Introduction:
A non-profit corporation allows a limited liability entity to engage in operations without having to pay federal or state taxes on its income and allows contributions to it to be tax-deductible to the donor. As discussed in detail in other articles on this website, such advantages require that the operations are limited to various specific purposes (charitable, educational, etc.) and requires application to and clearance by both state and federal authorities.
This sector of our economy has grown over the decades and constitutes a significant economic force in the United States. The advantages of being classified as a non-profit are considerable, not least in that people can contribute to the entity for its appropriate purposes and deduct the contribution from their federal and state taxes. Essentially, the federal government is subsidizing the operations.
But with those advantages come requirements that are not minor. From the point of view of the state of California, the entity is actually owned by the state, as are all of its assets. You are allowed to operate it so long as you comply with various requirements as to its purpose, governance, and operations, and if the entity ceases operations all of its assets belong to the state who will take control of them.
This fact is often overlooked by those using nonprofits. They see themselves as akin to any other limited liability entity, with a board of directors (often named Board of Trustees or something else), officers, and employees. While various documents have to be filed with the state attorney general annually and while certain activities have to be open to the public, the operations are so akin to any other business that it is easy to forget that this particular entity is subject to rigorous oversight by governing bodies. As one client put it, “Sure, we get tax benefits, but we are still subject to all the rules applying to corporations and a dozen other rules that apply only to us.”
In some states, such as California, the attorney general is rigorous in enforcing the requirements. Failure to file the annual form results in suspension. Wrong use of contributions can result in withdrawal of the right to operate, and the assets being seized by the state. Anyone can make a complaint to the attorney general as to violation of the rules applying to the entity and quite often the attorney general will begin an investigation.
One of the areas that are subject to review is the amount of compensation to the employees of the entity. That is the subject of this article.
Basic Law:
A non-profit entity in California is subject to all of the applicable employment laws that pertain to any other business operating in the state. While a charitable organization’s revenue is exempt from paying federal and state taxes, the income paid to staff as wages generally is subject to taxes. As a result, when tax-exempt organizations pay their staff, they are obligated to report that income, and make tax and withholding payments to federal and state governments. Employers must withhold federal income tax from wages paid to their employees. In addition, employers must withhold Social Security and Medicare taxes from their employees’ wages, while also paying the employers’ share of these taxes. These requirements are sometimes referred to as “FICA payments,” which stands for the Federal Insurance Contributions Act.
All the laws prohibiting discrimination, harassment, whistle-blower protection; workplace safety and injury prevention; employee privacy; and minimum wage and payment to volunteers and interns apply. A nonprofit employer may not refuse to hire an applicant or treat an employee less favorably in the terms and conditions of employment, or terminate an employee, because of the race, color, religion, gender, gender identity, pregnancy, marital status, disabling condition, age, or national origin of the applicant or employee. Charitable organizations are subject to employment rules addressing overtime pay, required break periods, recordkeeping, and related issues under both federal and state law.
However, one aspect of employee compensation that is unique to non-profits relates to “excessive compensation” to its higher-level employees. As part of their supervision of charitable organizations and their assets, the IRS and Attorney General may review compensation paid to an organization’s higher-level employees. The goal of this review is to ensure charitable assets are not being diverted for private gain. A typical example is a charity that donates thirty thousand dollars a year to educational purposes paying its founder/CEO two hundred thousand dollars a year. That type of imbalance can draw the attention of governmental authorities.
Nonprofit executives receiving excess compensation and their board of directors could be at risk for significant penalties. The IRS imposes severe penalties when a determination is made that excess compensation has been paid. The penalty includes a two-tier excise tax on the excess benefit paid and the person receiving the excess benefit needs to return those funds to the charity with interest. Even the board members approving the compensation could face penalties and in extreme cases, the 501C3 status could be endangered.
In order to determine what is excessive we have to understand what is “reasonable” as defined by the IRS. Reasonable compensation is defined by Reg. 1.162-7(b)(3) as the amount that would ordinarily be paid for like services by like organizations in like circumstances.
There are two methods used:
An amount test, focusing on the reasonableness of the total amount paid; and
A purpose test, examining the services for which the compensation was paid.
Note that compensation includes salary, assets and/or property transferred, deferred compensation, benefits, etc. Many organizations provide deferred compensation packages to retiring executive directors but do not factor this into their compensation studies which in turn could cause an excess compensation issue. Recent regulations as to what is counted as compensation have eliminated some medical reimbursements and loans and should be reviewed by a tax professional if necessary.
The Three IRS Requirements:
Compensation arrangements that satisfy three IRS requirements are eligible for a “rebuttable presumption of reasonableness” provided by federal tax regulations. If the IRS deems that compensation at your nonprofit is excessive but you have met the following requirements, it is unlikely that they will penalize your organization.
1. Approval in Advance by an Authorized Body (or Board of Directors). The terms of the compensation arrangement must be approved in advance by the Board of the organization or by an entity it controls. An authorized body is the organization’s governing body (i.e. board of directors, board of trustees, or an executive committee) that is reviewing and making the decision on the compensation arrangements. The authorized body must be composed entirely of individuals who do not have a conflict of interest in the compensation arrangement or the property transfer.
If any member of your decision-making body meets any of the following criteria, he/she has a conflict of interest:
Is a disqualified person participating in or benefiting financially from a compensation arrangement,
Is related to the person receiving the compensation,
Receives compensation or other payments subject to approval by the person receiving the compensation.
Is in an employment relationship under the direction or control of the person receiving the compensation.
Holds a material financial interest affected by a compensation agreement, or
Authorizes any transaction that provides benefits to the person receiving the compensation in exchange for benefits for his/herself.
2. Reliance on Comparable Data.
Compensation levels paid are similar to other organizations for similar functional positions.
Compensation surveys used are compiled by an independent firm.
There is availability of similar organizations in the geographic area.
A Small organization is considered to have appropriate comparable data if they have compensation data from three comparable organizations in the same or similar communities.
Property transfers must have current independent appraisals of the value and offers received as part of a competing and open bidding process.
3. Documentation. The board of directors must document the results and decisions and the records must include:
Terms of the transaction approved, and the date approved.
Members of the authorized body present during the debate and those who voted.
The comparability data relied on and how it was obtained.
Any actions taken by a member of the authorized body who had a conflict of interest in the transaction.
Basis for determination that compensation was reasonable when there is a difference from the range of comparable data obtained.
Larger organizations must disclose their compensation practices in their annual informational returns (Form 990).
Common Sense:
One client put it well in an e-mail: “Tax exemption is a gift. Gives me a huge advantage in our operations. The price is small, and I am not in this to make a lot of money.”
There is a tendency to look at the large pay packages that such entities as United Way or the Red Cross pay their top executives, who often fly in private planes, and think that this demonstrates that large pay packages are the rule. However, those entities are as large as the largest international corporations with tens of millions in donations and are not comparable to the average non-profit entity.
In order to maintain the 501(c)(3) tax-exempt status, one must ensure that the entity’s decision-making body is complying with the above IRS regulations. Governmental scrutiny is robust when it comes to evaluating nonprofit executive compensation. Take this seriously. Be aware of any conflicts of interest in your entity, and make sure that all compensation decisions are approved and documented.
One client had what she considered a fail-safe method for determining reasonable compensation for her non-profit. Once the analysis developed a “reasonable” level, she deducted ten percent from it and made that the salary allowed. Warned that she could lose some top candidates, she explained that anyone who would decline to serve her charitable purposes based on a slightly lower salary did not have the ethos she desired in her non-profit.