Presumed Reasonable: How Nonprofits Earn the Benefit of the Doubt on Executive Pay

When was the last time your organization analyzed whether its executive compensation was reasonable?

If the honest answer is “a few years ago” or “I am not sure,” your organization may not be alone. And while it may seem counterintuitive, the IRS is not especially interested in whether you pay your executive director too much, but instead in how the board reached its decision.

Reasonable compensation is a meaningful standard, but the protection available under the rules is built largely around process. A board that pays generously and can show its work is in a far stronger position than a board that pays modestly and cannot explain how it arrived at that amount.

That is often the most difficult part. Compensation can be an awkward topic. Board members are volunteers; the decision involves placing value on a sign-up to price a colleague’s work, and the executive director is often sitting right there in the room. As a result, the conversation may be brief, a number may be approved and the board may move on without fully documenting its reasoning.

The IRS has a specific view of what that conversation should look like. The framework is not especially complicated, but each step matters. When followed properly, it can help a nonprofit establish a rebuttable presumption that its executive compensation is reasonable.

What Is Reasonable Executive Compensation for a Nonprofit?

The rule itself is simple enough. A nonprofit cannot pay its leadership more than reasonable compensation, and the IRS defines that as what similar organizations would ordinarily pay for similar work under similar circumstances.

Two important points are often missed.

First, it is a market test, not a budget test. The question is not whether the organization can afford the compensation or whether the number feels like a lot of money for a charity. The question is what comparable organizations pay individuals in comparable positions to do comparable work. Paying below market does not necessarily demonstrate compliance, and it typically creates retention challenges.

Second, compensation means everything, not just salary. Compensation also includes bonuses, deferred compensation, severance, housing, a car, club dues, tuition benefits for a family member and personal use of organizational property. All of these forms of compensation must be counted together.

What Are the Consequences of Excessive Executive Compensation?

When compensation is found to be excessive, the tax does not fall on the organization. It falls on the individuals themselves. The IRS calls these the intermediate sanctions rules because they provide an enforcement mechanism short of revoking an organization’s tax-exempt status.

The 200% figure warrants particular attention. If the excess benefit is not corrected within the required period, the executive may be subject to an additional tax equal to 200% of the excess amount. Board members should also note the third row: A volunteer trustee may face personal financial consequences for approving an excess benefit transaction without reasonable cause.

However, nonprofits and their boards can strengthen their position by following a defined process when reviewing and approving executive compensation.

What Are the Three Requirements for a Rebuttable Presumption of Reasonableness?

The IRS offers what it calls a rebuttable presumption of reasonableness. If a board satisfies three specific requirements, the compensation is presumed reasonable. The burden then shifts to the IRS to develop sufficient evidence to rebut that presumption.

When all three of these requirements are met, the burden shifts. The IRS can still challenge the number, but it’s responsible for developing evidence strong enough to rebut the market data relied on by the board. That puts the organization in a considerably stronger position than having to support the compensation arrangement after the fact.

It is important to note that skipping this process does not automatically make the compensation unreasonable, and the regulations say so explicitly. It does, however, mean giving up the benefit of the rebuttable presumption. The organization may then need to support the compensation arrangement based on the relevant facts and circumstances, potentially years after the original decision was made.

What Counts as Appropriate Comparability Data?

Earning that protection requires upfront due diligence with comparability data. The IRS wants data well-substantiated enough that your board could actually tell whether the package is reasonable. The data should show what similar organizations pay for similar roles and what the market looks like in the organization’s part of the country. Relevant sources may include current surveys compiled by independent firms and competing written offers.

The regulations include a set of examples that illustrate this distinction:

The Same Decision, Two Different Outcomes

In the first example, a university sets its president’s pay near the high end of a national survey. The survey shows a wide range but does not break down the data by enrollment, revenue or geography, and no one on the committee has any particular expertise in university compensation. The IRS concludes that the survey does not provide appropriate comparability data.

In the second example, everything is identical except that the survey breaks the data out by institution size and region. By looking only at comparable schools in the same area, the range is far narrower, and the committee sets pay within it. The IRS concludes that the survey constitutes appropriate comparability data.

Same board. Same process. Same good intentions. The key difference is the quality of the data each board used to support its determination.

Small Organization Relief

An organization with annual revenue under $1 million can satisfy the data requirement with compensation information from three comparable organizations in the same or similar communities. The regulations indicate that an informal phone survey of three peer organizations, summarized in a short write-up by a board member, may qualify.

Two cautions apply. The threshold counts contributions, and it combines related entities, so organizations that appear to qualify may exceed the limit. And “comparable” still means comparable. Three nearby nonprofits that are substantially smaller and operate different programs may not be sufficient.

How Is Executive Compensation Reported on Form 990?

Form 990 asks the organization whether the process it used to set the executive director’s pay included all three elements: an independent review and approval, comparability data and documentation created at the time the decision was made. It asks the same question separately about other officers and key employees.

If an organization answers yes, it must describe the process, identify the positions it covered and state the year the process was last performed. That last item creates an expectation: If the current return says the last study was conducted years ago, it also discloses the age of the organization’s market data.

Answering no is not a violation, but the response may be notable because Form 990 is a public document that donors, funders, rating services and reporters read.

Compensation itself gets reported in detail on Form 990. There’s a separate schedule for higher-paid individuals that breaks out base pay, bonus, deferred compensation and benefits. It also asks about the specific arrangements the IRS is interested in, including first-class travel, discretionary spending accounts, housing allowances, club dues, severance and supplemental retirement plans. That same schedule asks which methods the organization used to set the top executive’s pay. The schedule also asks which methods the organization used to set the top executive’s compensation, including whether it relied on a “compensation survey or study.”

As noted, although none of this is required to maintain exempt status, the reporting questions indicate the elements the IRS considers relevant to the executive compensation-setting process.

Best Board Practices for Setting Nonprofit Executive Compensation

The three requirements outlined above establish the foundation. The following practices can help create a process that remains supportable over time:

Additional Considerations for Larger Organizations

If any individual at your organization is paid more than $1 million, a separate rule applies. A 21% excise tax applies to the amount above $1 million. Unlike the taxes discussed above, this tax falls on the organization rather than the individual. It applies whether or not the compensation is reasonable.

The Bottom Line

The compensation conversation is not only about a final number. It is about whether an organization can demonstrate to someone who was not in the room when the decision was made, maybe years later, that a group of independent decision-makers looked at real market data for genuinely comparable positions and made a well-documented, thoughtful decision.

The original question remains: When did your board last analyze whether its compensation is reasonable, and if someone asks tomorrow, could you show your work?

Israel Tannenbaum is a Partner in Withum’s National Tax Services Group, based in New York.

This article is general information and is not intended as, and should not be relied upon as, tax or legal advice. Decisions regarding executive compensation rest with the organization’s governing body and should take into account the organization’s specific facts and circumstances.