Signs Your Not-for-Profit Needs an Executive Compensation Study

When it comes to what not-for-profit organizations should pay their top executives, the “instructions” are not always clear or obvious. The directive is that compensation should be “reasonable”, but reasonable may mean different things depending on who you ask. Your board could have an idea for a figure that is convenient for the budget, but would not attract the quality candidate that your organization needs to further its reach. On the other end of the spectrum, your compensation package may be outsized for the type of organization you operate, which risks drawing the ire of regulators and the community you serve.

Compensation is an ever-present issue for not-for-profit organizations, and there’s even more of an incentive for organizations to do their compensation due diligence under the tax reform law. The law commonly known as the Tax Cuts and Jobs Act (TCJA) levies an excise tax on not-for-profit organizations for compensation paid above a certain level to any executive. Excise taxes on compensation have traditionally been directed only at for-profit companies, so the consideration of excise tax may be new to your organization. It also makes now as good a time as any to consider whether your organization could benefit from an executive compensation study.

You’re Making a High-Profile Hire

The reason not-for-profit organizations would need a compensation study for their executives is that the IRS considers compensation paid to a “named” officer, such as a Chief Executive Officer or a Chief Financial Officer, to be a transaction with a “disqualified person.”

And if the organization is considering hiring someone with certain links or ties to the organization, that hire could merit a compensation study as well. The IRS considers “disqualified persons” to also include any:

Voting member of the not-for-profit organization
Person or family member of a person who within five years had substantial influence over a not-for-profit organization
Entities that are at least 35 percent controlled by persons or family members of persons who had substantial influence over the not-for-profit organizations within a five-year span

Not-for-profit organizations are asked to use fair values for transactions with disqualified persons to ensure that arrangements are not giving “excess benefits” to individuals who have substantial influence over the organization. The IRS issues fines for excess benefit transactions, and in the most severe situations, not-for-profit organizations could lose their tax-exempt status.

The IRS’s “intermediate sanctions” regulations require a disqualified person who is a recipient of an excess benefit transaction to pay a 25 percent penalty on that excess benefit. If the situation is not corrected, the excess benefit penalty could climb as high as 200 percent of the excess benefit. Officers, directors, and trustees pay a maximum 10 percent penalty on the excess benefit with fees capped at $20,000.

You’re Unsure about the Fair Value for the Position

Not-for-profit organizations can mitigate their risk of an executive compensation arrangement turning into an excess benefit transaction by adhering to the “rebuttable presumption” procedures:

Compensation is approved in advance by an independent, authorized body without conflicts of interest;
The authorized body bases compensation on appropriate data; and
The authorized body concurrently and adequately documents the basis for making determination of compensation.

Finding the appropriate data could be time-consuming for an organization’s board of directors or other internal compensation committee to take on by itself. Regulators want to see that the data used as a reference point is purposeful and relevant. When benchmarking executive compensation, it’s important to include data from organizations with similar characteristics to yours, including the economic environment in which you operate (your mission/purpose, size and geographic location), and other factors such as an executive’s background and experience.

To substantiate the rebuttable presumption procedures, not-for-profit organizations will need documentation around how the comparable data was compiled, including the parameters used to identify the similar types of organizations.

You’re at a Higher Risk for Scrutiny

Certain subsectors of nonprofits will draw more regulator interest than others. Larger organizations such as health care systems, and higher education institutions tend to have some of the highest paid executives, and higher pay could draw a closer look from the IRS. Organizations that receive substantial support from local, state, or federal governments may also be more hard-pressed to justify their compensation expenditures. Religious institutions, and not-for-profits that work with animals, on the other hand, tend to offer their executives lower salaries and may run a lower risk of being asked to justify their executive pay rate.

You Want to Play It Safe

Whether or not your organization is going to incur the tax reform law’s excise tax on executive compensation in excess of $1 million, meeting IRS rules in order to avoid any other potential taxes (i.e., intermediate sanctions) on its compensation arrangements is critical. Organizations in the midst of high profile executive search may want to enlist the help of a compensation consultant just to ensure they are covering all of their bases.

For more information about the benefits of a compensation study, please contact us.

Signs Your Not-for-Profit Needs an Executive Compensation Study

You’re Making a High-Profile Hire

You’re Unsure about the Fair Value for the Position

You’re at a Higher Risk for Scrutiny

You Want to Play It Safe

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