Understanding Reasonable Compensation for Nonprofit Officers

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The IRS doesn’t tell nonprofits exactly what to pay their officers. But they’ve made it very clear what happens when you pay too much. It’s called intermediate sanctions, and it can hit both the executive who received the excess compensation and the board members who approved it.

Understanding “reasonable compensation” isn’t academic. It’s the legal standard that determines whether your organization faces excise taxes, whether your leaders face personal liability, and whether your tax-exempt status stays intact. For small and mid-sized nonprofits where compensation decisions are often informal, this is one of the most important compliance concepts you’ll encounter.

Let’s break down what reasonable compensation actually means, what happens when compensation crosses the line, and how to protect your organization.

What the IRS Means by “Reasonable Compensation”

The IRS defines reasonable compensation as the amount that would ordinarily be paid for like services by like enterprises under like circumstances. In plain language: what would a similar organization pay a similar person to do a similar job?

The IRS evaluates reasonableness based on the totality of circumstances, including:

• Compensation paid by similarly situated organizations: This is the most important factor. What do comparable nonprofits of similar size, in similar locations, doing similar work, pay for this role?
• The qualifications of the individual: Education, experience, certifications, and specialized skills all affect what’s reasonable
• The nature and scope of the person’s services: Hours worked, complexity of responsibilities, number of staff managed, budget overseen
• The size and complexity of the organization: An ED at a $5 million multi-program organization justifiably earns more than one at a $500,000 single-program org
• The need to compete for talent: Organizations in competitive labor markets or specialized fields may need to pay more to attract qualified candidates
• The organization’s financial health: An organization struggling financially shouldn’t be paying above-market compensation

Importantly, there’s no bright line. The IRS hasn’t published a salary cap or a ratio formula. They evaluate each situation individually. What’s reasonable for one organization might be excessive for another, even if the numbers are identical.

Excess Benefit Transactions: Where Things Go Wrong

An excess benefit transaction occurs when a disqualified person receives an economic benefit from a 501(c)(3) or 501(c)(4) organization that exceeds the value of what the person provided in return. Excessive compensation is the most common form of excess benefit transaction, but it’s not the only one. Sweetheart deals on property sales, below-market loans, and other favorable transactions also qualify.

When the IRS determines that an excess benefit transaction has occurred, the consequences are severe and personal.

Penalties on the Disqualified Person (the Executive)

First-tier tax: 25% of the excess benefit. If the IRS determines that $50,000 of an executive’s $200,000 compensation was excessive (meaning reasonable compensation was $150,000), the executive owes $12,500 in excise tax – on top of repaying the $50,000 excess to the organization.

Second-tier tax: 200% of the excess benefit. If the excess benefit transaction isn’t corrected within the IRS-specified time period, the additional tax is 200% of the excess. On that same $50,000 excess, the second-tier tax would be $100,000. This is a penalty designed to force correction, and it works.

Penalties on Organization Managers (Board Members)

10% of the excess benefit, up to $20,000 per transaction. Any organization manager (board member, officer, or person with similar authority) who knowingly approved the excess benefit transaction can be personally liable for 10% of the excess. Using the same example, each board member who voted to approve the compensation could owe $5,000 (10% of $50,000). This is capped at $20,000 per transaction per manager.

The “knowingly” standard is important. A board member who relied on professional advice (a compensation consultant, a CPA) or on proper comparability data may have a defense. A board member who approved compensation with no data, no discussion, and no documentation does not.

Who Is a “Disqualified Person”?

Intermediate sanctions only apply to transactions involving “disqualified persons” – a term with a specific legal definition under Section 4958 of the Internal Revenue Code.

A disqualified person includes:

• Any person who was in a position to exercise substantial influence over the affairs of the organization at any time during the 5-year period ending on the date of the transaction. This obviously includes the ED/CEO, but it can also include CFOs, development directors, program leaders, and others depending on their actual authority
• Family members of anyone in the category above (spouse, siblings, parents, children, and their spouses)
• 35% controlled entities: Any corporation, partnership, or trust in which any of the above persons own more than 35%

The “substantial influence” test is facts-and-circumstances based. The IRS regulations identify several factors that indicate substantial influence:

• Being a voting member of the governing body
• Having the power to control or veto decisions of the governing body
• Being the president, CEO, COO, treasurer, or CFO
• Managing a substantial portion of the organization’s capital, property, or income
• Having a compensation arrangement largely based on revenue from activities the person controls

At a typical small nonprofit, the disqualified persons usually include the ED, the board members, the CFO or finance director, and sometimes the development director. If you’re not sure whether someone qualifies, err on the side of treating them as a disqualified person and following the safe harbor process for their compensation.

Real Enforcement: What the IRS Has Actually Done

The IRS doesn’t just talk about intermediate sanctions – they impose them. Here are patterns from actual enforcement actions that illustrate how these rules play out:

The Founder Who Set Their Own Pay

A common pattern: a charismatic founder builds an organization from nothing, eventually reaches a point where the budget exceeds $2-3 million, and pays themselves well above market rate. The board, composed largely of the founder’s friends and allies, rubber-stamps compensation decisions without independent review or comparability data. When the IRS examines the organization – often triggered by a disgruntled former employee or a journalist – they find total compensation 40-60% above what comparable organizations pay. The founder faces a 25% excise tax on the excess, and the organization may lose its tax-exempt status.

