What the IRS Requires When Your Nonprofit Sets Executive Pay
Executive compensation at nonprofits is one of the most heavily regulated and reputationally sensitive areas of nonprofit law. A board that casually approves what it believes is a fair compensation package may be surprised to find that the Executive Director – and the board members themselves – receive a personal tax bill down the road. This isn’t a hypothetical; this is what the IRS calls intermediate sanctions, and it’s a tool the agency uses to police and enforce nonprofit pay. This article explores what’s required when setting pay, the penalties for paying too much, and how to avoid them.
The Legal Framework: What the IRS Actually Requires
The IRS requires that nonprofits not pay more than the value they receive from a good or service, and that includes executive compensation. In legalese, paying too much is called an excess benefit transaction, which is a transaction in which (a) an applicable tax-exempt organization provides an economic benefit, directly or indirectly, (b) to or for the use of a disqualified person, and (c) the value of the economic benefit provided exceeds the value of the consideration received by the organization.
This applies to organizations exempt under 501(c)(3) or 501(c)(4) at any time in the five-year period before the organization entered the excess benefit transaction. The IRS calls this window of time the “lookback period”. An applicable organization does not include private foundations, governmental entities not subject to taxation, foreign organizations exempt under 501(c)(3) or (c)(4) that receive substantially all their support from sources outside the United States, or an organization whose exemption has been revoked, unless the revocation was due to inurement or private benefit.
Executive compensation must be reasonable under IRC § 4958. All forms of compensation, including salary, bonuses, deferred compensation, severance, noncash payments, liability insurance premiums, taxable and nontaxable fringe benefits, and foregone interest on loans, among other items, are included in the calculation. Whether that pay package was reasonable involves looking at what “would ordinarily be paid for like services by like enterprises (whether taxable or tax-exempt) under like circumstances”. 26 C.F.R. § 53.4958-4. In other words, what would a similar organization pay in this situation?
A “disqualified person” is any person who, at any time during the lookback period could exercise substantial influence over the affairs of the organization. In general, this means the CEO/executive director, CFO, COO, voting directors on the board, and other key employees with comparable authority. Surprisingly to some, it also can include family members of those individuals, if the individual owns more than a 35% voting power, profit interest, or beneficial interest (sometimes called 35-percent controlled entities). The Treasury Department has explained that factors such as founding the organization, controlling substantial expenditures or budgets, or managing a substantial portion of the organization’s activities tend to establish substantial influence. 26 C.F.R. § 53.4958-3.
When compensation exceeds fair market value, the delta between the amount paid and the fair market value is an excess benefit. This is not just about the egregious cases—sloppy process exposes an organization to liability even when the pay itself is defensible.
The Risk Most Boards Don't See: Intermediate Sanctions
Section 4958 of the Internal Revenue Code imposes a layered regime of excise taxes on excess benefits. In code-speak, these are called intermediate sanctions, and they impose an initial excise tax on 25% of the excess benefit on the disqualified person. Organization managers — board members and officers who knowingly participated in approving the transaction — face a separate tax equal to 10% of the excess benefit (up to $20,000 per transaction). If the excess benefit is not reduced and corrected, the IRS imposes an additional tax of 200% of the excess benefit. So, the IRS is telling organizations, fix it immediately, or face a cascade of increasing taxes. Correcting the transaction requires returning the excess benefit amount, with interest.
Intermediate sanctions are the most common IRS response to excess benefit transactions. However, it’s important to know that revocation of tax status is on the table. But this significant response is typically reserved for the most egregious cases. For example, a nonprofit museum buys only its directors’ art at inflated prices over an extended period. In deciding whether to pursue revocation, the IRS considers (a) the size and scope of the organization’s exempt activities before and after the excess benefit transaction, (b) the amount of excess benefit relative to the organization’s overall activities, (c) whether the organization implemented safeguards that should reasonably prevent excess benefit transactions, and (d) whether the transaction was corrected or good-faith efforts to correct were made.
The Safe Harbor: Rebuttable Presumption of Reasonableness
Understanding how the IRS approaches these transactions illustrates the thought behind and steps necessary to establish a presumption that the transaction was reasonable (aka the safe harbor rule). This shifts the burden to the IRS to show that the transaction was excessive, and they have never attempted to do that. There are three steps to establish the presumption:
First, an authorized body without conflicts of interest approved the transaction. Before entering the transaction, the Board or a committee – excluding the disqualified individual and any person with a conflict of interest with respect to the transaction – must vote to approve the transaction.
Second, the authorized body must consider appropriate comparability data. This information includes (a) compensation levels paid by similarly situated organizations (both exempt and nonexempt) for functionally comparable positions, (b) the availability of similar services in the geographic area, (c) current compensation surveys compiled by independent firms, and (d) actual written offers from similar competing institutions. Similarity in organization means things like budget, number of employees, geographic market, etc., not just mission type. Organizations with less than $1 million in annual revenue can satisfy this if they have data on compensation paid by at least three comparable organizations. For larger organizations, an independent compensation consultant isn’t required, but it’s one of the most reliable methods to satisfy the comparability requirement. The absence of robust, documented compensation data (the type readily supplied by an independent firm) substantially increases the organization’s exposure. Organizations can also look to Candid salary reports (and form 990s) and sector- and state-specific surveys.
Third, the authorized body must adequately and contemporaneously document the basis for making its determination. This means the documents are produced at the time of the decision, not when the IRS calls. Documentation should show (a) the terms of the transaction and the data of approval, (b) who was present and voted on the decision, (c) conflicts recused, (d) comparability data obtained and relied upon (including how the data was obtained), and (e) any actions taken with respect to consideration of the transaction by anyone who had a conflict of interest regarding the transaction. 26 C.F.R. § 53.4958-6. The most common failure here is informal approval, failing to keep adequate minutes, or not having the comparability file—having and following process is critical.
