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Not-For-Profit Executive Compensation and Intermediate Sanctions Compliance at the Board Level

Jul 12, 2016

The IRS can apply penalties or intermediate sanctions to non-profit organizations that pay executives or board members too much relative to the market. Transactions with family members and their related businesses can also be subject to penalties and even the tax exempt status of the organization could be revoked. If there was excessive compensation the person must reimburse the organization. There can also be stiff penalties in excess of 200%. The organization’s managers who participated in the transaction may also be fined an aggregate of $10,000 per violation.

Compensation is viewed as reasonable if: (1) the compensation arrangement is approved, in advance, by an authorized body of the exempt organization, composed entirely of individuals without a conflict of interest, (2) the board or committee relied upon appropriate compensation and benefits survey data; and (3) the board or committee adequately documented the basis for its decision.

The media has picked up on this issue and is taking board and executive management to task for inappropriate compensation packages. And it is not just salary but perquisites such as cars, memberships in clubs, expense accounts and travel. Special retirement programs or deferred compensation plans are also under scrutiny.
Key best practices are:
  • Make compensation a priority in board meetings;
  • Establish a compensation committee;
  • Have a compensation policy for the organization with guidelines;
  • Use an independent consultant to determine market rates for compensation and benefits;
  • Have a conflict of interest policy that covers board members as well as employees;
  • Have a travel and reimbursement policy that covers board members as well as employees;
Board compensation should also be reviewed by outside third party experts.

Compensation committees should report to the full board (not an executive committee) and be comprised of independent board members. Because NFP boards are generally volunteers, it is important to assign a staff representative, preferably the person that manages human resources, to provide assistance to the committee. The committee chair should be strong and independent of the staff, mindful to not allow committee decisions to be a rubber stamp of staff recommendations. One technique to help manage this natural tendency is to have routine executive sessions excluding all staff.

A well written committee charter, approved by the full board, lays the foundation for a successful committee. Beyond the standard charter provisions regarding meeting schedules, membership, and term, the charter should clearly state the committee’s mission, its duties and scope of authority. The committee’s mission should include effectuating, through compensation policies, the mission of the organization. The committee should have the authority to seek outside expert opinions.

Compensation committees should oversee the formation of a compensation policy and establish the processes by which management’s implementation can be monitored. This would include the collection and review of compensation data on a regular cycle (not less than every three years) and always in conjunction with the hiring of an executive director.

Whether the board or the compensation committee is overseeing the process, it is the board that carries the legal burden associated with improper compensation.

The IRS, as well as many states, has made it clear in order to maintain NFP tax exempt status and avoid tax penalties, the quid pro quo is executives and board members will receive “reasonable” compensation. The IRS has helped (or hindered depending on a perspective) by publishing their recommended procedure to determine “reasonable” compensation. As an inducement, if that process is followed the burden of proof shifts to the IRS to prove the compensation is unreasonable.

A compensation policy should include the compensation philosophy of the organization, which comes from the board, and a description of salary, vacation, health benefits, payment of professional memberships, social membership dues (a real red flag so have this supported), lodging, car allowance, etc. The IRS requires all forms of compensation be disclosed and included in comparable data calculations. It has often been the non-standard/fringe benefits given by NFPs that have caused reputational harm. Good governance does not have to be difficult; it must however be thoughtful, transparent, and consistent in implementation. Routine policy reviews, board evaluations and other steps can help uncover weaknesses that are then able to be remedied.

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