What is “Reasonable” Compensation for a Non-Profit Executive?
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 also led some regulators, including the State of New York, to attempt to curb executive compensation levels at certain non-profits.1
What is “reasonable” compensation is a particularly relevant question for non-profit Boards, because unlike their public company counterparts, if the IRS finds that a benefit (compensation) paid to a non-profit executive 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.2 These IRS regulations are referred to as “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 actually not imposed on the organization itself.3
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 in Form 990, many non-profit organizations are now facing increased scrutiny for their compensation and governance practices. To address this, there are a number of steps that non-profits can take to help determine “reasonable” compensation and avoid such scrutiny.
Establish a Good Governance Framework
As a preliminary matter, non-profit Boards must establish good governance processes and procedures. 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.4
This article provides an overview of why and how to establish and implement good governance practices in the area of executive compensation. As described below, a good governance framework can help a non-profit Board effectively counter inquiries or audits regarding the reasonableness of compensation.
1. Established Procedures for Reviewing Compensation
While we address the specifics of what to consider and when in greater detail separately (see Systematic Compensation Review for Non-Profit Boards), it is critical to understand the importance of this preliminary step. 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. These procedures should include how to proactively establish a “rebuttable presumption of reasonableness” with respect to the individual compensation arrangements which are ultimately approved by the Board5 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.
Thorough Documentation of the Board’s Compensation-Related Actions
Once a compensation arrangement has been considered and approved in accordance with the established procedures, 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 for why the decisions were made.6 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 percentile (and in some cases even the 50th percentile) 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, the IRS has established a “rebuttable presumption of reasonableness.” If an organization follows the procedures and meets the conditions described below in the Rebuttable Presumption of Reasonable Compensation, the compensation is presumed to be reasonable and the responsibility of proving otherwise falls to the IRS.7 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).8
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 (i) all elements of compensation (base salary, incentive compensation and/or other perquisites), (ii) the nature and amounts of all expense reimbursements, and (iii) and any other benefits received by the organization’s executives.
I. Compensation arrangements for certain non-profit executives (referred to by the IRS as “disqualified persons”) 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.
II. The Board and/or Compensation Committee approval of the compensation must be based upon a review of appropriate and comparable compensation data.
Finding and Relying Upon Appropriate Comparable Compensation Data
The fact that compensation decisions are made by the Board and/or Compensation Committee following a review of appropriate and comparable compensation data is one of three conditions, which may help an organization establish a presumption of “reasonable” compensation.
Comparable data should be compensation paid to individuals holding similar positions, providing similar services at similar organizations.10 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.
III. The Board and/or Committee must document the decision and the basis for the determination of reasonableness.
The Importance of a Written Determination as to 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. Even without satisfying the conditions for the rebuttable presumption of reasonableness under the Intermediate Sanctions, when applying Intermediate Sanctions, the IRS considers a Board’s reliance on a written determination as to the reasonableness.
The written determination should:
- Be reasoned professional advice of the compensation consultant (or other qualified professional)11 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.12
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, any 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.13
1. See, e.g., N.Y. Exec. Order Limits on State-Funded Administrative Costs & Executive Compensation (Jan 18, 2012).
2. See generally I.R.C. § 4958 (1996); Treas. Reg. § 53.4958 (2002). 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.
3. 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.
4. See Compensation Issues for Exempt Organizations, IRS Phone Forum May 17-18, 2006.
5. See id. at 17.
6. See Treas. Reg §53.4958-6(c)(3).
7. See Treas. Reg. § 53.4958-6(a).
8. See Introduction to Treas. Reg. § 53.4958 – Background – Rebuttable Presumption That a Transaction is Not an Excess Benefit Transaction.
9. See Treas. Reg. § 53.4958-6(a).
10. See Treas. Reg. § 53.4958-6(c)(2).
11. 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).
12. See Treas. Reg. § 53.4958-1(d)(4)(iii).
13. See Introduction to Treas. Reg. § 53.4958– Background – Tax Paid by Organization Managers