How Are Nonprofit Compensation Practices Enforced?

Understanding the scrutiny that your nonprofit could face from the IRS

By Doug Mentes, Esq. | Reviewed by Canaan Suitt, J.D. | Last updated on November 10, 2023 Featuring practical insights from contributing attorney Noel A. Fleming

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Large-scale audits and lawsuits against nonprofits over executive compensation packages and misuse of funds garner a lot of media attention. Perhaps these events lead the public to believe enforcement is a risk for nonprofits they donate to.

However, the trends show that nonprofits are experiencing less enforcement of issues related to excessive compensation of chief executive officers or nonprofit board members.

Who Enforces Nonprofit Compensation Requirements?

“Nonprofit organizations are generally subject to two levels of review,” says Noel Fleming, an attorney who advises nonprofit organizations.

First Level: IRS

The first level of review is the Internal Revenue Service (IRS).

“The IRS has jurisdiction over them because they gave them tax-exempt status [based on their exempt purpose]. The IRS can revoke that tax-exempt status if the nonprofit doesn’t operate within [Internal Revenue Code] requirements. What you are left with is a state-law nonprofit corporation because the nonprofit entity was formed under state law. That is a taxable entity.”

Second Level: State

The second level of review is at the state level, typically through the attorney general’s office.

“If the nonprofit was formed in Pennsylvania, for example, the Pennsylvania attorney general has oversight,” Fleming adds. “If the AG in Pennsylvania believes a nonprofit is violating the rules somehow, they can come in, without regard to the IRS, and force a shutdown of the entity because they control the entity under state law.”

The division within the IRS that deals with tax-exempt organizations is called the Exempt Organization (EO) division… It’s good for the sector if there’s enough enforcement out there to keep organizations acting [with appropriate compensation practices].

Noel A. Fleming

How Aggressive Is the IRS With Nonprofits?

“The division within the IRS that deals with tax-exempt organizations is called the Exempt Organization (EO) division. They’re responsible for reviewing nonprofit tax-exempt organizations and conducting audits,” explains Fleming. “Because the IRS budget has been decimated over the last few years and is just getting worse, the EO division has lost so much funding.”

Fleming explains that because of these funding cuts, “a lot of nonprofits are acting with impunity. They’re not being examined in the numbers they probably should.”

Fleming finds this troubling not just for the public but for nonprofits as well. “It’s good for the sector if there’s enough enforcement out there to keep organizations acting [with appropriate compensation practices]. There probably are organizations that are getting away with things they should not get away with. We don’t see as many examinations or audits as we used to, say 10 years ago now. They are becoming a lot rarer at this point. But the IRS just doesn’t have the resources right now.”

What Enforcement Efforts Are Being Made?

Fleming explains that current IRS enforcement is “a lot more hands-off. What the IRS will do sometimes is what they call a correspondence audit. They’ll mail letters and ask for information by mail,” he says.

“Unless something comes on [the IRS’] radar through media reports or self-reported through IRS Form 990, the average run-of-the-mill nonprofit is pretty unlucky if they get selected for audit these days. It’s not that often anymore.”

As Fleming mentions, the opportunity for enforcement will come from the nonprofit’s filing of its annual income tax return: IRS Form 990. “The IRS is now using a lot of data-mining techniques to gather information from these returns and compile them,” says Fleming. The effort is to determine if anything is remarkable within any area of operation of the nonprofit.

Lack of Funding Allows Bad Actors Freer Rein

“Practitioners bemoan this fact because it’s better for us if there is more enforcement—only because it keeps our organizations operating the way they’re supposed to be,” Fleming says. “Even if we think a rule is too vague or it’s not fair, better if they all comply with those rules anyway because it keeps all entities honest at the end of the day.”

Although enforcement over nonprofit employee compensation may be reduced temporarily, nonprofits still must educate themselves on enforcement trends in the nonprofit sector. And, where the IRS is lacking, donors may step up to fill the void.

Nonprofits should sit down with an experienced nonprofit attorney before making any assumptions on the enforcement of their compensation arrangements. For additional information on this area, see our overview of business and corporate law.

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