Protecting Against Intermediate Sanctions: What is "Reasonable" Compensation for a Non-Profit Executive?

Protecting Against Intermediate Sanctions: What is “Reasonable” Compensation for a Non-Profit Executive?

July 16 2012

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The Current Focus on Compensation Paid by Non-Profits
Determining reasonable pay for executives is the biggest challenge faced by our non-profit clients today.  Increasingly, press reports focus on and critique all facets of executive pay at non-profit organizations.  Public outcry and donor sentiment have led some regulators to attempt to curb executive compensation levels at non-profits.  In May 2012, New York State Governor Cuomo, in cooperation with 13 State agencies, announced proposed regulations to limit executive compensation at certain non-profits that receive New York State support.1 Only one week later, the Massachusetts State Senate adopted legislation that would authorize the Massachusetts Attorney General to consider the reasonableness of the compensation paid by public charities (including those organized in other states but providing services in Massachusetts) to directors, officers, and senior managers acting in an executive capacity.2

IRS Penalties for Failure to Set Reasonable Compensation
What is “reasonable” compensation is a particularly relevant question for non-profit Boards, because unlike their public company counterparts, if the Internal Revenue Service (“IRS”) finds that a benefit (compensation) paid to a non-profit executive (or a “disqualified person”)3 is unreasonable or excessive, then the executive, and in some cases even individual Board members may be personally liable for IRS tax penalties, referred to as Intermediate Sanctions.4 These IRS regulations are “intermediate” because while penalties are imposed on the benefit recipient (at a minimum), the sanctions fall short of revoking the organization’s tax-exempt status and are not imposed on the organization itself.5 However, the IRS has indicated that an organization found to repeatedly approve excess benefits may ultimately lose its tax-exempt status.6

The penalties under the Intermediate Sanctions are imposed on the non-profit executive who received the excessive benefit,7 and in some cases, the organizational manager(s) (typically Board members)8 who participated in approving the excessive benefit.9 However, an organizational manager who takes appropriate steps to oppose a compensation arrangement that the IRS finds to be unreasonable will not be subject to penalties that would otherwise be imposed.10

Even though Intermediate Sanctions have been in effect since 1996 with the final regulations adopted in 2002, in the wake of the recent economic downturn and with the additional compensation disclosure requirements on Form 990, many non-profit organizations are increasingly focused on their compensation and governance practices.  To help improve this process, there are a number of steps that non-profits can take to help determine “reasonable” compensation and avoid scrutiny.

The Importance of a Good Governance Framework
As suggested by the Treasury Department, good non-profit governance in the area of executive compensation starts with the following basic framework:

  1. Set and follow established procedures for determining compensation;
  2. Use responsible effort to determine appropriate or reasonable levels of executive compensation; and
  3. Maintain appropriate oversight of executive compensation levels.11

1. Established Procedures for Reviewing Compensation
It is critical to understand the importance of having an established process for reviewing compensation.  By establishing policies and procedures that allow Boards to systematically review compensation decisions, non-profits are able to operate with greater efficiency and predictability and are more likely to protect against the imposition of IRS penalties.  While we address the specifics of what to consider and when in greater detail in a separate article,12 these procedures should include how to proactively establish a “rebuttable presumption of reasonableness” (described below) with respect to the individual compensation arrangements which are ultimately approved by the Board and how to react to an internal or regulatory investigation/ audit of compensation determinations.  Once these proactive and reactive procedures have been established, the Board is able to consider and approve compensation decisions.

Part of the procedures established by the Board should be a process for thoroughly documenting the Board’s considerations and ultimate decisions in the area of compensation.  In particular, the Board should take care to document:

  • the terms of the arrangement;
  • date of approval;
  • members present;
  • member voting results;
  • professional advice considered;
  • details on comparable data reviewed; and
  • the reasons why the decisions were made.13

Documenting the process and having a well thought-out rationale is even more important when a Board has decided to pay (or continue to pay) a non-profit executive above the 75th percentile14 of the market or where the approved compensation otherwise varies in material ways (form, mix, timing, etc.) from the market.

