Reasonable Compensation for Nonprofit Organizations: How Much Is Too
Much and How to Minimize Abuse
by Kaci N. Byford
Abstract
Tax-exempt organizations are supposed to pay their employees no more than a reasonable
salary. A lack of specific guidelines and insufficient monitoring by the IRS can lead to
nonprofits abusing their power and paying exorbitant salaries. Standards have been set out to
help organizations determine what is reasonable. There seems to be two problems with this:
making sure that these organizations make the right decisions, and finding and punishing the
ones that don’t. The Internal Revenue Service (IRS), for its part, has responded to the perceived
abuses with new sanctions and new financial forms, but many feel more needs to be done. This
paper will examine the current standards for determining reasonable compensation, discuss
current enforcement vehicles and sanctions, evaluate proposed solutions, and make
recommendations for the IRS and for nonprofit organizations. The paper will focus mainly on
charities, organizations exempt under 501(c)(3) of the Internal Revenue Code.
Table of Contents
I. INTRODUCTION............................................................................................................................ 2
A. OVERVIEW OF NONPROFIT ORGANIZATIONS ............................................................................ 2
B. NONPROFIT ORGANIZATIONS COMPARED TO FOR-PROFIT ORGANIZATIONS ............................. 3
C. REASONABLE COMPENSATION ................................................................................................. 3
D. COMPENSATION ABUSE IN NONPROFIT ORGANIZATIONS ......................................................... 4
E. EXAMPLES OF QUESTIONABLE COMPENSATION IN CHARITIES .................................................. 5
II. CURRENT REGULATION OF NONPROFIT ORGANIZATIONS ...................................................... 8
A. 501(C)(3) ................................................................................................................................. 8
B. THE NON-DISTRIBUTION CONSTRAINT & 503(B)(2) PROHIBITED TRANSACTIONS.................... 9
C. FORM 990................................................................................................................................. 9
D. STATE REGULATIONS OF NONPROFIT ORGANIZATIONS .......................................................... 11
1
III. STANDARDS IN DETERMINING REASONABLE COMPENSATION ............................................ 12
A. ARE LARGE SALARIES IN CHARITIES EVER JUSTIFIED? .......................................................... 14
B. COMPENSATION FOR MEMBERS OF A CHARITY’S BOARD OF DIRECTORS ............................... 16
IV. IRS SANCTIONS ...................................................................................................................... 17
V. MAIN CONCERNS ABOUT MONITORING CHARITIES ............................................................... 18
VI. PROPOSED SOLUTIONS ........................................................................................................... 19
A. FIRST, NEW LEGISLATION AND REGULATIONS ....................................................................... 19
1. Harsher Penalties on Nonprofits and their Board of Directors ........................................ 19
2. Limits on Salary ................................................................................................................. 20
B. SECOND, ENFORCING EXISTING REGULATIONS ...................................................................... 21
C. THIRD, SELF-REGULATION BY CHARITIES .............................................................................. 22
1. Guidance ............................................................................................................................ 22
2. Accreditation ...................................................................................................................... 22
VII. RECOMMENDATIONS ............................................................................................................ 23
VIII. CONCLUSION ....................................................................................................................... 26
I. INTRODUCTION
A. OVERVIEW OF NONPROFIT ORGANIZATIONS
Nonprofit organizations are organizations that typically qualify for tax-exempt status
under the Internal Revenue Code.1 About half of these organizations are public charities that
qualify for exemption under section 501(c)(3) of the Internal Revenue Code.2 These
organizations are considered “charitable” because they operate to serve some broad public
purpose or interest, such as providing education, providing religious services and helping the
poor. There are also exempt organizations under section 501(c)(3) called private foundations,
which are usually created to distribute money to public charities or individuals. Other provisions
1
National Center for Charitable Statistics, Frequently Asked Questions,
http://nccs.urban.org/resources/faq.cfm/nonprofitempnt&wagesinfo. (hereinafter NCCS)
2
See, e.g., National Center for Charitable Statistics, Frequently Asked Questions.
