Researcher Linda Lampkin outlines the issues and regulations a nonprofit should consider in making compensation decisions.
The first thing you have to think about when considering compensation is that if you want people to do good work for your organization, you need to pay them appropriately. And that means you have to set pay levels that attract, retain and motivate those dedicated staff members.
Yet when you are a public charity, you are accountable to a lot of people. Instead of stockholders, you have stakeholders: your clients, your donors, the foundations who fund you, and the list goes on and on.
If your salaries were to appear in the hometown newspaper, would you be comfortable with that? It’s not enough to have internal equity, you also have to have a rationale that will be satisfy questions from your stakeholders and keep your staff happy.
Finally, the IRS has some rules and has recommended practices that will help you comply with them.
First, set your compensation in advance, using appropriate comparable data. Second, involve the entire board, even if you have a compensation committee – all board members are responsible for a nonprofit’s compensation decisions. Third, make sure that no one directly involved in setting compensation has a conflict of interest. And fourth, document the decisions when they are made by the board.
Changing regulations: The new 990
These days the IRS is pushing to get more information, with more accuracy, on nonprofit executive compensation. The revised Form 990, which most 501(c)3 organizations must file annually each May, reflects this increase in interest from IRS.
One of the biggest changes in the revised Form 990 (to be filed in 2009) is that now nonprofits have to document their process for determining compensation. A totally new question asks if your organization has such a process, and if you do, you’re asked to detail it. A “no” answer may also bring unwanted attention from IRS.
The new 990 specifies that the process of determining nonprofit compensation should include the following: (1) review and approval by independent persons; (2) comparability data, and (3) contemporaneous substantiation of the deliberation and decision – in other words, you must record your compensation process when it occurs – no backdating.
This means that even though you don’t file the Form 990 until May 2009 if your fiscal year ends in December 2008, you should be thinking about how you will answer these compensation questions right now.
The IRS recommends that small nonprofits review salary data for at least three comparable organizations, with the implication that larger organizations should obtain more than three comparables.
IRS regulations call for compensation comparables:
- For “like” services – jobs similar in responsibilities and duties.
- In “like” enterprises – organizations similar in size, revenue, or number of employees and in a similar subsector would pay. Although budget size is often used as an indication of size, a nonprofit with a large budget, five employees, and one project may not be an appropriate comparison with a nonprofit group that has 50 lower-paid employees providing direct services to clients. So it’s important to consider many factors. The IRS will also accept for-profit comparisons if appropriate.
- In “like” circumstances – accounting for the value of additional benefits like housing or transportation.
The use of for-profit comparisons requires thought about the labor market for the job; if you’re hiring an accountant, does that require a strictly nonprofit background or could your job candidates have relevant experience in the for-profit sector?
Other reporting changes of interest on the revised Form 990 include:
- More detail on reporting compensation received from related organizations.
- A focus on increasing the accuracy of reporting on deferred compensation and additional benefits, with much more detailed instructions.
- Reporting of compensation based on the calendar year, rather than the nonprofit’s fiscal year, so reporting on W-2s and 1099s can be checked by the IRS.
The IRS is never going to tell an organization what’s too high and what’s too low, but if its top employees are near the average, salaries likely won’t be questioned.
On the other hand, a compensation package that deviates from the average won’t automatically incur IRS scrutiny. Again, it’s a matter of having a viable rationale, and there are many reasons the IRS might consider as an explanation for a higher than expected salary level: We just had a public relations disaster, we’re starting up a capital campaign or a new project, we have to match a competitive offer for the CEO we’ve had for the past 10 years.
If you follow the process as the IRS asks you to, you create what IRS calls a “rebuttable presumption.” This means that should your organization ever be audited, the IRS has to prove you’re in the wrong instead of requiring your organization to prove its innocence.
Nonprofits these days are often motivated to try to make their salaries disappear, because contributors want to think that 100 percent of their money goes to the recipient of the program’s services.
But it doesn’t work that way. In order to support good programs, you have to have a solid infrastructure and a major component of that infrastructure is capable and dedicated employees of the organization. Paying them appropriately may require some research and now is the time to develop the compensation process, with some guidance from IRS.
Linda Lampkin is research director at the Redmond, Wash.-based ERI Economic Research Institute, which provides salary surveys and cost-of-living comparison data for both the nonprofit and for-profit sectors.