The Governance Infrastructure This Requires
Establishing a thoughtful governance infrastructure is both a legal obligation and a risk management tool. The gold standard practices include:
- Independent compensation committee, composed of members without a conflict of interest, which approves compensation for the executive director and other disqualified persons.
- Written compensation philosophy, which articulates the organization’s goals and principles for executive pay (e.g., targeting a specified market percentile) and creates a documented framework for consistent decisions over time.
- Annual review and approval of the full compensation package of all disqualified persons by the board or compensation committee.
- Engaging independent compensation consultants to enhance objectivity and persuasiveness of comparability data and producing clear, written deliverables, which the committee genuinely evaluates.
- Conflict of interest policy and annual disclosure that includes procedures to ensure transactions are in the nonprofit’s best interest, avoid improper benefit, and requires directors to acknowledge the policy and disclose conflicts.
- Annual, formal performance evaluation of the executive director’s performance against pre-established and documented criteria, which relate to the needs and goals of the organization.
- Recusal and vote documentation of any board or committee member with a conflict of interest, which should be documented in the minutes alongside the votes of each director who believes the compensation level is excessive.
- Form 990’s Schedule J should be treated not just as a compliance formality but a public communications document. Payments – including compensation and value of benefits – to officers, directors, and highly compensated employees must be reported.
Jurisdiction-Specific Notes
A couple quick notes on the additional considerations for organizations within the four jurisdictions our firm serves.
Massachusetts
All MA public charities must register with the Attorney General’s Division of Public Charities and file annual reports. The AG has broad, independent authority to investigate unreasonable compensation at charitable organizations. The AG also has authority to review and investigate proposed sales, leases, or exchanges of substantial assets by nonprofit hospitals. Massachusetts law affords no immunity protection to individuals compensated more than $500 per year, who may be personally liable for breach of fiduciary duty claims, including those related to excessive or improper self-compensation.
DC
DC incorporates the Federal framework and imposes a multi-layered compliance environment. The DC Nonprofit Corporation Act requires notification to the AG of any proceeding involving a charity, so the AG maintains an awareness of all significant organizational disputes and can intervene if the public interest warrants. DC also has a special, categorical prohibition against directors engaging in financial transactions with their organization if it receives congressional appropriations.
New York
New York has a comprehensive state-level framework for nonprofit executive compensation. Any related party transaction (i.e., conflict transaction) must be authorized and determined to be “fair, reasonable and in the corporation’s best interest” at the time of approval. N-PCL § 715. Officer compensation must follow specific procedures, including considering alternatives, or else the majority of the board must vote in favor of the compensation. Director compensation over certain thresholds risk losing their independent director status, which implicates governance and committee composition. The AG has broad enforcement authority, and may enjoin, void, or rescind any related party transaction, including executive compensation arrangements, that were not reasonable or in the best interests of the corporation.
Connecticut
Connecticut is comparatively less codified at the state level—it has not enacted a highly specific standalone statute prescribing detailed procedures exclusively for executive compensation. Instead, directors are expected to apply general fiduciary duty principles and adhere to the Federal intermediate sanctions regime. For CT organizations, this means the federal rebuttable presumption process is the primary — and most reliable — protection available; following it carefully is especially important where state-level procedural safe harbors do not exist.
Practical Checklist: Before the Board Votes on Executive Pay
When setting executive compensation, there is meaningful compliance risk at both the Federal and state levels. At a minimum, all organizations should follow these steps before voting on executive pay:
Compensation committee convened, conflicts identified and recused.
Comparability data gathered from appropriately similar organizations.
Data reviewed and deliberated before the vote.
Minutes drafted concurrently and include all required elements.
Decision documented in a compensation file maintained by board secretary.
Process repeated (not just referenced) at each new employment agreement or material modification.
Conclusion
In general, nonprofits must not pay an amount that is greater than the benefit received for any service—whether the payment is compensation, a contractor fee, or another form of economic benefit. Doing so can expose directors, officers, and executives to personal tax liability for the difference between the amount paid and the fair market value of the service. It’s possible – and advisable – to establish a safe harbor by showing that the board or committee approved the transaction in advance after considering comparability data including actual payments for similar services by similar organizations and thoroughly documenting the process. Failing to properly document these amounts can cause the IRS to subject the full value of the transaction (not just the delta between fair market value) to sanctions, imposed directly on covered individuals.
If your board has approved compensation packages without this process in place, it’s worth a review before the IRS makes it urgent. Commonlight Legal works with established nonprofits in Connecticut, DC, Massachusetts, and New York to build the governance infrastructure that protects both the organization and the individuals who lead it. Contact us to talk through where your process stands.
This article is for general informational purposes only and does not constitute legal advice. Reading this article does not create an attorney-client relationship. For advice specific to your organization's situation, contact Commonlight Legal LLP.
Alex Booker is the Managing Partner of Commonlight Legal LLP, a boutique law firm serving nonprofits in Massachusetts, DC, New York, and Connecticut. He advises executive directors and boards on employment law, governance, and general nonprofit counsel.
Before founding Commonlight, Alex adjudicated federal employment cases at the U.S. Merit Systems Protection Board, where he researched and advised on novel issues in federal personnel law, and he litigated whistleblower, wage and hour, and civil rights cases on behalf of employees at a DC employment firm. He is admitted to practice in Massachusetts and Washington, DC.