2
provide tax-exemptions for various organizations including social welfare organizations, labor
and agricultural associations, business leagues and fraternal beneficiary societies.3
B. NONPROFIT ORGANIZATIONS COMPARED TO FOR-PROFIT ORGANIZATIONS
While the purpose of nonprofit organizations (NPOs) will usually be to provide a certain
benefit to the general public, for-profit organizations usual operate to generate income for the
individuals who own the organization. For-profit organizations are generally free to distribute
their income to the owners of the organization in any way they so arrange. In contrast, most
nonprofits are legally prohibited from distributing the organization’s earnings to the individuals
who exercise control over the nonprofit, such as officers, directors or members. Nonprofit
organizations are not prohibited from earning profits, but they must devote any surplus left after
reasonable organizational expenses to the continuing operation of the organization. In the
nonprofit sector this is known as the restriction on private inurement and all NPOs must comply
to continue to qualify as tax-exempt.4
C. REASONABLE COMPENSATION
Although charities are prohibited from distributing the organization’s income to
individuals with organizational control, under Section 501(c)(3) charities are to permitted to pay
for ordinary and necessary expenditures associated with the course of operations. This includes
reasonable compensation to employees within the organization. The question then becomes:
what is considered “reasonable” compensation? The term “reasonable” is vague and is not
defined in the IRS Code. The meaning seems to depend on the context or situation the term is
used in. Little help is given by the IRS except for the requirement that the compensation not be
3
Id.
3
“excessive,” and the organization is left with minimal guidance in deciding what is reasonable
compensation. Charities must look for additional direction from places like court decisions,
which have tended to interpret the term broadly, and to other sources for help.
Generally “reasonable compensation” is what similar persons in similar positions with
similar duties at similar organizations are paid.5 All sources of compensation should be
considered, including salary, fringe benefits, and retirement plans.6 While some guidelines and
standards can be established, largely it is a judgment call that is usually left to the discretion of
charity’s Board of Directors. This can lead to abuse by executives and board members in setting
compensation for employees.
D. COMPENSATION ABUSE IN NONPROFIT ORGANIZATIONS
When charities decide to pay excessive compensation, they are diverting donated money
away from the intended organizational purpose and into the hands of executives and directors.
Those who donate to charities expect their money to go to the intended beneficiaries and not to
the benefit of the charity’s employees in the form of excessive compensation. Excessive pay
within a charity can taint the public’s perception of donating.
Excessive salaries can have important implications not only for the offending charity, but
also for the entire charitable sector. In general, funding of charities depends largely on public
donations by individuals because of the individual tax deductions they receive. The Giving USA
Foundation publishes a report each year that details national estimates of charity funding based
4
Internal Revenue Code §501, 26 U.S.C.A. § 501(c)(3).
Board of Directors of the Council on Foundations, Recommended Best Practices in Determining Reasonable
Executive Compensation: A Guidance Memorandum from the Board of Directors of the Council on Foundations
(2002), http://www.cof.org/files/documents/governing_boards/execcomp2003.pdf.
5
4
on a number of sources.7 According to the National Center for Charitable Statistics, the Giving
USA Foundation’s 2006 report shows that $222.89 billion of charity funding in that year came
from individual donations and this accounted for 75.6% of total funding.8 It is safe to say the
tax-exempt sector would have a hard time existing without public support, and abuse by even one
charity is likely to reduce individual giving due to an unfavorable public opinion of charities in
general. It is within the best interests of the organization to comply with compensation
regulations, but this does not mean they always do.
An article published in PULSE newsletter in 2002 described a charity compensation study
conducted by salary survey provider Abbott, Langer & Associates analyzed over 1300 nonprofit
organizations and reported on over 51,000 employees in 125 benchmark jobs. The survey found
that the median annual income of Chief Executive Officers (CEOs) in nonprofit organizations
was $81,000.9 However, the survey showed that some of the highest paid CEOs earned well over
$600,000 a year.10 While it is safe to assume that some charity executives may have a fairly
difficult job, those high annual salaries have some wondering if the executives care more about
their own benefits than about the charities and their intended beneficiaries.
E. EXAMPLES OF QUESTIONABLE COMPENSATION IN CHARITIES
When charities pay excessive compensation it tends to be in exceptionally large amounts
and it receives widespread media and public attention. This is because charity executives are
essentially taking charitable donations and benefitting themselves at the expense of the intended
6
Consuelo Lauda Kertz, Note, Executive Compensation Dilemmas in Tax-Exempt Organizations: Reasonableness,
Comparability, and Disclosure, 71 TUL. L. REV. 819 (1997).
