Pacific Business News

December 3, 2004

Make sure your nonprofit can justify compensation

by Sally Little

The mere perception of excessive compensation is damaging to the reputation and integrity of a nonprofit.

Make sure your nonprofit can justify its compensation packages by following the new Internal Revenue Service guidelines on excessive compensation.

The IRS issued these guidelines in its October 2004 revised application for recognition of exemption under Section 501(c)(3) of the Internal Revenue Code—commonly known as the Form 1023. While these guidelines apply directly to prospective tax-exempt organizations, all nonprofits should consider adopting them as best practices.

The guidelines indicate that the IRS is interested in compensation that meets or exceeds $50,000 per employee and independent contractor, and it is interested in any compensation provided to officers, directors and trustees for services to the organization.

Although the revised application is optional until May 2005, the IRS suggests its immediate use. This may expedite the processing of your application and reduce the number of follow-up questions.

The following tips should prove helpful for new organizations completing the compensation section of the application. They also should be useful as guidelines for established nonprofits for developing policies to prevent excessive compensation.

* Determine compensation comprehensively. The IRS defines compensation broadly. Salary or wages, deferred compensation, retirement and benefits are included. The use of a personal vehicle, meals, lodging, payment of personal travel, athletic club memberships and so forth are also included. If you are planning to send a director to a conference pertinent to the mission of your organization, then their travel expenses could be considered compensation.

* Establish a conflict-of-interest policy. The IRS is interested in knowing whether any of the officers, directors or trustees are related through family or business relationships. The IRS also wants to know if officers, directors or trustees are related by family or business to the five most highly compensated employees or independent contractors. To assist you, the IRS has included a sample conflict-of-interest policy in the instructions for the revised Form 1023. Please keep in mind that any conflict-of-interest policy should also comply with Hawaii’s Nonprofit Corporation Law. Legal assistance may be required in drafting this policy.

* Develop a compensation table. You must submit a list of the names, qualifications, average hours worked and duties of each of your officers, directors, trustees, five highest compensated employees and independent contractors. You must also note whether any of them are compensated by an organization that is related to yours through common control. Common control means two nonprofits that are linked to each other when a majority or all members serve on both boards of directors.

*Use due diligence in determining reasonable compensation. The IRS has defined “reasonable compensation as the amount that would ordinarily be paid for like services by like organizations under like circumstances as of the date the compensation arrangement is made.” One of the best sources for information on nonprofit compensation is www.guidestar.org. Click on products and s er vices, then click on The 2004 Nonprofit Compensation Report. This reasonably priced book may be purchased for the entire United States or by region. Another option is to select nonprofits similar to yours in Hawaii and check their salary information on their Form 990 at www.guidestar.org. Make sure you document the results in writing.

* Establish a board compensation committee. Members should serve free from any conflict of interest. The IRS has set specific recommendations for the operation of this committee. If you fail to follow these guidelines, then you must report your alternative process. The compensation package should be based on information from similar corporate or nonprofit organizations, current salary surveys from independent firms or written offers from similar organizations. Members of the committee must approve compensation arrangements prior to paying compensation. The date and terms of the compensation package and the decision mad e by each person who voted must be documented in writing.

* Determine whether discretionary payments will be made to employees. Bonuses paid to employees based on performance evaluations are an example of these types of payments. If discretionary payments are made, you must describe the process of determining the amount, eligibility, reasonableness and whether you have placed a limitation on total compensation.

For more information on the new Form 1023 application go to www.irs.gov and search for Form 1023 under Forms and Publications.

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