How to Pay Yourself: Nonprofit Compensation Rules

Nonprofit organizations must navigate specific rules regarding how they compensate individuals. Maintaining tax-exempt status requires adherence to regulations and transparency. This involves understanding appropriate compensation and avoiding prohibited financial benefits.

Determining Appropriate Compensation

Compensation for individuals within a nonprofit organization must always be “reasonable.” The Internal Revenue Service (IRS) defines reasonable compensation as the amount that would ordinarily be paid for similar services by similar organizations under similar circumstances. This determination considers factors such as the type of work, skills required, organization size, geographic location, and the individual’s experience.

The board of directors holds the primary responsibility for setting executive and staff compensation. An independent compensation committee or external consultants often assist to ensure objectivity. Individuals whose compensation is being determined must not participate in the voting or decision-making process to avoid conflicts of interest.

To support compensation decisions, organizations should gather and document comparability data. This data includes compensation paid by similar tax-exempt and for-profit entities for comparable positions. Thorough documentation, such as meeting minutes, comparability studies, and written contracts, is essential to justify the compensation paid. This process helps establish a “presumption of reasonableness,” providing a safe harbor if compensation decisions are later scrutinized by the IRS.

Avoiding Prohibited Financial Benefits

Nonprofit organizations must avoid transactions resulting in “private inurement” or “excess benefit transactions.” Private inurement occurs when any part of a nonprofit’s net earnings benefits an insider, such as a board member, officer, or key employee. Even a small amount of inurement can jeopardize the organization’s tax-exempt status.

Excess benefit transactions, governed by Internal Revenue Code Section 4958, involve a tax-exempt organization providing an economic benefit to a “disqualified person” that exceeds the value of the consideration received by the organization. A disqualified person is generally someone who can exercise substantial influence over the organization, including officers, directors, key employees, and substantial contributors, as well as their family members and entities they control. These transactions can include loans, leases, or other financial arrangements where the disqualified person receives disproportionate value.

Violations can trigger “intermediate sanctions,” which are excise taxes imposed on the disqualified person and potentially on organization managers who approved the transaction. The initial tax on the disqualified person is 25% of the excess benefit. If not corrected, an additional tax of 200% of the excess benefit can be imposed. Organization managers who knowingly approve an excess benefit transaction can face a tax of 10% of the excess benefit, up to $20,000 per transaction. These penalties are intended to deter improper financial benefits, though revocation remains a possibility in egregious cases.

Forms of Permitted Compensation

Nonprofit organizations can provide various forms of compensation to employees and contractors, provided benefits are reasonable and not prohibited. Direct salary or wages, typically reported as W-2 income for employees, is the most common form. This includes regular pay for services rendered.

Permissible employee benefits include health insurance, contributions to retirement plans such as 403(b) accounts, and paid time off. These benefits are legitimate components of a compensation package, helping attract and retain qualified personnel.

Expense reimbursements are allowed for business-related costs incurred on behalf of the nonprofit. To avoid these being treated as taxable income, the organization must operate an “accountable plan.” This plan requires expenses to have a business connection, be substantiated with documentation, and any excess advances returned within a reasonable timeframe, typically within 60 to 120 days. For services from non-employees, such as consultants, payments are made as independent contractor payments and reported on Form 1099.

Reporting and Compliance Requirements

Nonprofit organizations are subject to specific reporting requirements for compensation practices. The primary document is IRS Form 990, the annual information return filed by most tax-exempt organizations. Part VII of Form 990 specifically details compensation paid to officers, directors, trustees, key employees, highly compensated employees, and independent contractors.

Form 990 and its attachments, including compensation information, are available for public inspection. This public disclosure requirement promotes transparency, allowing the public and potential donors to review how the organization utilizes its financial resources. Organizations must make their three most recent Forms 990 available for public inspection at their principal office and provide copies upon request, though they are not required to disclose donor names and addresses for public charities.

Maintaining thorough and accurate financial records is essential for demonstrating compliance. This includes detailed documentation for all compensation paid, expense reimbursements, and the processes used to determine compensation amounts. Regular, independent reviews of compensation practices, often by the board or external auditors, help ensure adherence to IRS regulations and best practices. Many states have oversight mirroring federal guidelines, emphasizing consistent record-keeping and transparent financial management.