The Care and Feeding of Nonprofit Executives: How to Balance Fair Compensation and IRS Requirements

The CEO of a nonprofit organization is the most visible, and likely, the most influential position in the organization. Great efforts should be expended in recruiting and retaining the right person for the job. It is vitally important to compensate the CEO at the levels that reflect the expectations anticipated to be achieved and the skill set required to attain those expectations.

Often nonprofit board members, clients, and other stakeholders believe that such positions can be or should be “below market” because either the organization’s budget is challenged, or they fear the donor’s response to such salaries would result in decreased donations or funding.

Obviously, no organization can afford to pay a CEO (or anyone else for that matter) at levels that are not sustainable. But care must be given to recognize that an outstanding leader will make the organization successful and deserves to be compensated at levels that reflect that success. Nonprofit organizations present unique challenges that require specific skill sets and experience. Why should persons that possess these skills not be compensated at the proper level?

Where to start

Like most decisions in business, the trick is to strike the right balance. Define the job, observe the field of likely candidates, and learn about the compensation packages that top performers will command.

There are practical limits on initial base compensation that can be offered to most incoming nonprofit CEOs, largely based on the budget that the CEO is inheriting. Often, base compensation is augmented with other considerations that involve either success-based bonuses, deferred compensation, and/or specifically tailored retirement benefits. Be aware that this type of pay structure can be risky down the road on the speculation that funds will be available to fulfill future obligations.

Consideration of regulations and disclosure

The IRS has promulgated regulations designed to prevent “private inurement” and “excess benefits,” together with public disclosure requirements of the process and amounts of executive compensation. These regulations are not only for the “common good,” but also help guide the organization in making rational and supportable decisions. For example, Form 990 asks about the criteria used to determine CEO compensation, such as:

• Compensation committee
• Independent compensation consultant
• Form 990s of other organizations
• Written employment contract
• Compensation survey or study
• Approval of the board or compensation committee

Not only does checking most or all of these boxes “look good” on Form 990, but substantial adherence to them will likely guide board members to make the best decisions.

Compensation techniques to be considered

Bonuses and Incentive-Based Compensation. As with any business, bonus plans for nonprofit executives are entirely appropriate. It is important that such plans have identifiable criteria and that the total of all compensation doesn’t exceed otherwise reasonable levels. Bonuses can be very effective motivators and can reward performance when aligned with the organizational mission. Further, whereas recurring annual raises may unintentionally inflate compensation by compounding increases over a period of years, bonuses are not built into the base and focus on recent achievements.

Deferred Compensation. Often coupled with a bonus plan, this option allows for a portion of otherwise reasonable compensation to be deferred to future years. Such plans are highly customizable and can be tailored to the cash flow considerations of both the organization and the CEO. They might contain features of “vesting” that have the further advantage of making CEO retention important, and act as a way to encourage the CEO performance to align with the long-term strategies of the organization.

Retirement Plans. Nonprofit organizations often struggle to provide employees with defined benefit or defined contribution plans that are as robust as found in the private sector. Many nonprofits offer standard 401(k) or 403(b) plans to a wide group of employees. More highly compensated executives could be offered the opportunity to participate in a 457(b) plan. Such plans generally allow higher levels of employee contribution, which therefore favor higher paid executives.

You might also offer Supplemental Executive Retirement Plans (SERPs). They act as a type of pension account funded by employers. Essentially, the organization agrees to provide supplemental retirement income to the executive based on vesting and other eligibility conditions. There are many different forms of SERPs, but they have risks of forfeiture and exposure to creditor rights which should be considered.

Nonetheless, carefully structured, they may provide the economics to both employee and employer that work well for highly valued long-term executives.

Understand what you’re offering

Before you offer an executive deferred compensation, a bonus plan or fringe benefits, make sure you understand all associated potential tax and compliance issues.