7
NCCS, supra note 1.
8
Id.
9
NCCS, supra note 1.
5
beneficiaries. Most abuse seems to occur in private family foundations, and since the inception
of the tax-exempt status, there have been several instances where charities and foundations acted
questionably:

The Bielfeldt Foundation paid family members a total of $21 million over 17
years, while spending only $25 million on charitable causes.11

Paul C. Cabot Jr., son of the founder of the Paul & Virginia Cabot Charitable
Trust, took $5.2 million in compensation from 1998 to 2002 but during that same
period the foundation only donated an annual average of $400,000 to charity. One
year Cabot Jr. even used an additional $200,000 to cover the expenses for his
daughter’s wedding.12

A judge in Hawaii ordered the removal of trustees from service on the board of
the Bishop Estate, a multibillion dollar trust which was responsible for
administering a private school. The decision was based on findings that the
school’s five trustees, who were responsible for $5 billion in investments, were
being compensated $1 million a year each for their member duties.13

An article published in 2006 about the compensation paid to executives of the
New York Public Library showed that in 2005 the organization met shortfalls in
the budget by selling property and artwork, but the executives were still getting
10
Id.
Richard Williamson, Charitable Funds Going To Least In Need, THE NONPROFIT TIMES (2003),
http://www.nptimes.com/fme/dec03/fme_1.html.
12
Michael Rezendes and Walter V. Robinson, Foundation Chief Agrees To Repay Over $4M, BOSTON GLOBE,
December 16, 2004, available at http://foundationcenter.org/pnd/news/story.jhtml?id=90700012.
13
Kent Allen, Special Section: Board Members Conflicted Over Compensation (2001),
http://www.foundationnews.org/cme/article.cfm?id=142&issueid=106.
11
6
paid large salaries.14 The President/CEO of the organization received about
$800,000 in salary in 2005, up $221,000 from the previous year, and two new
officers were hired and compensated higher than their predecessors.15 Also in
2005 the Library commenced an “emergency campaign” to raise $18 million, and
at the same time it reduced its employee tuition assistance program.16

In 2004 Public Interest Watch (PIW) called for an IRS investigation of some of
the top environmental charities in the country after a PIW report found at least
two, the Natural Resources Defense Council (NRDC) and Environmental
Defense, had paid enormous six-figure executive salaries while publicly seeking
urgent contributions to fund program activities.17 A third organization,
Greenpeace Fund, Inc., was found to have paid out more than $400,000 in annual
salaries, even though the organization served no apparent purpose other than to act
as a “pass-through” for donations to Greenpeace and other environmental
groups.18
These examples not only show the need to establish guidelines for determining
reasonable compensation in charities, but also the importance of subsequent monitoring. Tension
exists between the purposes of the charity and the reality of having to run the charity efficiently.
Charities exist to provide public benefits but they still have overhead expenses, including
14
New York Public Library Execs Paid Handsomely in 2005, PHILANTHROPY NEW DIGEST, November 30, 2006,
available at http://www.pnnonline.org/article.php?sid=7128.
15
Id.
16
Id.
17
IRS Investigation of Top Environmental Charities Called For (2004),
http://www.pnnonline.org/article.php?sid=5411.
18
Id.
7
compensation, which must be paid. Executives and directors of charities, however, should not be
allowed to benefit to the detriment of the entire organization and its intended beneficiaries. In
for-profit corporations shareholders are able to monitor executive compensation and even sue the
corporation. There are no shareholders in charities, so there needs to be other ways to regulate
and monitor the actions of the organization.
Compensation abuse by charities is not a small problem and should not be overlooked. In
2005 the Federal Government reported estimated losses of $15 billion per year due to abuses by
charities and their donors.19 At a Senate Finance Committee Hearing that year, IRS
Commissioner Mark Everson stressed the importance of the issue: “If Congress doesn’t do
something soon, public support for charities will wither.”20 Should Congress hold the sole
responsibility to reduce the abuse? What about the IRS or the charities themselves?
II. CURRENT REGULATION OF NONPROFIT ORGANIZATIONS
The IRS has established requirements and sanctions designed to ensure that charities
continue to be dedicated exclusively to furthering public purposes and benefits rather than private
interests.
