Be reasonable
Procedures, documentation essential when setting compensation

Nonprofits often vie against for-profit businesses for the same talent pool; to acquire and keep the employees you need, you must be competitive in your offers. But this offer-the-best-we-can approach is shadowed by growing regulatory pressures to provide “reasonable compensation” for key employees — and nothing more.

What’s reasonable?

Reasonable compensation is the amount that would ordinarily be paid for like services by like enterprises, whether taxable or tax-exempt, under like circumstances.

When determining reasonable compensation, count all of the economic benefits you pay that employee. The IRS, in a recent phone forum, identified several items often overlooked in considering the compensation amount:

• Personal components of business travel,
• Personal use of employer-owned property,
• Gifts and gift certificates,
• Expense reimbursements outside corporate policies,
• Spouse travel expenses,
• Nonaccountable expense allowances, and
• Items such as club memberships.

Your board has the ultimate responsibility over compensation, even if a compensation committee determines the amount. Either way, disinterested parties should set the compensation. And specific procedures should be in place for times when conflicts of interest arise. For example, committee members with a conflict could excuse themselves from the compensation discussion and abstain from taking part in the decision.

It’s critical for the board or committee making compensation decisions to properly document their steps. For instance, keep the data used for comparability, an analysis of the employee’s qualifications, and documentation of the discussions leading to the final decision.

What are the proper steps?

The committee making compensation decisions should compare the position with others sharing similar duties. Consideration also should be given to whether the position is national or local, the number of subordinates the employee manages and the size of the budget overseen.

Another factor in the compensation decision is whether the employee will manage multiple functions, facilities, departments or entities. For example, you would expect much higher compensation for an executive director who oversees an organization with a $100 million budget and multiple entities than one who leads a $5 million organization and a single program.

It’s also important to consider the number of hours the employee works. A $100,000 annual salary would probably be unreasonable for someone working two hours a week.

How can you find comparables?

The use of comparables is important in establishing compensation. You can use both for-profit and notfor-profit comparables. It is advisable to have at least three comparables — for larger organizations, more are recommended. Comparables should be obtained for a geographic area similar to your organization’s. For example, a suburban not-for-profit preschool could use salary information from both for-profit and not-for-profit preschools in the same or an economically similar suburb.

Commissioning a custom survey is probably the most accurate method of obtaining comparables. An accounting or consulting firm can design a survey to match the specific position being compared.

You also can glean this information from trade association surveys, telephone polls and Internet research. Because the information is public record for nonprofits, it should be readily available. A useful Internet resource is GuideStar.org, which publishes an annual Nonprofit Compensation Report.

Regardless of how your organization gathers comparables, the process should not be carried out by the employees themselves.

What warrants above-average compensation?

When awarding above-average compensation, the organization must clearly justify it. Some factors to consider are 1) the ratio of the organization’s revenue and/or expenses to the proposed compensation, 2) the executive’s track record with and outside of the organization, 3) the difficulty of replacing the executive, 4) other written offers the executive has received, 5) competitive market pressures, and 6) special circumstances that may impact the decision, such as the executive’s unique talents, which will be valuable in addressing your not-for-profit’s specific needs.

For example, your hospital’s new marketing director has experience not only in marketing but in hospital marketing and also has worked as a hospital administrator. Additionally, she received a job offer from another hospital that you needed to match or surpass.

What if there’s excess compensation?

If the IRS determines there’s excess compensation (that is, a key employee receives more compensation than is deemed fair market value), it can impose intermediate sanctions. The employee must repay the excess compensation to the organization, with interest, and a 25% penalty tax. If repayment isn’t made in a reasonable amount of time, the employee is subject to a 200% penalty.

In addition, an officer, director or trustee of the nonprofit, who knowingly approved the excess benefit, can be liable for an excise tax of 10% of the excess amount.

Is it time to review your procedures?

In the current environment of heightened scrutiny of nonprofits’ compensation of key employees, it’s more important than ever to ensure your documentation is complete. This would be a good time to ask your accountant to assess your compensation procedures to make sure you’re doing everything you can to support your decisions. •