Protect Your Tax-Exempt Status and Avoid Personal Liability: A Guide for Boards of Directors Considering Compensation of Nonprofit Executives and Other Insiders
Nonprofit organizations need to make special considerations when determining fair and reasonable compensation for nonprofit executives, managers, founders, or board members (“Insiders”).
To be recognized as exempt, “no part of the net earnings” of an organization may inure to the benefit of “any private shareholder or individual.”
Organizations exempt from taxation under Section 501(c)(3) of the Code are prohibited from providing any “excess benefit” to these nonprofit Insiders (e.g. someone with a close relationship with and/or an ability to exert influence over the tax-exempt organization).
Any Insider compensated by the nonprofit, along with the officers and directors who participate in determining the Insider’s compensation, even if only by approving it, could be personally liable for significant penalties if the compensation is deemed unreasonable and/or excessive. (Compensation includes salary and benefits, such as insurance, a car, housing allowance, or other fringe benefits.)
In the case the IRS deems compensation unreasonable and/or excessive, the agency could impose significant penalties against the following two categories of individuals:
1. Insiders who receive compensation from the nonprofit organization that exceeds fair-market-value; and
2. All Insiders who knowingly participate in the decision that resulted in the excessive compensation to an Insider from the nonprofit organization.
The penalty for organizational managers with knowledge of the excess benefit is 10% of the total transaction amount, up to a maximum of $20,000 USD per transaction. For other Insiders, the excess benefit penalty is 25% of the total transaction amount for each transaction. If the transaction is not corrected within the applicable tax period, the IRS could impose an additional penalty equal to 200 percent of the excess benefit on each Insider. These penalties to individual Insiders cannot be paid by the nonprofit organization and are not covered by the nonprofit directors and officers insurance policy, but must be paid by each individual from his or her personal assets.
In addition to the potential for significant individual penalties, if a nonprofit organization violates the prohibition against Insider transactions, the penalty is revocation of its tax-exempt status.
However, with the following procedural safeguards, the nonprofit board of directors has the ability to protect the organization, and its decision-makers, from IRS scrutiny and potential penalties. The IRS generally considers an Insider compensation arrangement “fair and reasonable” if:
1. The Board of Directors, made up of individuals without a conflict of interest with respect to the executive compensation, approves the arrangement in advance of making any payments to the Insider, including:
- Ensure your organization has an up-to-date Conflict of Interest Policy;
- Recuse any director with a conflict of interest from participation in the decision-making process in accordance with your Conflict of Interest Policy; and
- Record the decision to approve the compensation arrangement, along with the decision-makers present at the meeting, in your board meeting minutes or written consent resolutions.
2. Prior to the decision, the Board of Directors obtains and relies upon comparable data to make its determination;
- Review compensation surveys for nonprofit executives and consultants, which are commonly published by local, state and national organizations, including:
- Appoint a Compensation Task Force (or the Executive Committee) to conduct an internal survey of other similarly situated nonprofit organizations (e.g. by sector, geographic location, revenue, assets/investments, number of members, etc.) for comparative analysis of salary or independent contractor compensation.
3. Following the decision, the Board must adequately and timely document how it made its determination of the compensation amount.
- Document the data upon which the directors relied upon when considering the executive compensation in advance of the decision; and
- Include the documentation of the data relied upon in the board meeting minutes or written consent resolutions at the time of the decision (not weeks or months later).
If the Board of Directors is careful to follow the procedural safeguards outlined above, it is less likely the IRS could impose penalties on any organization Insiders. However, even with the above measures in place, the IRS could develop its own contrary evidence to rebut the presumption of reasonableness of the comparability data relied upon by the nonprofit organization.
For additional guidance and to protect your nonprofit organization from potential penalties imposed for excessive compensation of Insiders (or any other excess benefit transactions with Insiders), we invite you to schedule a complimentary 15-minute consultation with one of our nonprofit attorneys to explore your options.