A. 501(C)(3)
Section 501(c)(3) of the Internal Revenue Code states the requirements needed in order to
qualify for tax exemption and grants tax exempt status to organizations that qualify. The Section
501(c)(3) Federal tax exemption is granted to organizations whose activities benefit the public
19
Margaret Ann Miille, Nonprofit Groups Give Their All, or Most of It (2008),
http://www.lvrj.com/news/16724986.html.
20
Senate Finance Committee Discusses Nonprofit Accountability (2005),
http://www.ombwatch.org/article/articleview/2794/1/337.
8
and society as a whole.21 Tax exemption seems to be premised on the theory that the public
benefits received from the organization outweigh the lost taxes and inequality caused by the
exemption. The reasoning behind this theory starts to fade when individuals in the nonprofit
organization abuse their power and take large amounts of money from the organization as
compensation.
B. THE NON-DISTRIBUTION CONSTRAINT & 503(B)(2) PROHIBITED
TRANSACTIONS
State Nonprofit laws and Federal Tax laws impose a non-distribution constraint on
nonprofit organizations.22 Under the non-distribution constraint nonprofit organizations are
prohibited from distributing profits to individuals who exercise control over the organization.23
Complying with this constraint is required to qualify for, and maintain, tax-exempt status.24 Any
surplus income realized from the nonprofit must be allocated to continuing operations.25
Charities are also prohibited from engaging in prohibited transactions.26 Under Section
501(b)(2) prohibited transactions include any transaction in which a nonprofit organization pays
any compensation in excess of a reasonable allowance for salaries or other compensation.27
C. FORM 990
The IRS requires nearly all nonprofit organizations, other than religious organizations, to
annually file and IRS Form 990.28 The form allows the IRS to review and monitor the financial
21
Id.
Id.
23
NCCS, supra note 1.
24
Id.
25
Id.
26
Internal Revenue Code §503, 26 U.S.C. §503(b)(2).
27
Id.
28
Kertz, supra note 10; NCCS, supra note 1.
22
9
information of nonprofit organizations and it also provides greater accountability to the public
since anyone can view the form.29 Tax-exempt organizations with $5,000 or more in annual
gross receipts must register with the IRS, but they are not required to file a Form 990 unless their
annual gross receipts exceeds $25,000.30 Nonprofits with over $25,000 in annual gross receipts
are required to file a Form 990, and foundations of any size must register and file a Form
990PF.31
Originally, organizations had to provide financial information including a list of the
organization’s officers, trustees and key employees, and also had to list the compensation paid to
the five highest-paid individuals in the organization.32 In December of 2007 the IRS released a
redesigned Form 990 which replaced the old form for the 2008 tax season.33 The redesign was
due to the IRS deciding that Form 990 disclosure needed to be more complete, accurate and
timely.34 One of the changes requires tax-exempt organizations to list the names and
compensation of every person who receives more than $150,000 per year in compensation.35
The new Form 990 provides more disclosure to the public so that individual donors and
other interested people know where their money is going.36 The increased disclosure provides a
benefit to organizations because donors tend to give more when they believe their contributions
29
Jonathan B. Forman, IRS lets the sunshine on tax-exempt organizations, JOURNAL RECORD, September 22, 2008,
at 6A.
30
NCCS, supra note 1.
31
Id.
32
Forman, supra note 29.
33
Internal Revenue Service Form 990 Redesign for Tax Year 2008 Background Paper, (2007),
http://www.irs.gov/pub/irs-tege/background_paper_form_990_redesign.pdf.
34
Kertz, supra note 6.
35
Forman, supra note 29.
36
Kertz, supra note 6.
10
are effectively spent.37 Abuse by any nonprofit tends to hurt the public perception of nonprofits
as a whole, but filing and producing a Form 990 helps these organizations to keep public trust.38
However, the new Form 990 has faced resistance from nonprofit organizations and lobbyists
claiming it violates privacy, among other objections.39 Nonprofit organizations must also trust
that the average donor can interpret and understand the information provided on the form.
Donors want their money spent right, but they also have to realize that just like any other type of
organization or business, nonprofits have costs and expenses.
