Keeping compensation in line
IRS probe underscores need to review practices
The executive compensation practices of about 2,000 charities and foundations
are under scrutiny as a result of an IRS initiative announced in August.
Although most not-for-profit leaders would agree that excessive compensation
isn't a widespread problem, a handful of cases involving exorbitant pay and
insider transactions have piqued the interest of government regulators.
Although
the IRS initiative is limited in scope, it's a wake-up call to all not-for-profits
to ensure that their compensation practices are compliant and effective.
Get your board involved
Charities reporting pay packages in excess of
$1 million were initially targeted in the probe. The IRS has since
broadened its focus to look more generally at "outliers" - that is, out-of-range salaries or unusual
dealings that set an organization apart.
To prevent abuses in this area, your
board must be active in setting and approving all compensation and
benefits for the executive director and other key employees. This requires
developing competitive pay packages that offer good incentives without
being excessive.
Steer clear of intermediate sanctions
The intermediate
sanctions rules allow the IRS to assess penalties against individuals
or board members who receive or approve excessive compensation; this
is a priority enforcement area for the IRS. To avoid intermediate sanctions,
you must:
- Use an independent committee or the board to set compensation,
- Compare compensation against similar organizations,
and
- Document findings and conclusions.
The
IRS requires you to consider total compensation in evaluating what
is appropriate. Generally speaking, it considers compensation to
include: regular salary and bonuses, retirement plan contributions,
insurance, housing allowances and payment of nonbusiness expenses.
Additionally, you must properly structure
loans between your organization and so-called "disqualified persons" - such as board members
or key employees who have influence over your not-for-profit's affairs.
Otherwise, when determining whether pay
is excessive, the IRS may treat the loans as additional compensation.
You can protect your organization by identifying in contracts with
disqualified persons all economic benefits you're giving to them.
Benchmark compensation
Benchmarking compensation
is necessary to avoid possible penalties, but the practice also
helps your board develop creative and competitive pay packages. In
evaluating compensation, consider factors such as:
- Your not-for-profit's
size and administrative complexity,
- Geographic location, service
category and financial stability,
- Qualifications needed in the position, and
- Competitiveness of the
package in relation to comparable organizations.
To assess how your
offerings measure up, use salary surveys in the not-for-profit
sector and review salaries for similar for-profit positions. Again,
carefully document any findings that form the basis for compensation
decisions, paying close attention to those that could be considered
unusual.
Review transactions with insiders
Insider transactions are another
area of interest for regulators. These can include loans, consulting
agreements, or the sale, exchange or leasing of property to board
members, trustees or key employees.
Because insider transactions require
careful observance of laws and conduct codes, board members should
review and approve any such arrangements to ensure they can withstand
IRS scrutiny.
Ensure practices are sound
Although your compensation
practices may never be subject to regulatory review, the IRS
enforcement initiative offers a valuable blueprint of what you should
and shouldn't do in this area. This is also an opportunity to conduct
internal housekeeping and gain assurance about the integrity of your
practices.
Consider incentive compensation
More not-for-profits are using
incentive pay, including cash bonuses, nonqualified deferred
compensation arrangements or supplemental retirement plans. To
be effective, tie incentives to measurable performance goals
agreed on by the board and chief executive. Many organizations
create measures to gauge improvements in areas such as fund raising,
program and service delivery, and financial and special initiatives
management.
In addition, structure incentive pay to truly motivate
performance. If packages incorporating bonus pay or other incentives
remain heavily weighted toward base pay, you can weaken the
pay-forperformance link.
For example, a not-for-profit executive
receiving a base salary of $120,000 with a bonus potential
of 5% annually may be less motivated to achieve goals than a
colleague with a smaller base salary and a larger variable pay
component.
Regardless of the approach, your board should evaluate
the executive director's performance each year. Regular reviews
provide a reference point for setting and awarding annual compensation
and demonstrating why pay is fair and reasonable. |
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