Executive compensation can be a consistent point of contention for many not-for-profit organizations. Many find themselves trying hard to strike a balance between:
- Paying compensation that can attract and retain the level of talent needed to help the organization fulfill its mission and purpose, and
- Complying with IRS rules related to paying compensation that is “reasonable”
Meeting donor (and media) perceptions and expectations with regard to how much executives within a not-for-profit organization should be paid can be complicated. Information on highly compensated employees is readily available to interested parties because it is included as part of the IRS Form 990, which not-for-profits are required to file annually. However, the information required for year-end reporting doesn’t always tell the full story. Organizations should be prepared to explain any of their compensation figures, including how the pay was determined. Now may be a particularly good time for a review of current policies. Additionally, excise taxes on highly compensated employees in the new tax law will bring even greater scrutiny to larger not-for-profits.
Get an Objective Opinion
Your organization may want to begin with a compensation study. A third-party evaluation of your current practices against industry standards can answer some important questions, such as: “Is your organization paying its executive team comparable rates for your organization’s size and sector?” Recent survey results, for example, indicate that Chief Executive Officers (CEOs) within the health care sector and higher education space tend to draw the biggest paychecks. Organizational size is also a big factor. Executives of arts organizations and human services organizations tend to make more the larger their organization’s program expenses are. Educational salaries tend to correlate with fixed assets. Religious leaders’ salaries depend more on their facility’s investment portfolio.
Another question a third-party salary study answers is whether your compensation is higher than your peers. If that’s the case, organizations will want to carefully look at how the current salary was determined and whether there is reasonable evidence to support the higher salary, such as your executive’s level of experience or background and their contribution to the organization’s success.
Be On Guard for Conflicts of Interest
All not-for-profit organizations should also closely examine board composition. One of the key elements of meeting IRS rules related to “reasonable compensation” is that compensation should be approved in advance by an independent, authorized body without any conflicts of interest. Who are the trustees responsible for setting compensation for your executives? Do they have any ties to the organization (or to employees of the organization) that could influence their compensation decision-making? A recent examination of compensation trends among not-for-profit associations revealed that in one association, nearly one-third of an association’s board of trustees had family relationships with the association’s leadership and nearly the same percentage of trustee members had business ties to the organization. Existing relationships between the board and the organization’s personnel—particularly executives—could mean that the compensation determined is not an objective value.
Explain Numbers That Look Deceiving
In the year that an executive retires, his or her compensation may look particularly large due to retirement plan payouts. Those following your Form 990 may have some questions about why an executive’s pay is suddenly so much higher, and you should be prepared to answer them. Organizations with retiring executives may want to include additional information about the nature of a particular executive’s retirement package in communication to boards or other interested parties, such as significant donors or with media inquiries.
Why Reviewing Compensation is Important
Aside from the new tax law’s excise tax on compensation over $1 million, not-for-profits need to be consistently reviewing their compensation practices to avoid what the IRS terms “excess benefit transactions.” The IRS does not provide strict guidelines for reasonable compensation, but it does specify that transactions (including forms of compensation) between tax-exempt organizations and their named officers and board members be conducted at a fair market value level.
If transactions exceed fair market value, they are considered to be excess benefit transactions, which could cost a not-for-profit its tax-exempt status. Excess benefit transactions also come with financial penalties; an executive on the receiving end of the excess benefit transaction would have to pay up to 25 percent on the excess benefit, with maximum penalties up to 200 percent if not corrected. Additionally, organizational managers (e.g., members of the organization’s board of trustees or directors) are also subject to fines equal to 10 percent of the excess benefit up to $20,000 for each transaction.
To protect their organization and executives, not-for-profit organizations should be extremely careful with their approach to compensation. The process used to determine compensation levels should also be documented in the event the IRS or other interested parties have any questions.
A third-party provider may be able to assist in the review of your current practices and could identify any policies or practices that may raise red flags with the IRS. For more information, please contact us.
Hal Wallach is a Director for CBIZ’s talent and compensation solutions division.
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