By: Blair Howard (Intern, GHJ) and Lauren Haverlock (Principal, GHJ)
Managing executive compensation for the highest paid executives in any company can be difficult, but it becomes much more complex when discussing tax-exempt organizations. Not only must a nonprofit consider the effects of salary levels on the operating budget, the organization must strike a balance in paying salaries that are competitive in the market while being conservative enough to not attract the attention of the IRS…or even worse, the scrutiny of a nonprofit’s lifeline: the donating public.
Public perception aside, creating a compensation strategy within the IRS’s guidelines is fortunately rather straightforward as long as organizations are aware of their requirements. Nonprofits often have the reputation of being labors of love, and with limited resources, they offer employees a very important nontangible – fulfillment and purpose – as a significant part of their compensation package. However, nonprofits are businesses too and require top talent and skill, especially in management positions. They need to have the freedom to compensate at a fair and competitive rate.
How can an entity be sure that they’re striking the right balance in the marketplace? The IRS has “gifted” nonprofit organizations with a great guideline for determining compensation of its top executives. The “rebuttable presumptions test” outlines best practices for a Board of Directors when creating a compensation plan for its top management. If a nonprofit properly establishes rebuttable presumptions, then an organization’s Board of Directors can feel confident that they have created a fair and arm’s length compensation policy for its executives. As a further bonus, if compensation is ever challenged by the IRS, the burden would be on the IRS to prove that the compensation an entity determined for its executives is unreasonable.
There are three prongs to the test that all need to be met in order to establish rebuttable presumptions.
- The compensation needs to be comparable to other executives with analogous services and expertise and other companies with similar enterprises and circumstances.
Sometimes the first step is the most difficult one to take. This first prong requires the most diligence and consideration. The tax law expressly allows “reasonable compensation” for efforts of nonprofit employees, but what exactly does this mean? When looking into the reasonableness of the compensation, the IRS will look specifically at the services performed, the size and scope of the organization and circumstantial aspects such as region and included benefits. An organization should do the same thing – and they are even able to look beyond the nonprofit world when seeking that comparability data.
What is the best way to accomplish this?
The most effective way to undertake this is to engage a compensation expert to perform a reasonable compensation study for the top management and financial executives and any key employees. There are many pros to this strategy – including efficiencies, reliability of independent third-party analysis and advices and risk and burden reduction to a Board. But, on the other hand, the biggest drawback is that a compensation study can also be very costly. Studies can cost upward of $10,000 per person. In determining an organization’s risk appetite, many elements can be considered – including Board independence and compensation levels.
But if a compensation study isn’t right for an organization, there are very effective ways that a board can take on this first prong. One recommended way to accomplish this task is to create a compensation committee: a group of people dedicated to this issue who can put their full efforts into the research and exploration of the topic and the various factors involved. This endeavor should be executed completely separate from management and should be pursuant to specific legislation drafted by the Board of Directors or trustees with regard to clear employee compensation criteria. These criteria should include responsibilities, measures of success and included benefits.
How should comparability data be gathered?
As mentioned above, consideration of all aspects involved in an executive’s position is essential to understanding the full picture of how these individuals need to be fairly and competitively compensated. When comparing services performed, aspects focused on should include:
- Number of employees this individual manages
- Numbers of hours worked or percent of time devoted to the firm
- Size of the budgets or assets managed
- Whether the work is local, national or international in scope
- Specific duties and responsibilities
A comparison of duties and responsibilities encompasses the most important part of this analysis but by no means is it the only part. While it may seem trivial, geographic location is another rather important factor. A study done by Charity Navigator found that CEOs working in the Northeast earn roughly $47k more than their counterparts in the Mountain West.
When conducting this research, all methods of compensation need to be taken into consideration, including unpaid deferred compensation, fringe benefits, personal use of property or facilities owned by the company, pension plans and payment of personal expenses.
As a result of an exhaustive comparison analysis, the compensation committee should be able to point to at least three executives from other companies that are used together to come up with a comprehensive plan of compensation. This diversity in comparable compensations is paramount in this research because it will be difficult to find a truly comparable executive in the same position or requiring the same responsibilities. The variety allows flexibility in fine tuning a salary to perfectly fit the unique situation of each company.
A very important step that is often missed (and would thus negate this entire prong) is for an organization to be sure to document why and how comparable data is chosen. An organization should explain how they determined that the entity and position were comparable to the one in question.
How often does an entity need to perform comparability analyses?
