When it comes to nonprofit governance, one area that receives a significant amount of scrutiny is executive compensation.
Those who work in the nonprofit sector are all too familiar with the fact that nonprofit staffers are frequently paid significantly less than their for-profit counterparts.
As far as regulators, the media, and the public are concerned, however, there is a lingering notion that nonprofit staffers, especially those at the top, may be overpaid.
This is thanks, in part, to the occasional scandal, such as United Way in the ‘90s or, more recently, Southwest Key.
So what is best practice for California nonprofits when it comes to compensating their executives?
Nonprofit executive compensation overview
Nonprofit CEOs and executive directors are NOT required to take a vow of poverty.
The organizations they work for conduct a wide array of activities that benefit our society. Chief executives often bring advanced degrees, professional licenses, specialized knowledge and decades of experience to their organizations.
Nonprofits must often compete with for-profits (think hospitals, law firms, research institutions, etc.) in order to attract the talent they need in order to move their organizations forward.
That being said, there is an expectation that nonprofits shouldn’t overpay their chief executives.
Accordingly, regulators have set forth a series of criteria that nonprofits should follow when evaluating and setting executive compensation.
Those who serve in senior leadership roles or on governing boards of nonprofits should be well-versed in these to avoid undue scrutiny.
IRS disclosure
Each year on its annual 990, a nonprofit must disclose if and how it reviews/approves compensation of its top management officials, as well as other officers and key employees (as defined in the Form 990 instructions).
Part VI, Question 15 asks if the process for determining compensation included:
- A review and approval by independent persons;
- Comparability data; and
- Contemporaneous substantiation of the deliberation and decision.
In other words, did the board of directors review the compensation using salary data for similar positions at other employers, and did they document their thought processes and ultimate approval?
In order to answer “yes” to this question, all three elements must be present.
Furthermore, if a nonprofit answers “yes”, a written statement is required in Schedule O, describing how the process was accomplished.
It should be noted here that a “yes” answer is not required for Question 15. The IRS won’t necessarily audit you or revoke your tax exemption just because you answer “no”.
However, since your form 990 is posted on Guidestar, your answer will be on display for the whole world to see.
Regardless of how you answer this question, nonprofits should always be prepared to demonstrate to the IRS that their executive compensation is not excessive.
Not doing so could lead to penalties.
California Nonprofit Integrity Act (CNIA)
California has its own requirements that go beyond the aforementioned IRS guidelines.
Charities “must have their governing board or authorized board committee review and approve the compensation of the Chief Executive Officer or President, and the compensation of the Chief Financial Officer or treasurer, to ensure that the payment is “just and reasonable.”
The review and approval must occur at the time of initial hiring, when the term is renewed or extended, and when the compensation is modified… and compensation includes benefits.
Many nonprofits have an “executive director” instead of a CEO and a “director of finance” instead of a CFO. As Adler & Colvin have pointed out, California nonprofits cannot avoid the requirements described above simply by selecting alternative job titles.
Some nonprofit boards might apply an across-the-board percentage salary increase to their entire staff, including the chief executive. These organizations should consider this a modification to the chief executive’s compensation, and therefore follow California’s protocol described above.
Additionally, a nonprofit executive director’s salary and/or benefits might increase or decrease because this individual converts from full-time to part-time, or vice versa. In this scenario, we recommend that you consider this a modification to compensation and follow the California requirements accordingly.
A summary of best practices for nonprofit executive compensation
To summarize, we recommend the following approach to executive compensation in nonprofits, in light of state and federal guidelines and to conform to best practices:
- Designate a board committee to research what similarly situated organizations are paying for similar executive positions. This can be done by purchasing a compensation survey, or for free by reviewing Form 990 filings at Guidestar.org.
- Discuss the research at the board level, in conjunction with a broader conversation on the executive’s overall performance and value to the organization, budgetary considerations, etc.
- Establish a compensation level based on steps 1 and 2.
- Document steps 1 – 3 in the form of a memorandum to be placed in the executive’s personnel file. This should be signed by at least two board members. A summary of steps 1-3 should be included in the respective board meeting minutes.
Bear in mind that every situation is different. We’ve provided general guidance but it should not replace expertise from qualified tax advisors and legal counsel.