Even if the IRS achieved its goal of making Form 990s more accurate and complete for
reviewing, problems still exist. The IRS does not have near enough people to review all the
forms filed. The number of nonprofits, and therefore the number of Form 990s filed,
substantially outnumbers the IRS employee’s and the nonprofit sector is continuing to grow.
Even with the lack of resources in the IRS, Congressional scrutiny and new reforms such as a
redesigned Form 990 are bringing nonprofit practices into the open.40
D. STATE REGULATIONS OF NONPROFIT ORGANIZATIONS
In addition to Federal rules and regulations, charities must also comply with State
regulations. Each state imposes its own set of regulations that are typically set by the office of
the Attorney General or the Secretary of State. Charities must comply with both Federal and
State rules regulations to avoid incurring sanctions from one or both.
37
Id.
Id.
39
Forman, supra note 29.
40
Forman, supra note 29.
38
11
III. STANDARDS IN DETERMINING REASONABLE COMPENSATION
Usually the charity’s Board of Directors evaluates and sets compensation for employees.
The IRS suggests few standards to help set and evaluate reasonable compensation. Charities can
look to case decisions, various websites’ suggested guidelines or elsewhere for direction. Due to
the countless differences that exist between organizations, between jobs, and between
individuals, reasonable compensation should be examined in light of all circumstances and facts
for each specific organization, job and employee.
Compensation is a necessary and reasonable expense, and charities are entitled to pay
reasonable amounts to their employees.41 When setting compensation, charities should keep in
mind the importance of acquiring and keeping public trust, especially since legitimate
organizations can be undeservingly tainted by the bad acts of others. The charity needs to be
well-managed to be successful. It is desirable to attempt to strike a balance between attracting,
motivating and retaining competent and skilled employees and at the same time assuring the
public and the IRS that public resources aren’t being wasted on exorbitant salaries and
perquisites.
Courts tend to look at each case by a totality of the circumstances, with no single factor
being required or determinative.42 Some commonly used factors are listed in Table 1.43
41
Laureldall Cemetery Ass’n. v. Matthews, 47 A.2d 277 (Pa. 1946). (hereinafter Laureldall).
Mayson Mfg. Co. v. C.I.R., 178 F.2d 115 (C.A.6 1950). (Mayson).
43
See, e.g., Couriers –Susquehanna, Inc. v. County of Dauphin, 645 A.2d 290 (Pa. 1994); First Baptist Church of
Friendly v. Beeson, 841 A.2d 347 (Md. App. 2004); Kertz, supra note 10; Bethesda Foundation v. Bd. of Review of
Madison County, 453 N.W.2d 224 (Iowa App. 1990); Borough of Princeton v. State Bd. of Taxes and Assessments,
115 A. 342 (N.J. Sup. 1921); Hartman v. Cmty. Responsibility Ctr. Inc., 87 P.3d 202 (Colo. App. 2003); In re
Ogontz School, 65 A.2d 150 (Pa. 1949); In re Hill School, 87 A.2d 259 (Pa. 1952); Laureldall, supra note 46;
Mayson, supra note 47; Baldwin Research Inst., Inc. v. Assessors of Town of Amsterdam, 45 A.D.3d 1152 (NY
2007); Beard v. Achenbach Mem’l Hosp. Ass’n., 170 F.2d 859 (C.A.10 1948); Group Health Coop. of Pugent
42
12
Table 1. Common Factors Used in Reasonable Compensation Analysis
Compensation to other employees in charity
Monetary decisions/where money is spent
Specific characteristics of the organization
Salary of employee in previous years
Specific job duties and responsibilities
Number of people managed
Increase or decrease in job duties
Prevailing economic conditions
Size of organizational budget
Charity performance
Charity performance under employee
Length of service/past services
Scarcity of qualified employees
Employee’s qualifications and experience
Job requirements
Employee’s other job offers
Size and complexities of organization
Amount of work actually performed
The most frequent approach for analyzing the reasonableness of compensation is to
compare the salaries of similarly-situated employees in similar positions at similar organizations.
