Nonprofit Compensation under the Microscope

June 2009

The vast majority of U.S. charities are small organizations with annual gross revenues of less than $25,000. The people involved with these nonprofits usually volunteer their time or work for a pittance. Leaders of the remaining organizations, however, need to examine their compensation-setting processes carefully to ensure that they are following best practices.

Donors, journalists, and some lawmakers have long viewed nonprofit salaries—especially those paid to the CEOs of large, well-known charities—with skepticism and even suspicion. Now, increased IRS scrutiny has drawn even more attention to nonprofit compensation:

• March 2007—The IRS reported that it had levied $21 million in excise tax assessments (i.e., "intermediate sanctions") for excessive compensation at tax-exempt organizations. The assessments resulted from the Executive Compensation Initiative Project, which the service had launched three years earlier. Read more about the Executive Compensation Initiative Project
• December 2007—The IRS released the revised Form 990. The new return requires filers to describe the processes their organizations used to set compensation levels. Read more about reporting compensation on the new 990

• February 2009—The IRS published its exempt organizations hospital study. The executive summary addresses compensation practices at tax-exempt hospitals:

  • "Although many of the compensation amounts reported may appear high to some, nearly all examined amounts were upheld as established pursuant to the rebuttable presumption process and within the range of reasonable compensation" (p. 4).
  • "The area of executive compensation poses similar challenges. Amounts reported appear high but also appear supported under current law. For some, there may be a disconnect between what, as members of the public, they might consider reasonable, and what is permitted under the tax law" (p. 4).
  • "The IRS will continue its enforcement work in this area through examinations and other compliance initiatives. As part of this work, the IRS will seek a better understanding of the impact of certain aspects of existing law, including the permitted use of for profit comparables, and the rule excepting the initial contract between the organization and the executive" (pp. 4-5).
  Learn more about the exempt organizations hospital study

Add in public outrage over executive compensation at for-profit companies that received TARP (Troubled Asset Relief Program) payments, and it is clear that compensation, at both for-profit and nonprofit organizations, will continue to attract attention for some time to come. Nonprofit leaders, especially the boards and executives of 501(c)(3) public charities, need to ensure that they understand the rules governing nonprofit compensation and that their organizations are following best practices in establishing compensation levels and in documenting the decision-making process.

New Resource for Charities

To help charities navigate this complex issue, GuideStar has published a free resource, "The Private Inurement Prohibition, Excess Compensation, Intermediate Sanctions, and the IRS's Rebuttable Presumption: A Basic Primer for 501(c)(3) Public Charities." Written by Karl E. Emerson, an attorney with Montgomery, McCracken, Walker & Rhoads, LLP in Philadelphia, nationally recognized speaker on nonprofit compliance issues, and past director of the Pennsylvania Bureau of Charitable Organizations, the paper:

• Defines private inurement and the situations that fall into this category.
• Examines excess compensation, the most common form of private inurement.
• Describes how a charity can ensure that the compensation it pays its executives is "fair and reasonable."
• Outlines the financial consequences ("intermediate sanctions") that can result from private inurement.
• Identifies the persons on whom the penalties can be levied.
• Explains how a charity can establish a "rebuttable presumption" that will demonstrate to the IRS that the organization followed appropriate steps in setting compensation for its executives.

Nonprofit leaders need to put their organizations' compensation practices under the microscope. Failure to do so could erode public support, make board members and nonprofit executives personally liable for stiff financial penalties, or even trigger loss of tax-exempt status.

Download a free copy of "The Private Inurement Prohibition"

Suzanne E. Coffman, June 2009
© 2009, GuideStar USA, Inc.

Suzanne Coffman is GuideStar's director of communications and editor of the Newsletter.