it;
• The comparability data obtained and relied on by the members of the board and information on how the data was obtained; and
• Any actions taken by a regular member of the authorized body who had a conflict of interest with respect to the transaction (e.g., did the member leave the meeting and refrain from taking part in the decision?).   

The documentation must be completed before either the next meeting of the board or committee, or 60 days after the final action or actions are taken, whichever is later. The board or committee must also review the documentation and make any needed corrections to it within a reasonable amount of time.