2. Take Steps to Determine Reasonable Compensation
Unfortunately, there are no hard and fast rules or bright-line tests to help non-profit Boards identify compensation levels that the IRS will deem to be reasonable for executives.  However, as described in further detail below, the IRS has established a “rebuttable presumption of reasonableness.”  If an organization follows the procedures and meets the conditions described in the rebuttable presumption, the compensation is presumed to be reasonable and the responsibility of proving otherwise falls to the IRS.15 On the other hand, if an organization is not in compliance with the rebuttable presumption, the burden of proof falls on the individual subject to the penalty (i.e. the executive and possibly even the Board members).16

3. Appropriate Oversight
The last of the three fundamental steps towards good governance for non-profits is ensuring continued and appropriate oversight of executive compensation programs.  The Board of Directors must be diligent and maintain appropriate oversight of executive compensation levels.  Such oversight should include at least an annual review of:

  • All elements of compensation (base salary, incentive compensation and/or other perquisites);
  • The nature and amounts of all expense reimbursements; and
  • Any other benefits received by the organization’s executives.

Rebuttable Presumption of Reasonableness
Under the Intermediate Sanctions, to qualify for the rebuttable presumption of reasonableness, a non-profit Board must do the following three things:17

  1. Compensation arrangements for certain non-profit executives must be approved by an independent Board and/or Compensation Committee.
  2. The Board and/or Compensation Committee approval of the compensation must be based upon a review of appropriate and comparable compensation data.
  3. The Board and/or Committee must document the decision and the basis for the determination of reasonableness.

1. Compensation arrangements for certain non-profit executives must be approved by an independent Board and/or Compensation Committee
As discussed above, it is critical that the Board establish procedures for approving compensation arrangements.

2. The Board and/or Compensation Committee approval of the compensation must be based upon a review of appropriate and comparable compensation data.
Comparable data should be compensation paid to individuals holding similar positions, providing similar services at similar organizations.18 In some respects, this process mirrors the process undertaken and subsequently disclosed by for-profit companies.  The challenge, however, is that non-profits are not subject to the same disclosure requirements as for-profits.  Therefore, finding comparable peers can be a more time-intensive, research-based process.  The selected peer group should be appropriately comparable across a number of factors including, size, location, and mission.

In certain situations, it may not be possible to form a peer group of comparable organizations and the organization may be forced to rely upon surveys for comparable data.  However, relying upon survey data presents its own challenges, as the underlying characteristics of the survey respondents are not always apparent due to differences in data collection and disclosure, and therefore comparability of the data may be less reliable.

3. The Board and/or Committee must document the decision and the basis for the determination of reasonableness.
Documenting the Board and/or Committee’s process in assessing reasonableness, including reliance upon written professional advice as to reasonableness, is the last of the three conditions to establish a rebuttable presumption of reasonableness.  When considering whether to impose penalties under the Intermediate Sanctions, even where a non-profit has failed to establish a rebuttable presumption of reasonableness, the IRS will look favorably upon a Board’s reliance on a written determination of reasonableness.

The written determination of reasonableness should:

  • Be reasoned professional advice of a compensation consultant or other qualified professional19 with respect to all elements of the decision within the consultant’s expertise;
  • Address all the facts;Detail the comparable data;
  • Articulate and apply the applicable standards; and
  • State and explain the determination as to reasonableness.20

While the IRS may refute the presumption of reasonableness if enough evidence is gathered to rebut the significance and/or relevance of the comparability data, and may even find that the written determination (meeting the above requirements) came to the wrong conclusion, the IRS cannot impose penalties on individual members of the Board for properly relying upon such reasoned written opinion.21


About Steven Hall & Partners
Steven Hall & Partners (“SH&P”) is an independent compensation consulting firm, specializing exclusively in the areas of executive compensation, board remuneration, non-profit compensation and related governance issues.  By focusing solely on this critical and complex segment of the human resources arena, we are able to provide our clients with the highest quality expertise and best counsel available on a practical basis.

