For decades, executive compensation in the for-profit sector has been an area of increasing scrutiny, with shareholders, the media and the public criticizing executive compensation packages as excessive. Increasingly, this same scrutiny is arising in the nonprofit sector, with regulators, the media and the public turning their attention to the pay of nonprofit CEOs (aka executive directors).
Unlike in the for-profit sector, where the impact on shareholders is the primary concern, the scrutiny in the nonprofit sector is about making sure nonprofit assets are being used to advance the nonprofit's charitable missions and not someone's private interest. However, in both sectors, the board of directors has a significant governance role to play in determining whether compensation is excessive.
Here are five key things for any nonprofit director to know in navigating their governance duties in reviewing and approving CEO compensation.
1. The Board Is Responsible for Reviewing the Executive’s Compensation
The board of directors is ultimately responsible for setting and approving the compensation of the nonprofit's CEO. This is one of the board's most crucial governance duties. The entire board should be involved in approving the final compensation package, even if a committee facilitates the review process and takes the lead in making a recommendation to the whole board on the compensation package.
Related story: 3 Key Areas That Optimize Your Nonprofit Board's Governance
2. Understand the IRS Three-Step Process
Directors serving on 501(c)(3) or 501(c)(4) organizations need to be aware that the IRS prohibits "excess benefit transactions," which include, among other things, paying CEOs excessively. The IRS can impose steep taxes on CEOs and executive directors who receive excessive compensation from a nonprofit and the directors who approve that compensation.
Accordingly, directors must understand the IRS rules on excess benefit transactions, including the agency’s three-step process for reviewing executive compensation to assess whether it is "reasonable compensation." The three steps include:
Independent Approval
Independent directors must conduct the compensation review process without conflicts of interest. This can be the whole board or a committee, as long as all of the directors who are involved are independent. For example, directors who are family members of the CEO should not be involved. Nor should the CEO, if they are also a director.
Comparability Data
The board must use comparability data showing what similar organizations pay their CEOs. The IRS suggests looking at organizations similar in size, mission and geographic area. Using multiple data sources, such as compensation surveys, is recommended. The comparability data should cover the entire compensation package, including bonuses — not just base the salary.
Documentation
Comprehensive records of the decision-making process must be kept in the board's records. This documentation should reflect, among other things, the terms of the approved compensation package, the date it was approved, the directors present for the discussion, how they voted, and how the comparability data was obtained and relied upon.
Following this process creates a "rebuttable presumption of reasonableness" that can protect the organization in case of an IRS audit, and directors and nonprofit leaders are encouraged to speak with counsel for more detailed information about the specific requirements of each step.
3. Know Your State Law
Nonprofit directors must be aware of their state's specific laws regarding executive compensation. Some states have additional requirements or restrictions beyond federal regulations. For example, in California, nonprofit boards are required to determine whether the compensation paid to their organization’s CEOs and chief financial officers is "just and reasonable."
4. Keep Open Lines of Communication
Boards should engage in clear discussions with CEOs about how the compensation review process will occur. Maintaining transparent communication is essential. This includes things such as clear communication of performance goals and how they relate to compensation. It is also helpful to make sure that all directors understand the process; who will take a leading role, such as the board chair or the executive committee; and what will be expected of directors during the process, such as timely responding to CEO performance surveys.
5. Don't Forget the Performance Review
The compensation review process should be closely tied to a comprehensive executive performance evaluation. The board should conduct the CEO's evaluation annually, include both quantitative and qualitative measures, align with the organization's strategic goals and mission, and provide constructive feedback for improvement. A thorough performance review justifies compensation decisions and supports the executive's professional growth and the organization's overall effectiveness.
By focusing on these five key areas, nonprofit directors and nonprofit leaders supporting directors can help enhance a nonprofit's governance and, ultimately, its effectiveness by creating an executive compensation review process that is sufficient to attract top talent, avoid excessive compensation and retain effective leaders.
The preceding post was provided by an individual unaffiliated with NonProfit PRO. The views expressed within do not directly reflect the thoughts or opinions of NonProfit PRO.
- Categories:
- Board
- Staffing & Human Resources
Casey Williams is a partner and chair of the Nonprofit Practice Group at Liebert Cassidy Whitmore, a trusted adviser to California’s public entities, educational institutions, and nonprofits. Her practice focuses on helping mission-driven organizations achieve their goals while staying compliant and working through complex disputes.
Attorney Nandini Ruparel provides expert advice and counsel on labor and employment law matters at Liebert Cassidy Whitmore.