For many years now, charities have been encouraged to act more like for-profit companies, with a focus on measuring their outcomes and the impact of their programs.  The logical next step is to reward those that succeed with performance bonuses.  At the same time, the IRS and other charity regulators have some pretty clear guidelines on what type of compensation is permitted for charity executives.  The basic principles follow:

  1. Charities are not allowed to pay excessive compensation to nonprofit executives, and
  2. Charities cannot set up compensation arrangements that lead to “private inurement” (where revenues or donations flow directly to an organization “insider”).

There are many practical challenges and obstacles to the idea of tying executive bonuses to achieving the organization mission.  For example, organizations should consider what exactly needs to be measured to define success, the short-term outcomes versus long-term impacts, the cost and difficulty of tracking and measurement, etc., all of which have been discussed for years.  For the moment, let us assume that an organization has decided that a bonus program is needed to improve executive performance.  The process should include the basic steps that are listed below.

First, any incentives should be tied to mission-related metrics.  What is measured can include financial and fundraising goals, but this is tricky.  Organizations should include some measures that are preconditions for success rather than measures of success already achieved.

  • The IRS will want to know that there is a “real and discernable business purpose” for implementing the bonus plan.  Does it promote the organization’s charitable purposes (for example, improving services or motivating cost containment)?
  • The plan must not be simply a way to distribute profits to principals of the organization.

Second, a bonus plan must be established and implemented only with an independent board of directors.  A committee of the board, such as personnel or compensation, also would be acceptable if comprised of independent board members.

  • Board members are not “independent” if they, or individuals or businesses with which they are affiliated, receive compensation from or transact business with the organization.
  • There must be an arm’s length relationship between the organization and the employees benefiting from the plan. Board members receiving compensation from or transacting business with the organization cannot discuss and vote on matters relating to that compensation and those transactions.

Third, there must be safeguards to ensure that charitable services will not be reduced if goals are met and bonuses need to be paid.

  • The organization must be on track to provide all the program services it has committed to in its annual program budgets and plans before paying out bonuses.
  • Managers should not set aside program funds for the bonus pool.

Fourth, total compensation – including amounts paid under the bonus plan, plus all other forms of compensation – must be reasonable.

  • The IRS wants to see compensation in line with the compensation that would ordinarily be paid for similar services by a similar enterprise under similar circumstances.
  • The board should retain the discretion to cancel or reduce the bonus plan at any time if doing so is in the organization’s best interests.
  • In general, compensation based on incentives, including bonuses, is often scrutinized by the IRS to ensure that no prohibited private benefit results.

Careful research on what similar organizations pay is needed to ensure that compensation is in line – check out ERI’s Nonprofit Comparables Assessor to find salaries of executives in comparable organizations.  Then, organizations need to review the impact on total compensation if the executive meets the goals and is paid the whole amount available.  This review ensures that the earned bonus will not change a “reasonable” salary package into one deemed “unreasonable.”

The other caution is that the organization needs to have a source of funds to pay the bonuses without a negative impact on programs and services.  What looks like a good management program in theory could even have a negative impact on executive morale if earned bonuses cannot be paid. A cap on the size of the bonus plan will help ensure that total compensation is reasonable and will help in budgeting for payments under the plan.

Yes, charities can set up incentive plans and pay executive bonuses, but the IRS requirements and the nonprofit budget constraints must be carefully considered.