SH&P has established a practice dedicated to non-profit compensation because we recognize the unique and particular importance of providing executive compensation consulting to those organizations.  Our clients seek to balance the need to pay competitively to retain talented executives with the desire to honor the organization’s mission and use donor resources responsibly while navigating the waters of public scrutiny and regulatory reforms.  Unlike their peers at public companies, when assessing the reasonableness of compensation, non-profit Boards are faced with a deficit of timely, publicly available compensation data for non-profit organizations.  We strive to partner with our non-profit clients to ensure that they have the tools and information needed to successfully navigate the questions surrounding non-profit executive compensation.  For more information on our non-profit practice, please see “Non-Profit Compensation” on our website at


Contacting Steven Hall & Partners
This publication is provided by SH&P as a service to clients and colleagues.  The information contained in this publication should not be construed as legal, tax or accounting advice.  Questions regarding the matters discussed in this publication may be directed to the consulting staff listed below.  If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Kathie Mulroe (212-488-5400;


Sandra Pace


  1. See Press Release, New York Governor’s Press Office, Governor Cuomo Announces Proposed Regulations to Ensure That State-Funded Providers Do Not Pay Excessive Executive Compensation or Administrative Costs (May 16, 2012) at
  2. See Massachusetts Bill S.824 (May 2012) at (to be codified at Mass, Gen. Laws Ann. ch. 180 §30 – 32).
  3. Generally, a disqualified person is a person (or even an entity) in a position to exercise “substantial influence” over the affairs of the non-profit at any time during the five-year period before the date of the excess benefit transaction.  “Substantial influence” generally exists if such person’s compensation is primarily based on revenues derived from activities of the organization that the person controls.  Such influential persons include those holding the power of presidents, chief executive officers, chief operating officers, treasurers, chief financial officers and/or voting members of a governing body.  Depending on all the relevant facts and circumstances, certain other persons, including family members of a disqualified person, may also be deemed disqualified persons.  On the other hand, under the rules, individuals such as independent contractors providing advice to the organization, including compensation consultants, attorneys, accountants, or investment managers are likely not disqualified persons.  However, the introduction to the intermediate sanctions suggests that “being in this category of persons is merely a factor tending to show no substantial influence…” but that it is not determinative.  See I.R.C. § 4958(f)(1); Treas. Reg. § 53.4958-3.  For a detailed list of the statutory categories of disqualified and non-disqualified persons as well as the facts and circumstances tending to suggest one or the other see Treas. Reg. § 53.4958-3.
  4. See generally I.R.C. § 4958; Treas. Reg. § 53.4958.  Not all non-profits are subject to intermediate sanctions.  In fact, only those organized under I.R.C. § 501(c)(3) or certain non-profits organized under I.R.C. § 501(c)(4) are affected.  Certain private foundations, governmental entities and certain foreign organizations are not subject to these sanctions.  See Treas. Reg. § 53.4958-2.
  5. See Lawrence M. Brauer and Leonard J. Henzke, Intermediate Sanctions (I.R.C. § 4958) Update, Internal Revenue Service Exempt Organizations Technical Instruction Program for FY2003.
  6. See preamble to 1998 I.R.C. § 4958.  The Treasury Department listed four factors that the IRS would consider in determining whether to revoke a non-profit’s exempt status: (i) whether the non-profit has been involved in repeated excess benefit transactions; (ii) the size and scope of any excess benefit transactions; (iii) whether after excess benefit transaction, the non-profit implemented safeguards to prevent recurrences; and (iv) whether there was compliance with other applicable laws.
