IRS regulations require that charities not give any benefit to an organization insider other than in the form of reasonable compensation. So, after an “organization insider” is defined, the discussion begins about what is “reasonable” and what is “compensation.”
The IRS has written extensively on what is included in compensation – basically encompassing what is captured on the employee’s W-2 filing for income tax purposes, but there are many more details and examples in the Form 990 instructions and the form itself. And regulations on what is reasonable have not changed for years – it is determined by comparing the compensation for the executive in the organization of interest to what would ordinarily be paid for like services by a like enterprise under like circumstances. This analysis is completed on a case-by-case basis.
While often nonprofits seem to pay less than for-profit counterparts where they exist, this is not a given. When collecting comparable data, there is no requirement that all data come from nonprofit organizations. However, the IRS has stated that, while some comparisons can come from the for-profit sector, nonprofit comparables should always be included. The goal is to find similarly situated individuals, and they may come from all relevant sectors.
The IRS has provided a “safe harbor” process because of the subjective nature of the analysis required. If an organization follows this process, then there will be an assumption that the compensation is reasonable – the burden of proof that compensation is not reasonable moves to the IRS (called a “rebuttable presumption”). The process includes the following general steps (but beware – there are lots of details, so check with a lawyer or Form 990 expert):
- Compensation must be approved in advance by a disinterested board of trustees/directors.
- The board must rely on comparability data from other organizations, which may be nonprofit as well as for-profit organizations. For charities with less than $1 million in gross receipts, data from at least three other organizations are needed. The IRS has only stated that “more” comparables are needed for larger organizations.
- The board must document the basis for its determination of compensation.
Although there is much talk about nonprofit salaries that seem excessive, the circumstances actually determine what is reasonable. So board members must collect data and use them as the basis for setting compensation. Even if compensation is clearly reasonable, the organization must be certain to properly document its compensation. The Form 990 compensation data is a valuable source of data for this process, and ERI’s Nonprofit Comparables Assessor allows the user to easily analyze what compensation is for comparable executives in similar organizations and access the actual Forms 990 for more detailed comparisons. The data are just what the IRS wants to see, and, in fact, the IRS and state charity regulators use this software for their analyses of what is reasonable.