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When your nonprofit sets the salary for an executive director or other individual key to the organization, the board of directors wants to make sure it’s paying what’s necessary to attract or retain the most qualified, capable individual for the position. But that’s not the only consideration that should be on the radar screen.

“Excess benefits” and “disqualified persons”

Internal Revenue Code Section 4958 prohibits 501(c)(3) and 501(c)(4) organizations from engaging in an “excess benefit transaction” with a “disqualified person.” Disqualified persons generally include anyone in a position to exercise substantial influence over the organization’s affairs at any time in the five-year period before the transaction, including officers and directors.

An excess benefit transaction takes place when a disqualified person receives a benefit that exceeds the value the organization receives in exchange — for example, when an executive director is paid a salary that far exceeds the salary of executive directors at similar organizations. Violations of Sec. 4958 can lead the IRS to impose excise taxes (intermediate sanctions) on the disqualified person who benefited from the transaction as well as the not-for-profit’s leaders (for example, board members) who approved it.

When is compensation “reasonable”?

Federal tax regulations provide a “rebuttable presumption of reasonableness” for compensation arrangements that satisfy three requirements. If you have met the following requirements, it will be up to the IRS to prove otherwise.

First, an authorized body of the nonprofit — typically the board of directors or a subcommittee composed of board members — must approve the salary and benefits before the compensation package is offered to the candidate or employee. It’s critical that none of the participants have a conflict of interest regarding the arrangement. For example, if the individual is already a staff member, neither the individual nor a subordinate of the individual can participate in the compensation decision.

Second, the authorized body must rely on appropriate comparability data before it determines compensation. It can rely on data derived from industry surveys, documented compensation of individuals in similar positions in similar organizations, expert compensation studies or other data about reasonable compensation for the position. If your organization’s gross annual receipts are less than $1 million, you will need compensation data for three similar positions in similar communities. The regulations don’t specify the requisite number of comparables for larger organizations.

Remember that similar job titles don’t necessarily mean similar jobs. When evaluating comparability data, the positions must have comparable duties, not just titles.

Last, the authorized body must adequately document the basis for its determination while making that determination, such as in the meeting minutes. This requirement is often overlooked. Documentation must include terms of the arrangement and the date it was approved, members of the body who were present during debate and those who voted on it, comparability data that was relied on and how it was obtained, and any actions by a member with a conflict of interest.

You must prepare the documentation before the later of the next meeting of the authorized body or 60 days after the body’s final vote on the compensation. The body also must approve the documentation within a reasonable time after preparation.

When is there a conflict of interest?

Conflicts of interest must be avoided during the compensation-setting process. A member of the authorized body charged with approving a compensation arrangement has a conflict of interest if he or she fits any of several criteria.

For example, a member can’t be a disqualified person participating in or economically benefiting from the compensation arrangement or a family member of any such disqualified person. Nor can a member be in an employment relationship subject to the direction or control of any disqualified person participating in or economically benefiting from the compensation arrangement. Consult with your CPA regarding all of the criteria.

Playing by the rules

Determining an executive’s compensation package can be tricky. It’s easy for subjective considerations to come into play. Contact us during the compensation-setting process to make sure that your nonprofit is playing by the rules