The Hidden Compensation Package

An executive receives a modest base salary of $85,000 at a $1.2 million organization – seemingly reasonable. But the organization also pays the executive’s car lease ($8,400/year), cell phone ($1,800/year), professional dues and travel ($12,000/year with limited documentation), and provides a $10,000 “housing allowance” with no accountable plan. The real compensation is over $117,000, and none of the extras were evaluated by the board as part of the compensation package. This is exactly the kind of arrangement that triggers scrutiny, especially if the Form 990 only reports the base salary.

The Revenue-Based Bonus

A development director at a nonprofit hospital receives a bonus equal to 5% of all funds raised. In a good year, this pushes total compensation well above market rate. The IRS has been particularly skeptical of revenue-based compensation arrangements because they create incentives that may conflict with the organization’s exempt purpose and can result in compensation that bears no relationship to what comparable organizations pay.

How to Protect Your Organization

The good news is that protecting your organization from intermediate sanctions is straightforward. It requires discipline, not expertise.

Follow the Rebuttable Presumption Process

This is the single most important thing you can do. The IRS has established a three-step safe harbor that, when followed, creates a rebuttable presumption that compensation is reasonable. That means the IRS has to prove your compensation is excessive rather than you proving it’s reasonable. The three steps are:

1. The compensation arrangement is approved by an independent body (no conflicts of interest)
2. The body obtained and relied on appropriate comparability data
3. The body documented the basis for its decision concurrently

Follow all three steps for every disqualified person’s compensation, every year. No exceptions.

Get Real Comparability Data

The foundation of reasonable compensation is comparability data from similarly situated organizations. Don’t guess. Don’t rely on one data point. Conduct a proper compensation study using multiple data sources, organizations of similar size and scope, and appropriate geographic comparisons.

Evaluate Total Compensation, Not Just Salary

The IRS looks at the entire economic benefit package. Base salary, bonuses, retirement contributions, insurance, allowances, personal use of organization property – all of it. Make sure your board is reviewing and approving the total compensation package, not just the salary line.

Document Every Decision

Board minutes should reflect who was present, what data was reviewed, what was discussed, and how the vote went. Keep the comparability data, the analysis, and any consultant reports in a permanent file. Documentation is your evidence that you did it right.

Review Annually

Market conditions change. Your organization changes. Compensation that was reasonable three years ago might not be today – in either direction. Annual review of executive and officer compensation isn’t optional; it’s the standard of care.

Manage Conflicts of Interest

Anyone with a financial interest in the compensation decision should be excluded from the deliberation and vote. This means the executive whose compensation is being set, any board members with family or business relationships with that executive, and anyone else whose objectivity could reasonably be questioned. Use a written conflict of interest policy and enforce it consistently.

Be Careful with Unusual Arrangements

Certain compensation structures attract extra IRS attention:

• Revenue-based bonuses or commissions: These can produce compensation that’s unreasonable in good years even if the formula seemed fine when it was set
• Loans to officers: Below-market loans are economic benefits that count as compensation
• Personal use of organization assets: Vehicles, housing, equipment – if there’s personal use, there’s a compensation component
• Severance and change-of-control arrangements: Large severance packages can push total compensation into unreasonable territory
• First-class travel, club memberships, luxury perks: All reportable, all scrutinized

None of these are prohibited. But each one requires extra care in documentation and reasonableness analysis.

What If You Discover a Problem?

If you review your compensation practices and realize they haven’t been following the proper process – or worse, that compensation may actually be excessive – take action now rather than waiting for the IRS to find it.

For process failures: Start following the rebuttable presumption process immediately. You can’t fix prior years retroactively, but establishing proper procedures going forward demonstrates good faith.

For potentially excessive compensation: Conduct a thorough comparability analysis. If compensation is above market, adjust it prospectively. If there’s been a clear excess benefit, consult a nonprofit attorney about correction options. The tax code provides a correction mechanism that, if used promptly, can prevent the 200% second-tier tax.

For reporting issues: If your Form 990 hasn’t been accurately reporting compensation, work with your tax preparer to correct future filings and consider whether amended returns are appropriate for prior years.

The worst thing you can do is nothing. The IRS’s examination programs are increasingly sophisticated, and 990 data analysis makes it easier than ever for them to identify compensation outliers. Better to find and fix a problem yourself than to have the IRS find it for you.

The Balance: Fair Pay and Public Trust

Here’s what gets lost in the compliance discussion: nonprofits need to pay competitively to attract and retain good people. The “reasonable compensation” standard doesn’t mean “as little as possible.” It means “consistent with what the market pays for similar work at similar organizations.”

Underpaying your executive isn’t virtuous. It leads to burnout, turnover, and weaker leadership – all of which hurt your mission. As we cover in our salary benchmarking guide, the cost of replacing a leader far exceeds the cost of paying them fairly in the first place.

The goal isn’t to minimize compensation. It’s to ensure that whatever you pay is defensible – backed by data, approved through proper governance, and documented thoroughly. When you do that, you protect your organization, your leaders, and the mission you’re all working to advance.