February 24, 2025 - In the third article in our Governance Best Practices for Not-for-Profit Organizations Series, we review penalties that can be assessed around executive compensation in excess of what is considered to be reasonable and how an extensive compensation review process can help keep your not-for-profit on the right track. Please watch for additional articles in our series, which cover topics such as: crafting a mission statement, document retention and destruction policies, the purpose of a governing body, conflicts of interest, and establishing a whistleblower policy.

In 1996, a provision was added to the tax code to impose penalties on influential persons connected to charities and social welfare organizations who had received excessive economic benefits from the organization, rather than to punish the organization itself. Prior to that, the IRS’ only recourse with respect to an organization providing excess benefits to such persons was to revoke its exempt status. The 2008 revision of IRS Form 990 included measures to enhance the transparency of compensation reporting by not-for-profits (NFPs) by broadening the types of individuals whose compensation must be reported, as well as requiring the reporting of compensation paid by related organizations, and even unrelated organizations, in some cases. More recently, NFPs became subject to a new tax on “excess remuneration” paid to certain employees.

While it is critical for an NFP to obtain and retain talent, it must be careful not to provide compensation in excess of what is reasonable. Because NFPs are required to disclose so much information about their compensation practices, it is relatively common for journalists and others to scrutinize such information closely to see what kind of perception it creates. Media reports about excess executive compensation have caused many boards to examine their governance practices and issues related to the determination and approval of executive pay.

A robust compensation review process that is carried out annually aids in evidencing that compensation paid by the NFP is reasonable. The process can also serve to establish the “rebuttal presumption of reasonableness” of the compensation paid to influential persons (officers, directors, key employees, and similar) for purposes of avoiding the penalties mentioned previously. The policy should outline the frequency with which the review will be conducted, the factors that will be considered in determining compensation amounts, who will perform the review, and how the review will be documented.

To meet the rebuttable presumption standards:

• Compensation must be reviewed and approved by persons who are independent of the individual whose compensation is under consideration;
• Data as to comparable compensation for similarly qualified persons in functionally comparable positions at similarly situated organizations must be used; and
• Deliberations and decisions regarding the compensation arrangement must be written and documented contemporaneously to the compensation decision.

An NFP’s Form 990 reports significant information about compensation in the following areas:

• Part VI asks whether the organization followed the rebuttable presumption procedure for determining the compensation of the organization’s CEO, Executive Director, top management official, other officers, and key employees. If so, then the organization must describe the process, including which offices or positions the process was used for and the year in which the process was last undertaken for each person.
• Part VII displays by individual name, the calendar year compensation (W-2 amount as well as nontaxable benefits) paid to each officer, director, and trustee serving during the tax year as well as the top 20 key employees and top 5 highest compensated employees serving during the calendar year ending within the organization’s tax year. In certain circumstances, former officers, directors, trustees, key employees, and highest compensated employees are also required to be listed.
• Schedule J includes a series of questions about whether particular types of compensation were provided to persons listed in Part VII such as first class or charter travel, housing allowances, severance payments, nonqualified retirement plans, and incentive compensation. If such compensation was provided by the NFP, then an explanation that identifies the name of the person (or class of persons such as all officers) who received the benefit and, in some cases, also the amount of the benefit, whether it was treated as taxable compensation, and/or the terms of the benefit must be provided.

How Can We Help

While it is important to remember that having a formal executive compensation policy and a compensation review process in place are not required by the IRS to obtain or maintain exempt status, an NFP which has adopted such policies and procedures is putting its best foot forward in the eyes of its many stakeholders. If you work with a not-for-profit in an oversight capacity, be sure to take some time on an annual basis to review the policies that are currently in place, consider updating them as your organization matures, and if any of these policies are not in place, consider adding them. Also, regularly review your organization’s Form 990 to be sure its disclosures regarding these governance practices, as detailed in Parts VI and VII as well as Schedule J, are complete and consistent with your understanding of how the practices are carried out. If you have any questions, please reach out to your Citrin Cooperman advisor. Our Not-For-Profit Industry Practice will work with your organization to ensure the best policies are in place to support future growth and success.

An important note on governance issues

Not-for-profit organizations (NFPs) face scrutiny from a multitude of perspectives – the Internal Revenue Service (IRS), the legislature, watchdog organizations, donors, news media, and the states in which they operate. Because the annual information return (Form 990) filed by most NFPs is readily available on the internet, these stakeholders have easy access to data about an organization’s operations which they can use to make judgements about it. The first line of defense is the establishment of good governance practices which are regularly followed.

Although the federal tax laws do not require the adoption of any particular policies or procedures, it is essential for an NFP to carefully consider which governance practices are most appropriate to enable the organization to operate in an effective and compliant manner. Additionally, since the Form 990 discloses information about a number of governance-related items, not only have they become the de facto best practices for NFPs, there will be many data points from which readers of the form can draw conclusions about the organization.

Therefore, it is not only crucial for an NFP to establish good governance practices, it must also prepare its Form 990 while disclosing these practices effectively. This series explores the key governance areas disclosed in the Form 990 and highlights important considerations for not-for-profit organizations.