Compensation and private benefit are among the most sensitive areas of nonprofit tax compliance—and among the most closely reviewed by the IRS.
Tax-exempt organizations are required to operate for a public purpose, not for the benefit of private individuals. When compensation or financial arrangements appear excessive or improperly structured, they can raise significant compliance concerns.
Understanding how the IRS evaluates these areas is essential for reducing audit risk.
Understanding Private Benefit and Private Inurement
The Internal Revenue Code prohibits tax-exempt organizations from allowing their net earnings to inure to the benefit of insiders. This concept is commonly referred to as private inurement.
In addition, organizations must avoid providing excessive private benefit to any individual or entity, even if they are not insiders.
Insiders generally include:
- Officers
- Directors
- Key employees
- Individuals or entities with significant influence over the organization
Violations can result in penalties or, in extreme cases, loss of tax-exempt status.
Why Compensation Is an IRS Focus
The IRS pays close attention to compensation because it is one of the primary ways that private benefit may occur.
Compensation must be reasonable and based on the value of the services provided. This includes not only salary, but all forms of compensation.
If compensation exceeds what would be paid for similar services in a comparable organization, it may be considered an excess benefit transaction under Internal Revenue Code Section 4958.
Common Audit Triggers
Excessive Compensation
Compensation that appears above market levels without appropriate support may raise concerns.
This includes:
- Base salary
- Bonuses or incentive compensation
- Deferred compensation arrangements
The IRS evaluates whether the total compensation is reasonable in light of the services provided.
Lack of Documentation
Even when compensation is reasonable, the absence of documentation can be problematic.
Best practices include:
- Approval by an independent board or compensation committee
- Use of comparable market data
- Documentation of the decision-making process
Without proper documentation, it can be difficult to demonstrate that compensation is reasonable.
Transactions with Related Parties
Transactions involving insiders or their affiliated entities are subject to heightened scrutiny.
Examples include:
- Contracts with a board member’s business
- Consulting or service arrangements
- Lease agreements
These transactions must be conducted at arm’s length and fully disclosed on Form 990.
Unreported or Indirect Benefits
Compensation is not limited to salary. It may also include:
- Housing allowances
- Expense reimbursements
- Use of organizational property
- Other fringe benefits
Failure to properly report these benefits can result in incomplete or inaccurate filings.
Revenue Sharing and Financial Arrangements
Arrangements that allow insiders to share in the organization’s revenue or receive financial benefits tied to organizational activities can raise concerns.
The IRS evaluates whether these arrangements result in impermissible private benefit.
The Importance of Process
When evaluating compensation, the IRS considers not only the amount, but also the process used to determine it.
A well-structured process can help establish what is known as the rebuttable presumption of reasonableness, which includes:
- Approval by independent decision-makers
- Use of appropriate comparability data
- Contemporaneous documentation of the decision
This process is critical in demonstrating that compensation decisions are reasonable and appropriate.
Potential Consequences
Issues related to compensation and private benefit can lead to:
- Excise taxes on excess benefit transactions
- Required correction of improper payments
- Increased IRS scrutiny
- Reputational risk
Because these issues are often visible on Form 990, they may also be reviewed by donors and other stakeholders.
A Practical Approach to Reducing Risk
Organizations can reduce risk by:
- Establishing formal compensation review procedures
- Using independent data to support compensation decisions
- Documenting board and committee approvals
- Reviewing related-party transactions regularly
- Ensuring complete and accurate reporting on Form 990
Coordination between leadership, governance, and finance is essential.
Final Thought
Compensation and private benefit are among the most common areas of IRS scrutiny for nonprofits.
Even well-intentioned arrangements can create risk if they are not properly structured, documented, and disclosed.
By taking a proactive and well-documented approach, organizations can strengthen compliance and maintain trust with both regulators and stakeholders.