Executive compensation needs to be reviewed and voted on annually by the Board of Directors. But how often does this burdensome comparability process need to be undertaken? How long can a Board rely on the data as being “good”? There is no official guideline for this. A conservative approach would dictate that this should be undertaken annually as the market, industry and compensation plans are always changing. But as long there are no major changes occurring industry wide and the executives’ compensation grows at a similar pace to the rest of the employees’ (without any extraordinary raises or bonuses), the compensation committee should be able to rely on the study for a bit, as long as their reliance is properly referenced in documentation.
How does an entity use this data?
While the comparative analysis is an important resource in deciding on a compensation plan, it is not the only factor of the decision. It should help put an organization in the right arena of market pricing, but should not dictate the policy completely. In many cases, compensation for an executive will deviate from the research. Factors such as special knowledge, experience and qualifications; special relationships with essential clients or donors; and other competing offers for the same level all need to be comprehensively taken into consideration and may augment salary. These adjustments are perfectly fine, as long as they are documented and analyzed. When considering these additional components, keep in mind that the IRS will only focus on the compensation offered for the employee’s specific contribution to the organization’s ability to accomplish its charitable purpose. Adding in compensation for a skill that this executive possesses that offers no special value to the nonprofit organization is not justification for salary inflation.
- The compensation must be approved by a governing body of the organization with no conflicts of interest in the transaction.
According to the IRS website, every one of the compensation cases that the IRS has reviewed in recent years in that the courts determined the amount to be unreasonable were in cases where negotiations were not completed at an arm’s length. It is this concept of keeping those deciding compensation and those receiving compensation completely separate that is one of the most crucial parts of setting salaries. One way that many companies have found success is through adopting a thorough conflict of interest policy that includes Board members completing an annual questionnaire. The policy should encompass a plan of how to address any issues that may arise and preclude the company from meeting the rebuttable presumption test. The annual questionnaire provides a proactive way for Board members to affirm or deny any financial or personal conflicts that may exist. Having this sort of protocol in place is an efficient way of preventing situations of inurement.
Inurement typically occurs when there is a conflict of interest and the compensation becomes unfairly beneficial to the executive. This kind of problem can arise when a compensation plan creates a joint venture between the company and the executive or is used as a way to ratably distribute profits. Regardless of whether the compensation is reasonable, inurement is a violation of the rebuttable presumption and is never allowed.
These conflicts are simple to avoid if an entity takes the necessary precautions. An effective way of protecting a nonprofit against these potential issues is by discussing the compensation procedure with a nonprofit expert – whether that is the CPA who prepares the entity’s Form 990, an attorney or a compensation expert. These efforts can serve as valuable and strategic methods for discovering and correcting weaknesses in an organization’s internal procedure.
- Every step of the process must be appropriately documented and recorded.
The IRS passage on rebuttable presumption instructs that records should include “the terms of the transaction and the date of its approval, the members of the authorized body present during the debate and vote on the transaction, the comparability data obtained and relied upon, the actions of any members of the authorized body having a conflict of interest, and documentation of the basis for the determination.” Including accurate records of each step taken and factor considered makes a potential audit by the IRS much simpler and less threatening. If the IRS can follow the logical steps to the same conclusion using a nonprofit’s records, there is less likely to be an issue. If, however, there are chunks of research missing or a lack of records of protocol followed, the IRS will usually have no choice but to complete an investigation into the fair compensation of the executives themselves.
Moreover, comprehensive records of research completed will be useful when reevaluating salaries and benefits every year. A detailed report that includes the research undertaken and the sources of comparability data will allow increasing efficiency in addressing and examining this issue every year.
Consequences of Excessive Compensation
Generally, if all the steps above are properly undertaken, the IRS will have a difficult time determining that compensation is, in fact, unreasonable. But what happens if the IRS does take that position? If the IRS does decide that the amount a company pays is too much or that insiders have abused their position for increased pay, the IRS can impose penalties in the form of excise taxes under section 4958. These taxes are based on the amount deemed excessive and include a 25 percent tax on the recipient of the unreasonable amount as well as a 10 percent tax on the Board that approved the amount. These taxes are levied on individuals deemed responsible rather than the organization itself.
In addition to consequences by the IRS, tax-exempt organizations that pay their employees too much face the harsh critique of the public. Nonprofit organizations tend to survive off of donations and the favorable view of the public, so an image as a company that frivolously spends donated dollars extravagantly can be crippling. While a favorable public perception is essential to the functionality of a nonprofit, so are the experience, skill and connections of a top executive. Nonprofits can no more afford to lose effective management than they can to lose public favor. As always, nonprofits have to walk a fine line between two competing interests. But with the proper guidance and procedures, they can maintain control of the one thing that they can harness: their own narrative.