Nonprofits need to be careful they're not overpaying top executives. This might seem challenging when they have to compete with the hefty salaries of for-profits in luring top executives, but, in fact, the law requires nonprofits to follow certain guidelines. Due to nonprofit salary scandals, Congress passed legislation in 1996 that permits the Internal Revenue Service more leeway in penalizing those responsible for overcompensation. Nonprofits must fully consider, document and report executive compensation.
Fair and Reasonable
The IRS permits nonprofits to pay executives "fair and reasonable" compensation, although it doesn't provide any hard and fast rules for determining compensation, which includes benefits such as insurance or a car. As the people responsible for a nonprofit's mission and polices, the nonprofit's board members determine salary and benefits packages. To determine a fair and reasonable salary, the IRS permits nonprofits to research market rates. They determine these by finding out what someone in a similar position would receive at a similar organization -- for example, one of similar size and similar mission or field. The nonprofit's board can also include similar for-profit organizations in the search for comparables. While large nonprofits can get comparability data from purchased compensation surveys, such as those from groups such as Charity Navigator or the ERI Economic Research Institute, the IRS allows smaller nonprofits -- those with annual gross revenues of $1 million or less -- to rely on other small nonprofits' annual informational tax returns available on websites of the Foundation Center and National Center for Charitable Statistics. The IRS guidelines advise getting at least three annual informational tax returns as comparables for an executive salary.
Besides basing a decision on comparability data, the nonprofit's board should approve the compensation, based on performance goals, before hiring someone. It should also ensure that no one who participates in the decision has a conflict of interest, such as a board member with a friend who might want the job. The board must also document its decision-making process. The IRS states that documentation should include the terms of the transaction, its approval date, the people who were present during debate on the compensation and voted on it, the comparability data used for determining the salary, what actions board members who had a conflict of interest took and the documentation of anything else that provided the basis for the determination. Having this information can help satisfy the IRS requirement for the reasonablenss of compensation, if the IRS has questions about how a decision for compensation was made, providing the nonprofit a means of protecting itself from possible penalties.
Most tax-exempt nonprofits must file annual informational tax returns with the IRS. Tax-exempt nonprofits with annual revenues of $50,000 or less file Form 990-N and don't have to provide compensation information. GuideStar, an organization that collects nonprofit financial information, points out that nonprofits with higher annual revenues file Form 990-EZ, 990 or 990-PF. These organizations must provide information on compensation or they may have to pay fines. The IRS requires compensation information for paid directors, trustees, officers, key employees and the five highest-paid employees who aren't directors, trustees, officers and key employees as well as other employees who earn more than $100,000 annually. Nonprofits that complete the long Form 990 also must provide information about the way they established and approved executive compensation. Since the IRS wants details regarding compensation, nonprofits must frequently define their processes on a supplemental schedule.
The IRS may use an excise tax, known as an intermediate sanction, to penalize nonprofit executives who receive excessive compensation, along with each board member who supported the salary decision or did nothing to prevent it. The IRS may rule that overcompensated executive must pay back the excess amount with interest or impose a 25-percent excise tax on the amount and impose a 200-percent excise tax, if the organization doesn't correct the excess salary. It can also fine board members a 10-percent excise tax on the overpayment.
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