  7. A non-profit executive who received an “excess benefit” (the benefit paid to the executive in excess of the value of the services performed in exchange for such benefit) will be subject to an “initial tax” equal to 25% of the excess benefit.  An “additional tax” equal to 200% of the excess benefit is imposed if the initial tax is not paid within the “taxable period.”  If the excess benefit is corrected during the 90-day period after the notice of the deficiency is mailed, then the “additional tax” will not be imposed.  The “taxable period” begins on the date of the excess benefit transaction and ends on the earlier of (i) the date the IRS mails the notice of deficiency or (ii) date on which tax imposed under I.R.C. § 4958(a)(1) is assessed.  If only part of initial tax is paid during the taxable period, then an amount equal to 200% of only the unpaid portion of the excess benefit will be due.  See Treas. Reg. § 53.4958-7.  See also I.R.C. § 4962 regarding mitigation of the initial tax.
  8. An organizational manager is generally any officer, director or trustee of an organization or any individual having powers or responsibilities similar to such positions regardless of title, or any individual who is part of the authorized body of the organization. An individual who is not an officer, director, or trustee, yet serves on a committee of the governing body of an applicable tax-exempt organization (or as a designee of the governing body described in Treas. Reg. § 53.4958-6(c)(1) that is attempting to invoke the rebuttable presumption of reasonableness described in Treas. Reg. § 53.4958-6 based on the committee’s (or designee’s) actions, is an organization manager for purposed of the tax imposed under I.R.C. § 4958(a)(2).
  9. An organizational manager who approves an excess benefit transaction knowingly, willfully, and without reasonable cause, is liable to pay a penalty equal to the lesser of (i) 10% of the excess benefit or (ii) $10,000. An organizational manager “knowingly” participates in a transaction only if the person (i) has actual knowledge of sufficient facts so that, based solely upon those facts, such transaction would be or is an excess benefit, (ii) is aware that such a transaction under these circumstances may violate the tax law governing excess benefit transactions or (iii) negligently fails to make a reasonable attempt to ascertain whether the transaction is an excess benefit transaction.  Evidence tending to show that an organizational manger had reason to know of a particular fact or a particular rule is relevant in determining whether the manager had actual knowledge of such a fact or rule.  The IRS bears the burden of proof in cases involving the issue of whether an organizational manager knowingly participated in an excess benefit transaction.  See Treas. Reg. § 53.4958-1(c)(2)(iii).
  10. See I.R.C. § 4958(a)(2); Treas. Reg. § 53.4958-1(d).
  11. See Compensation Issues for Exempt Organizations, IRS Phone Forum May 17-18, 2006.
  12. See Systematic Compensation Review for Non-Profit Boards” on our website at
  13. See Treas. Reg. §53.4958-6(c)(3).
  14. The May 2012 NY State proposed regulations have introduced the possibility that the compensation paid to certain non-profit executives will need to be within the 75th percentile of an applicable compensation survey.  For a description of these proposed regulations, see Press Release, New York Governor’s Press Office, Governor Cuomo Announces Proposed Regulations to Ensure That State-Funded Providers Do Not Pay Excessive Executive Compensation or Administrative Costs (May 16, 2012) at also NY Proposes Limits on Non-Profit Executive Compensation” on our website at
  15. See Treas. Reg. § 53.4958-6(a).
  16. See Introduction to Treas. Reg. § 53.4958 – Background – Rebuttable Presumption That a Transaction is Not an Excess Benefit Transaction.
  17. See Treas. Reg. § 53.4958-6(a).
  18. See Treas. Reg. § 53.4958-6(c)(2).
  19. An “appropriate professional” on whose written opinion the organization may rely are limited but include compensation consultants, attorneys, accountants, and investment managers.  See Treas. Reg. § 53.4958-1(d)(4)(iii).
  20. See Treas. Reg. § 53.4958-1(d)(4)(iii).
  21. See Introduction to Treas. Reg. § 53.4958– Background – Tax Paid by Organization Managers.