Rules known as “intermediate sanctions” allow the IRS to assess penalties against nonprofit executives who receive excess compensation — and the board members who approve it. This article discusses what’s considered excess compensation and what’s viewed as a conflict of interest during the compensation-setting process.

Rules known as “intermediate sanctions” allow the IRS to assess penalties against nonprofit executives who receive excess compensation — and the board members who approve it. Do you and your board of directors know what’s considered excess compensation and what’s viewed as a conflict of interest during the compensation-setting process?

Internal Revenue Code Section 4958 prohibits most 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 preceding the transaction, such as officers, directors and members of their families.

An excess benefit transaction takes place when a disqualified person receives a benefit that exceeds the value of the service, property or payment the organization receives in exchange. An example: an executive director being paid a salary that far exceeds the salaries of executive directors at similar organizations. Violations of Sec. 4958 can lead the IRS to impose excise taxes on the disqualified person who benefited from the transaction as well as the nonprofit’s leaders (for example, the board members) who approved it.

Federal tax regulations provide a “rebuttable presumption of reasonableness” for compensation arrangements that satisfy three requirements. If all of the following are met, it’s up to the IRS to show that compensation was nonetheless unreasonable.

Compensation generally must be set in advance by the board of directors or a subcommittee composed of board members. It’s critical that none of the participants have a conflict of interest regarding the arrangement. For example, neither the executive nor a subordinate of the executive can participate in the compensation decision.

The authorized body also must rely on appropriate comparability data prior to making its compensation determination. The data can be derived from industry surveys, documented compensation of individuals in similar positions in similar organizations, expert compensation studies or other comparable data about reasonable compensation for the position. If the organization’s average gross annual receipts are less than $1 million, it only needs compensation data for three similar positions in similar communities. The regulations don’t specify the requisite number of comparables for larger organizations.

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

What’s more, the authorized body must adequately document the basis for its compensation decision while making that determination. 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 on the arrangement 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 actions. The group also must approve the documentation within a reasonable time after preparation.

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 the following five criteria:

1. Is a disqualified person participating in or economically benefiting from the compensation arrangement or is a family member of any such disqualified person,
2. Is in an employment relationship subject to the direction or control of any disqualified person participating in or economically benefiting from the compensation arrangement,
3. Receives compensation or other payments subject to approval by any disqualified person participating in or economically benefiting from the compensation arrangement,
4. Has a material financial interest affected by the compensation arrangement, or
5. Approves a transaction providing economic benefits to any disqualified person participating in the compensation arrangement, who in turn has approved — or will approve — a transaction giving economic benefits to the member.

In setting compensation for key employees, the IRS requires nonprofits to consider total compensation. This generally includes regular salary and bonuses, retirement plan contributions, insurance, housing allowances and payment of nonbusiness expenses. Contact your CPA if you have questions about reasonable vs. excess compensation.