It is also possible to examine compensation at comparable for-profit organizations, however,
differences in the general structure and purpose between the two could also be a factor.44
Charities have nonmonetary and mission-driven goals and aspirations that are not present in forprofit organizations, and these factors are not considered in the for-profit compensation
analysis.45 There are also nonmonetary rewards involved in charity employment, such as
personal fulfillment and growth, a sense of “doing good,” flexible lifestyles and prestige from the
Sound, Inc. v. State through Dept. of Revenue, 722 P.2d 787 (Wash. 1986); Elliotts Inc. v. C.I.R., 716 F.2d 1241
(C.A.9 1983).
44
Kertz, supra note 6.
45
Id.
13
association with the organization.46 These rewards are often absent in for-profit employment.47
In some cases expert testimony is admitted with examples of data including organizational
charts, job descriptions, salary records and wage and salary surveys.48 There are various useful
tools for helping charities set compensation.
In determining the presence of compensation abuse within a charity, the IRS or court will
evaluate the reasonableness on a case-by-case basis and consider the facts and circumstances of
each particular case. Factors outlined in previous cases can provide guidance in future cases for
other courts or the IRS, and are also valuable in giving charity board members direction when
attempting to set compensation within their own organizations.
A. ARE LARGE SALARIES IN CHARITIES EVER JUSTIFIED?
A charity must spend some of their money on organizational costs such as overhead
expenses and salary to employees. These costs take money away from the intended beneficiaries.
Generally, charities should attempt to keep their costs low so the beneficiaries receive as much
as possible. Sometimes circumstances exist that justify paying a large salary to an employee
even though paying large salaries could potentially cause the public to have an unfavorable
public perception towards the charity, and ultimately result in a reduction of individual
donations. An individual may look at a large compensation payment and see the dollar amount
but fail to consider the reasons and justifications behind it. Salaries that look especially large
may sometimes be reasonable when considered in light of all the facts and circumstances.
46
Id.
Id.
48
Group Health Coop. of Pugent Sound, Inc. v. State through Dept. of Revenue, 722 P.2d 787 (Wash. 1986).
47
14
Nonprofit hospitals usually pay very large salaries to their medical staff. Doctors and
surgeons are often paid hundreds of thousands of dollars per year and may make up to $1 million
or more per year. Normally, compensation of $1 million to a charity employee would seem to be
unreasonable, but in some circumstances it could be difficult to find the compensation is not
justified. The extremely high level of skill, amount of training and importance of obligations
associated with some jobs can perhaps justify the salary.
Another situation that may justify paying larger than normal compensation is when a
charity executive is in control of an extremely large and complex business with large assets and
many responsibilities. Large charities function in many ways like businesses and a sufficient
amount of skill is required to manage successfully. Salaries need to be competitive to attract and
retain competent personnel. For example, Thomas Werner, the head of Adventist Health System,
made $943,706 in 2002.49 While an annual salary of almost a million dollars may appear to be
unreasonable compensation for a nonprofit, Werner was responsible for overseeing thirty-nine
hospitals in twelve states.50 Similarly, John Hillenmeyer of Orlando Regional Healthcare
Systems was compensated nearly $802,000 in 2002 for overseeing seven hospitals and 11,000
employees.51
Opinions on allowing million-dollar salaries in special nonprofit settings vary inside and
outside of the sector. Some believe salaries that large are unreasonable and unacceptable in any
nonprofit organization, regardless of circumstances. Mary Beth Durnell, Executive Director of
AIDS Volunteers, Inc., feels her modest $38,000 annual salary takes away from her
49
Melissa Harris, Central Florida Nonprofits Defend CEO Pay and Perks, ORLANDO SENTINEL, August 08, 2004,
available at http://www.foundationcenter.org/pnd/news/story.jhtml?id=75800058.
50
Id.
15
organization’s goals and feels that the extraordinary compensation paid to some nonprofit
executives “are ridiculous.”52 She “can’t imagine what kind of work someone could do to earn
almost $400,000 per year from a charity.”53
B. COMPENSATION FOR MEMBERS OF A CHARITY’S BOARD OF DIRECTORS
The position of a member of the Board of Directors for a charity is different from other
positions within the company, but compensation of board members can also be unreasonably
high. Serving on a board for an organization is rarely a full-time job. Most board members are
employed and compensated at a regular job and devote a portion of their time to be a Board
member. Some nonprofit organizations compensate Board members for their services while
others pay Board members nothing. Opinions vary on whether or not Board members of
nonprofits should be compensated. Board membership is rarely a full-time job, but it can involve
significant time commitments and fulfillment of various duties. Originally the assumption was
that most board members chose to serve out of the goodness of their heart or because of an
interest in the organization. Now board compensation has become more common. Because of
the increasingly complex legal requirements and potential liabilities involved, it may be hard to
find people willing to serve as members.54 Compensation can also encourage participation of
members with different skill levels and different economic circumstances, which in turn can be
beneficial to the organization.55
51
Id.
