The following discussion is provided for informational purposes only and is not intended to serve as legal advice. For advice on nonprofit executive compensation, consult your attorney.
Question: We are a new nonprofit trying to determine the appropriate compensation for our executive director. What standards should we go by right now, and what should we look to for standards as the organization grows and becomes older?
Nonprofit organizations that are recognized as exempt from federal income tax under section 501(c)(3) of the Internal Revenue Code are required to act in a manner that does not result in "private inurement." (Many other types of tax-exempt organizations are also subject to this private inurement prohibition.) In the compensation context, this prohibition requires that amounts paid to an officer or other person in a position to exert substantial influence over the organization be reasonable and not above fair market value. In addition to the private inurement prohibition, individual officers and other insiders may be subject to personal financial penalties if they engage in transactions that result in excessive benefits to them. Finally, those organization managers who approve excessive benefit transactions may be subject to individual financial penalties as well.
Having said that, if a person is new to the nonprofit and is negotiating an initial contract to be executive director, there is a strong argument that the prohibition on private inurement and the penalties on excessive benefits would not apply because the person was not an "insider" at the time he/she negotiated the deal.
However, most nonprofit managers and boards would prefer not to unduly risk revocation of tax-exempt status and/or individual excise tax penalties and, even for newly hired executive directors, will want to take precautions that compensation is reasonable. As such, in both instances addressed in the question above (new nonprofit organization and existing nonprofit), the usual process that an organization will undertake to manage against the risks are:
1. Obtain valid comparability data (such as through www.guidestar.org) to see what similarly situated nonprofit organizations pay executive directors with similar backgrounds.
2. Have a disinterested body (e.g., a compensation committee where no member has a relationship with the candidate that would present a conflict of interest) approve the proposed compensation arrangement.
3. Document contemporaneously the decision of that disinterested body and the fact that the body relied on the valid comparability data in making its decision.
Taking those above three steps should give an organization a presumption that the compensation amount paid to its executive director is reasonable and should not be challenged by the IRS. This presumption may be rebutted by the IRS if, for example, the IRS determines that the comparability data was not accurate or proper to use under the circumstances. Note that there are more detailed regulatory requirements to the three-step process described above which need to be followed. Note, too, that states (notably, New York for New York-incorporated nonprofits) have become more active in regulating executive compensation.
For more information, please see:
George E. Constantine, Esq., Venable LLP
© 2014, Venable LLP
George E. Constantine is a partner at Venable LLP in Washington, D.C. He co-chairs Venable's Regulatory Practice Group.