It is generally true that individuals do not work for nonprofits for the purpose of accumulating wealth. And while compensation for nonprofit employees is anecdotally low that doesn’t mean there aren’t rules for setting compensation for employees at a nonprofit organization, particularly when it comes to the executives.
Tax-exempt organizations, including churches, are prohibited from existing for the purpose of benefiting and compensating individuals or shareholders. To begin, Section 501(c)(3) of the United States Code states “no part of the net earnings of which inures to the benefit of any private shareholder or individual.” This word, inure or “inurement,” literally means “to benefit”.
However, while a nonprofit’s net earnings can’t benefit an individual, the IRS does allow reasonable compensation to be paid to individuals for their service to the tax-exempt organization.
Treasury Regulation 1.162-7(b)(3) states “In any event the allowance for the compensation paid may not exceed what is reasonable under all the circumstances. It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances. The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned.”
If compensation is not “reasonable” as described in the abovementioned regulation, the IRS can penalize the individual recipient, the board members who approved the income, and the organization itself.
For example, §4958 of the Internal Revenue Code penalizes “Excess Benefit Transactions” which could be defined as compensation above the value of services provided to the nonprofit. If an executive is paid $300,000 by a nonprofit, but the IRS determines the value of such services is $100,000 or less, then $200,000 would be considered an excess benefit. The penalty equals 25% of the excess benefit for the individual receiving the compensation and up to 10% of the excess benefit for the directors or managers involved in setting and paying the compensation.
Nonprofits can get ahead of this problem by setting compensation within the Internal Revenue Service’s (“IRS”) “Safe Harbor” – meaning, the IRS will presume the compensation is fair market value, although the presumption is rebuttable with sufficient evidence.
To achieve this Safe Harbor, the nonprofit organization must follow these steps in setting compensation:
The documentation of the authorized body, usually the board of directors, 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 Internal Revenue Service may refute the presumption of reasonableness only if it develops sufficient contrary evidence to rebut the probative value of the comparability data relied upon by the authorized body.
If an organization does not satisfy the requirements of the rebuttable presumption, a facts and circumstances approach will be followed. This means the IRS will look at all the relevant facts and circumstances surrounding the compensation amount and the services provided to determine if the total compensation is reasonable.
Whenever a client establishes a new nonprofit corporation, compensation for executives is sometimes far from the current budgetary reality. However, the IRS still wants to know how compensation will be set and paid once the nonprofit is up and running. On the IRS’s Application for Recognition of Exemption (Form 1023), the IRS asks applying nonprofits the following questions:
While a “yes” answer isn’t always required for each question, these questions are used to determine if the nonprofit organization violates the Internal Revenue Code’s prohibition of “Excess Benefit Transaction.”
If you have founded a nonprofit, or are thinking about it, you should contact legal counsel experienced with nonprofit matters to discuss compensation prior to paying officers or employees of the organization.
Do you have questions about setting compensation? We would love to help your organization navigate the legal landscape. Fill out the contact us form and a member of our team will reach out.
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Anthony & Sparkman, PLLC is a law firm located in both Dallas/Fort Worth and Georgetown, Texas that provides legal counsel to both churches and nonprofits around the world. John Anthony & Michele Sparkman have spent over a decade providing general counsel to churches and nonprofits on issues ranging from incorporation, governance, employment, policies and procedures, taxes, succession planning, real estate development, and much more. For more information visit our website at www.thenonprofitteam.com.