Archives: Foundation Heads Averaged $363,000 in Pay, Philanthropy News Online (1998),
http://www.pnnonline.org/article.php?sid=1710.
53
Id.
54
Determining Reasonable Compensation for Foundation Directors and Trustees, (2002),
http://www.cof.org/files/documents/governing_boards/trusteecomp2003.pdf.
55
Id.
52
16
IV. IRS SANCTIONS
Nonprofit organizations are responsible for following the specific rules set out by the IRS
in order to maintain their tax-exempt status and continue receiving tax benefits. The constraint
on distributing profits is a regulation that can be violated if the organization pays in excess of
“reasonable compensation.” If the IRS finds a violation, the organization can be subject to
sanctions. Historically, the only option of the IRS for punishing organizations who committed a
violation was revocation of the nonprofit’s tax exempt status. This remedy was extremely harsh
since even a de minimus amount of private inurement caused the loss of the tax exemption.56
In 1996 legislation added intermediate sanctions in the form of a penalty tax. The
sanctions apply when the IRS finds evidence of excess benefit transactions with disqualified
persons inside the nonprofit organization.57 A disqualified person is one holds a position within
the organization that is able to exercise substantial influence over the organization’s affairs and
can include donors, officers, trustees and other employees.58 The value of economic benefit to
the employee cannot exceed the value of consideration or services received by the organization.
The new penalty tax is two-tiered and is imposed in addition to any income taxes.59 The first tier
requires the disqualified person to pay a tax of 25% of the excess benefit transaction, and any
managers who knowingly participate must pay 10%. The organization pays nothing but must
report the details of the incident and the names of those involved on their Form 990. If the
organization does not correct the situation the IRS imposes a 200% tax penalty.60
56
Kertz, supra note 6.
Id.
58
Id.
59
Id.
60
Id.
57
17
V. MAIN CONCERNS ABOUT MONITORING CHARITIES
Due to growing concerns about abuse in charities and other nonprofits, there have been
Congressional Hearings devoted to addressing these problems and possible solutions.61
Testimony was introduced about large salaries and extravagant perquisites being paid to
executives and board members of nonprofits. Congress claimed the need for more financial
accountability and disclosure to provide the public with more information and help the IRS
monitor the organization. Findings and testimony were serious enough to result in new
legislation in the form of intermediate sanctions and the new Form 990.62
Many feel that more needs to be done because the tax-exempt sector is growing at such a
quick rate.63 The Senate Finance Committee held a hearing on the issue of excessive
compensation paid to nonprofit executives which focused on the lack of effective enforcement
vehicles available to the IRS to police nonprofits.64 According to one Senate Finance Committee
staff aide, tax returns of nonprofits get little scrutiny because the IRS lacks the staff to look at
even one percent of the forms filed.65 There were concerns expressed on how to monitor the
thousands of nonprofits and fix the abuse without discouraging the formation and good work of
charities.66
Standards are in place to determine reasonableness, and sanctions are available for those
who pay excess compensation, but the real problem seems to be with the lack of monitoring. In
61
Kertz, supra note 6.
Id.
63
Kertz, supra note 6.
64
Senate Finance Committee Discusses Nonprofit Accountability (2005),
http://www.ombwatch.org/article/articleview/2794/1/337. (hereinafter Senate).
65
Stuart Kahan, Oversight By Whom? Regulators finding NPO Enforcement is Difficult, NONPROFIT TIMES (2005),
http://www.nptimes.com/jun05/npt3.html.
62
18
order to punish charities for committing abuse the abuse must first be caught. The new Form 990
will help with accountability and disclosure, but there are not enough people available to read
them all, and the number of nonprofits continues to grow. From 1992-2002 the IRS division that
oversees nonprofits went from 960 employees to around 800 while the number of organizations
applying for tax exempt status increased from 60,000 to 90,000.67 This is in addition to the more
than 900,000 charities and 690,000 other tax exempt groups the IRS is currently responsible for
monitoring.68 Several ideas and suggestions have been made and opinions vary on which, if any,
would be effective.
