Million-Dollar Salaries and Charities: An Unlikely Mix?

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Feeling underpaid and overworked at your nonprofit organization?  For many nonprofit workers, such conditions are the norm.  Nonprofit employees are often willing to accept less pay than their private-sector counterparts because they also enjoy rich non-financial rewards:  helping others in need, serving worthy causes, and achieving goals not attainable through ordinary economic forces.   According to a recent Wall Street Journal article, however, top executives at some charities are increasingly very well paid.   The article states that over 2,700 top executives made more than seven-figure salaries in 2014.  How can some nonprofits justify such high salaries, and what can the rest learn from them?

1.  As a Practical Matter:  Keeping Good Executives

According to the WSJ article, 85% of very highly paid nonprofit executives work at health care organizations and institutions of higher learning. Is higher pay justified in such settings? As the articles notes, organizations like hospitals and universities are massive, complex operations with annual revenues in excess of a billion dollars.  For example, the University of Illinois’ projected budget for fiscal year 2015 was about 4.5 billion dollars.   Large nonprofit entities often need to pay competitive salaries in order to attract competent talent to effectively manage their extensive operations.   

2.  Legal Standard:  What is “Reasonable”?

Regardless of a nonprofit’s size, nonprofit employees may receive only “reasonable compensation” under applicable federal law.  What is considered “reasonable” depends largely on comparable salary data for similarly situated nonprofits, the employee’s job qualifications, and actual work performed.  Comparable salary data may be obtained through specialized consultants or by reviewing salary data in other organizations’ Form 990s, available through Guidestar

A disinterested, independent board of directors must make the compensation determination, apart from any conflicts of interest and in keeping with each director’s fiduciary duties of due diligence, loyalty, and obedience to the corporate mission. The board’s determination should be contained in a written board resolution (or minutes), reflecting the employee’s personal qualifications, summary information about comparable salary levels, and the conclusion that such salary amount is fair and in the organization’s best interests. The board resolution should also memorialize the appropriate handling of any conflicts pursuant to the nonprofit’s IRS-compliant conflicts of interest policy, including recusal of conflicted directors (e.g., the employee to be compensated, if he or she is also a director). 

Penalties for paying unreasonable employee compensation can be severe.  The IRS treats them as “excess benefit transactions,” subject to excise taxes under the Tax Code’s Section 4958 “intermediate sanctions” provision.  Translated into plain English, a person who receives compensation later deemed to be too high may be required to pay back the “excess” compensation or face penalties of 25% to a whopping 200% of such amount.  (They are indeed intended to be punitive).  The directors who approve such excess compensation additionally may be personally liable for a 10% penalty, likewise based on the excess compensation amount.   No small risk!

3.  Diligent or Sleepy Board?

How do all the nonprofit executives featured in the WSJ article receive seven-figure salaries without getting into trouble with the IRS?   Very carefully, one would think! 

If nonprofit boards responsibly do their homework, such high amounts may be justifiable – given each individual’s well-documented high qualifications, extensive job responsibilities, and nature of the organization.   Such salaries may effectively leverage on each other, given that part of the legal standard requires comparability data.  The WSJ article reports that such salaries have jumped thirty percent since 2011.  So if they largely increase together, then perhaps such salaries are not so problematic – at least from the IRS’s perspective.

But if a nonprofit board is inattentive to these important fiduciary considerations, it may well risk painful IRS excess benefit transaction consequences – for both the paid employee and its individual board members.  An organization that pays modest salaries thus likely will not need to worry about such problems.  The board should remain attentive, however, to conflict of interest issues that may arise regardless of an employee’s salary amount, which is a great segue to the next point.

4.  May Nonprofit Directors Even Get Paid?

Our clients frequently ask this question.  It often arises within the context of a new nonprofit organization driven by a single visionary leader, who has a strong passion for the nonprofit cause, would therefore like to serve on the governing board, but also would appreciate getting paid. 

As one option, the leader may serve as a volunteer director.  Such arrangement certainly makes the legal aspects simpler, since the main issue here is financial – namely, whether payment to a leader could amount to abuse of charitable resources or other improper private benefit (known in IRS parlance as “inurement,” when corporate insiders are involved).

Alternatively, one or more directors may be compensated for services performed for the organization which is quite common. If so, however, the nonprofit must have a sufficient number of other directors who can act as disinterested, independent board members in evaluating compensation information.  For example, if the founding director plans to constitute the board with his or her spouse and another family member, inherent conflicts exist precluding the requisite independence.  But if the founding director recruits other directors who are not related through family or business (as the IRS defines such relationships), then the other directors presumably may make such compensation decision.  The legal standard is what is fair to the organization and in its best interests (not necessarily what will please the founder), considering all the circumstances both financial and non-financial. 

5.  What About the Donors?

Also key for nonprofit compensation are donors.  How will it look to donors if the organization’s executive director or other employees receive a high salary, and especially relative to the overall revenues of the organization?  The Wall Street Journal article questioned one nonprofit ministry whose top two leaders earned $4 million in compensation of the organization’s total annual revenue of $8 million.   What impact does such compensation, once known, have on donors to the ministry?  Will they be less inclined to give? These considerations are not inconsequential, as a nonprofit organization remains continually accountable to its donors – particularly as its financial data remains easily accessible through its publicly available Form 990 returns.