Nonprofit Tax Risk & Strategy Series (Part 3)
Compensation is one of the most sensitive areas of nonprofit tax compliance—and one of the most closely reviewed by the IRS.
Nonprofit organizations are permitted to compensate their leaders and staff. However, that compensation must be reasonable, properly structured, and well-documented.
When compensation arrangements are not carefully evaluated, they can raise concerns about private benefit and excess benefit transactions, both of which carry significant compliance risk.
Understanding the Core Principle: No Private Benefit
Tax-exempt organizations must operate for a public purpose—not private interests.
This means that the organization’s earnings cannot be used to improperly benefit insiders, including:
- Officers
- Directors
- Key employees
- Individuals with substantial influence
This concept is commonly referred to as private inurement.
Even well-intentioned arrangements can create risk if they result in an improper benefit.
What the IRS Evaluates
The IRS evaluates compensation based on both amount and process.
Key considerations include whether compensation is:
- Reasonable for the services provided
- Determined through an independent decision-making process
- Supported by appropriate documentation
Compensation includes more than base salary. It may also involve:
- Bonuses and incentive compensation
- Deferred compensation arrangements
- Fringe benefits
- Use of organizational assets
All forms of compensation must be considered together when evaluating reasonableness.
Common Areas of Risk
Excessive Compensation
Compensation that exceeds what would be paid for similar services in comparable organizations may be treated as an excess benefit transaction under Internal Revenue Code Section 4958.
This can result in excise taxes and require corrective action.
Lack of Independent Approval
Compensation decisions should be made by individuals who are independent and free of conflicts of interest.
When insiders participate in determining their own compensation, it raises concerns about objectivity and oversight.
Limited or No Documentation
Even reasonable compensation can raise concerns if there is insufficient documentation.
The IRS expects to see:
- Approval by an independent board or committee
- Use of comparable market data
- Written records of the decision-making process
Without documentation, it is difficult to demonstrate that compensation is appropriate.
Unreported or Indirect Benefits
Compensation is not limited to salary.
It may also include:
- Housing allowances
- Expense reimbursements
- Personal use of organizational property
- Other fringe benefits
Failure to properly account for these items can result in incomplete disclosures.
Informal or Unstructured Arrangements
Informal agreements or undocumented arrangements can create significant compliance risk.
All compensation and benefit arrangements should be:
- Clearly defined
- Properly approved
- Documented and periodically reviewed
The Importance of Process
One of the most important concepts in this area is the rebuttable presumption of reasonableness.
An organization can strengthen its position by demonstrating that compensation decisions were made through a structured process that includes:
- Approval by independent decision-makers
- Use of appropriate comparability data
- Contemporaneous documentation
The IRS evaluates not only the amount of compensation, but also how the decision was made.
Why This Matters
Issues related to compensation and private benefit can result in:
- Excise taxes on excess benefit transactions
- Required correction of improper payments
- Increased IRS scrutiny
- Reputational risk
Because compensation is disclosed on Form 990, it is also subject to public review by donors, regulators, and watchdog organizations.
A Practical Approach
Organizations can reduce risk by implementing a structured process:
- Establish formal compensation review procedures
- Use independent data to benchmark compensation
- Ensure decisions are made by disinterested board members
- Maintain detailed documentation of approvals
- Periodically review compensation arrangements
A well-documented process is essential for demonstrating compliance.
Final Thought
Compensation is not just about how much is paid—it is about how decisions are made.
Even well-intentioned arrangements can create risk if they are not properly structured, documented, and disclosed.
A thoughtful and well-documented approach helps protect both the organization and its mission.
What’s Next
In Part 4, we will explore another key area of IRS scrutiny:
Related party transactions—and how to structure them properly.
