United States: By The Book—Setting Executive Compensation Correctly

Last Updated: November 6 2014
Article by Kelly H. Buchheit

Overpaying executives is a hot topic this year, as legislators and the public fume over salaries in the financial, automotive and other industries receiving federal bailout dollars. In the not-for-profit arena, the IRS is also cracking down on salaries it considers to be unreasonable and is requiring stringent information about compensation on the new Form 990. To protect yourself from sanctions, you need to make sure that your board of directors, at the time it sets an executive salary, arrives at a "reasonable" amount based on comparables for similar positions and adequately documents that research. And, if compensation is above the norm, you need to be ready to justify it.

Excessive executive compensation is a controversial topic in the current world of business, in both the for-profit sector and not-for-profit sector. In the not-for-profit industry, the IRS is cracking down on salaries it considers to be unreasonable and is requiring stringent information about compensation on the new Form 990.

To protect yourself from sanctions, you need to make sure that your board of directors, at the time it sets an executive salary, arrives at a "reasonable" amount based on comparables for similar positions and adequately documents that research. Additionally, the person who will benefit from the salary-setting decision should not be involved in the data-collecting and salary-setting process.

Ensuring Compensation is "Reasonable"

The IRS demands "reasonable compensation" for key employees, defining it as the amount that ordinarily would be paid for like services by like enterprises, whether taxable or tax-exempt, under like circumstances.

Your board of directors ultimately is responsible for compensation, even if a compensation committee determines the amount. Either way, disinterested parties should set compensation, and specific procedures should be in place for times when a conflict of interest arises. For example, committee members with a conflict of interest should excuse themselves from the compensation discussion and abstain from taking part in the decision.

In addition, board committee members making compensation decisions should properly document their steps for determining the appropriate level of compensation and how that conclusion was reached. For instance, they should retain the data used for comparability, an analysis of the employee's qualifications and documentation of the discussions leading to the final decision.

Comparing Apples to Apples

When evaluating a compensation issue, your board's committee should compare the position with others sharing similar duties. It should also consider the scope of the position (national or local), number of subordinates managed and size of the budget it oversees.

Another factor in the compensation decision is whether the employee will manage multiple functions, facilities, departments or entities. For example, it would be reasonable to expect higher compensation for an executive director who oversees an organization with a $100 million budget and multiple locations and/or programs than one who leads a $5 million organization with only one program.

Finding Comparables

Using comparables from both not-for-profit and for-profit entities is important in establishing compensation. Organizations should have at least three comparables, with more recommended for larger not-for-profits. For example, your board could use comparables from a similar geographic area. To expand further, a suburban not-for-profit hospital might, for example, use salary information from both for-profit and not-for-profit hospitals in the same, or an economically similar, suburb.

Commissioning a custom survey is arguably the most accurate method of obtaining comparables. An accounting or consulting firm can help design a survey to match the specific position you want to compare.

You also can obtain this information from trade association surveys, telephone polls and Internet research. Because the information from not-for-profits is public record, it should be readily available from sites such as GuideStar.org, which publishes an annual Nonprofit Compensation Report.

Justifying High Compensation

When awarding above-average compensation, your organization must clearly justify it. Some factors to consider are:

  1. The ratio of your organization's revenue and expenses to the proposed compensation;
  2. The executive's track record within and outside your organization;
  3. The difficulty of replacing the executive;
  4. Other written offers received by the executive;
  5. Competitive market pressures; and
  6. Special circumstances that may impact the decision, such as the executive's unique talents that will be valuable in addressing your not-for-profit's specific needs.

Avoiding Sanctions

Even when you feel that above average compensation is justified, the IRS can determine it is excessive and impose intermediate sanctions. These sanctions stipulate that the employee must repay the excess compensation to the organization, with interest, and a 25% penalty tax. If the employee does not make repayment in a reasonable amount of time, he or she is subject to a 200% penalty.

In addition, an officer, director or trustee of a not-for-profit who knowingly approved what the IRS considers to be an excess benefit can be liable for an excise tax of 10% of the excess amount.

It is important to note that, if you follow the steps described above, the burden of proof for imposing any sanction will be on the IRS. If you do not follow these steps, however, the burden of proof in a challenge is shifted to the not-for-profit organization.

Disclosing on Form 990

Sanctions aside, your executive compensation practices are now subject to heightened public scrutiny due to the required reporting of substantial compensation information on the IRS's new Form 990. Starting with tax year 2008, Part VII of the Form 990 requires you to report compensation directly from employee W-2 forms and independent contractors' Form 1099s. There are also additional disclosures in Schedule J, including information on base pay, bonuses, severance, deferred compensation and nontaxable benefits, that are required reporting in the Form 990.

Compensation information is required for officers, directors, trustees, key employees and your five highest-compensated employees other than the aforementioned. The IRS defines key employees as employees other than officers, directors and trustees who: 1) had reportable compensation above $150,000, 2) had organization-wide authority or control and 3) were among your not-for-profit's top 20 highest-paid employees who satisfied the previous two tests.

The new Form 990 also includes the definition of an officer, which includes, at a minimum, a not-for-profit organization's CEO. Similarly, IRS officials have warned against claiming there to be no officers in an organization. The IRS deems this to be a "bad position" to take.

Getting the Best Talent

The process of setting appropriate executive compensation is a balancing act. On the one hand, you need to make sure compensation is in line with similar positions elsewhere and that the research to determine the compensation amount is unbiased and thorough. On the other hand, you must consider what the competition is offering.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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