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Determining Reasonable Compensation for a Nonprofit Job

The IRS guidelines for organizations in Pennsylvania

Compensation for higher-level employees is often an issue of concern for nonprofits. No one wants to see a nonprofit—many times organized as a public charity—take advantage of their donors and tax-exempt status. They don’t want to give the appearance it’s over-compensating its executives. That may lead to donor complaints and possibly a decline in donations or funding. How can the nonprofit properly compensate its employees and avoid appearances of improper conduct?

“Nonprofits are governed by a whole host of rules to ensure that the assets of the nonprofit are not used to benefit private individuals,” says Noel Fleming, an attorney who advises nonprofit organizations. “With the prohibition of using assets to benefit private individuals, there is an exception for payment of what the IRS calls reasonable compensation. Individuals can receive reasonable compensation for the services they provide to a nonprofit.”

What is reasonable compensation?

“There is no real definition,” says Fleming. “It’s a facts and circumstances test. But essentially, it comes down to what a similar organization in a similar situation would pay for the same types of services.”

Fleming provides an example of a nonprofit hospital looking for a new CEO. “To determine what is reasonable [for the CEO], we can look at other hospitals, not just necessarily nonprofits—we can look at for-profit entities to determine what might be reasonable under the circumstances,” Fleming says.

“If another organization is out there providing the exact same types of services that we hope to provide—providing those services in a similar community and where all other background is similar—we can then use that for-profit as a comparable to show that’s one of the ways we are arriving at this reasonable compensation.”

How can a nonprofit be sure compensation is reasonable?

The IRS provides a three-step process to gain a presumption of reasonableness for the compensation they offer. “The burden is on nonprofit to prove to the IRS that what they’ve paid is reasonable,” Fleming says. “If they follow this procedure, called the rebuttable presumption, then they are presumed to be paying reasonable compensation.”

The process protects nonprofits, and public charities as a whole, from excessive compensation practices. The three steps to demonstrate compensation is reasonable are:

  1. Obtain and use comparable compensation data from other organizations that are similarly-situated prior to the determination
  2. An independent body of the board of directors must review that data—meaning persons with a conflict of interest must not take part
  3. Document the review process and comparable data in board minutes once the decision is made

Following this simple procedure should help assure the nonprofit it’s paying its key employees and executives within the law. “It’s helpful only in that normally when the IRS challenges anything, the burden is automatically on the taxpayer, where in this case you can shift the burden,” explains Fleming. In situations the presumption applies, it still may be overcome if, “the IRS comes up with more definitive evidence to show that what the nonprofit is paying is not reasonable,” he adds.

Some caution needed for awarding fringe benefits

“The idea is that just because someone is working for a nonprofit, they shouldn’t have to take a lesser salary,” Fleming says. “They should be entitled to the same compensation they would get at a similarly situated for-profit entity—so retirement benefits, deferred compensation, and other benefits.”

The caveat with benefits is that a nonprofit generally cannot distribute dividends as a part of its compensation package because of the IRS restriction on revenue inuring to the benefit of shareholders and private individuals.

To steer clear of excessive compensation, whether through pay or benefits, a nonprofit should engage an experienced Pennsylvania nonprofit attorney to assist it in determining and drafting proper compensation packages for higher-level employees. For more information on this area, see our overview of closely held business.

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