Determining reasonable pay for executives is the biggest challenge faced by our non-profit clients today. Non-profit boards must balance the need to provide competitive compensation that will attract, retain and motivate their executive talent with the desire to honor the organization’s mission and use donor resources responsibly while also navigating the waters of public scrutiny and regulatory reforms.
IRS Penalties for Failure to Set Reasonable Compensation
If the Internal Revenue Service (“IRS”) finds that a benefit (compensation) paid to a non-profit executive (or a “disqualified person”) 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.
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. However, the IRS has indicated that an organization found to repeatedly approve excess benefits may ultimately lose its tax-exempt status.
The penalties under the Intermediate Sanctions are imposed on the non-profit executive who received the excessive benefit, and in some cases, the organizational manager(s) (typically Board members) who participated in approving the excessive benefit.
The Importance of a Good Governance Framework
To protect executives and board members from penalties and stakeholder scrutiny, many non-profit organizations have focused on improving their governance practices regarding executive compensation to ensure the compensation and benefits provided to senior executives are reasonable.
There are a number of steps that non-profits can take to help determine “reasonable” compensation and avoid scrutiny. As suggested by the Treasury Department, good non-profit governance in the area of executive compensation starts with the following basic framework:
Set and follow established procedures for determining compensation;
Use responsible effort to determine appropriate or reasonable levels of executive compensation; and
Maintain appropriate oversight of executive compensation levels.
1. Established Procedures for Reviewing Compensation
This step is critical. 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.
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:
Terms of compensation arrangements
Date of approval
Members present and voting results
Professional advice considered
Details on comparable data reviewed
Reasoning behind the decisions made
Documenting the process and having a well thought-out rationale for decisions made is even more important when a Board has decided to pay (or continue to pay) a non-profit executive above the 75th 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, 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. 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).
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. It is the responsibility of the Board of Directors to maintain appropriate oversight of executive compensation levels. At a minimum, non-profit boards should conduct an annual review of:
All elements of compensation (base salary, incentive compensation and/or other perquisites)
The nature and amounts of all expense reimbursements
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:
Compensation arrangements for certain non-profit executives must be approved by an independent Board and/or Compensation Committee.
The Board and/or Compensation Committee approval of the compensation must be based upon a review of appropriate and comparable compensation data.
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. In some respects, this process mirrors the process undertaken and subsequently disclosed by for-profit companies.
3. The Board and/or Committee must document the decision and the basis for the determination 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 professional 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
State and explain the determination as to reasonableness
While the IRS may refute the presumption of reasonableness and may find 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.
Unlike their peers at public companies, when assessing the reasonableness of compensation, non-profit organizations are faced with a deficit of timely, publicly available compensation data for non-profit organizations. It is important for non-profit organizations to ensure that they have the tools, information and processes needed to successfully attract, retain and motivate their executive talent with a program that is appropriate and defendable to the organization's stakeholders.