VI. PROPOSED SOLUTIONS
Solutions to the problem of compensation abuse seem to fall into three categories.
A. FIRST, NEW LEGISLATION AND REGULATIONS
1. Harsher Penalties on Nonprofits and their Board of Directors
New penalties would be higher and would include punishing members of the charity’s
board of directors that knew or should have known of the abuse. The Senate Finance Committee,
chaired by Charles Grassley, introduced a series of suggestions for greater oversight of the
nonprofit sector. These suggestions included laying down explicit rules for governance and
financial transparency, clarifying gray areas in proper compensation practices, and imposing
greater punishments for infractions.69 Imposing harsher penalties would deter some charities
from overpaying employees because they would want to avoid having to pay the tax. Fear of
66
Senate, supra note 68.
Richard Williamson, Charitable Funds Going To Least In Need—Foundation Board Members, NONPROFIT TIMES
(2003), http://www.nptimes.com/fme/dec03/fme_1.html.
68
Id.
69
Beverly Goodman, From Wall Street to Your Nonprofit’s Office, NONPROFIT TIMES (2004),
http://www.nptimes.com/fme/oct04/fme_1.html.
67
19
having personal penalties could make the organization’s board members take more time in
evaluating proper compensation and internally monitoring to make sure there is no abuse. On the
other hand, penalties on board members may deter some from serving on a board in the first
place.
2. Limits on Salary
The IRS could set limits on salaries within the charities. By setting a compensation
ceiling or requiring that no person in the organization may be paid over a certain percentage of
net income or assets, the IRS could eliminate having to decide on a case-by-case basis if abuse
was present. Forms would be easy to monitor because anything over the limit would be
considered abuse. Limits have been avoided because they are seen as too rigid to apply across all
nonprofits. In 2000 a judge in Hawaii tried to set a limit while ousting trustees of an nonprofit
who were each being paid a million dollars per year.70 This doesn’t take into consideration
places like hospitals which sometimes must pay more than a million dollars per year to attract
top-notch surgeons. Most patients would probably prefer to be under the care of a top-paid
surgeon instead of a surgeon with a $100,000 salary-cap. Nonprofit organizations are different in
so many ways and a bright-line limit such as a salary-cap would be too inflexible in practice.
More rules and penalties may deter some abuse for fear of being penalized, but they could
also discourage the formation of charities. Also, if the charities who are paying excess
compensation aren’t following the current rules, there is a good chance they would not follow the
new ones either. New rules would not solve the issue of the IRS not having enough people for
70
Allen, supra note 13.
20
monitoring and enforcement. In addition, new laws affecting charities would be met with fierce
resistance from charities and their lobbyists.
B. SECOND, ENFORCING EXISTING REGULATIONS
In 2004 the Exempt Organizations Division of the IRS created new offices to focus on
compensation abuses in charitable organizations.71 One of the offices, the Exempt Organizations
Initiatives Office is responsible for acquiring data sources that will aid the IRS in more easily
comparing executive compensation paid by nonprofits.72 A report issued by the Urban Institute,
Foundation Center and Guidestar suggested implementing electronic filing of nonprofit forms
that will permit better differentiation of expenses.73 There has also been a recommendation that
lawmakers place a requirement that all nonprofits be subjected to a review by the IRS every five
years where they would have to answer questions on organization expenses and pay.74
Developing better ways to monitor charities and regular reviews by the IRS may deter
abuse since charities will be afraid of getting caught overpaying employees. Charities want to
avoid paying a penalty tax or losing tax-exempt status and the reduction of abuse would
strengthen public confidence in charites and increase donations. However, the IRS needs more
money and more people to effectively monitor all nonprofit organizations. In 2006 over 1.48
million tax-exempt organizations had formally obtained recognition of their tax-exempt status
71
Jay R. Schuster, David A. Thomsen, Patricia K. Zingheim, Executive Compensation Within Charitable and Social
Welfare Organizations (2005), http://www.pnnonline.org/article.php?sid=5712. (hereinafter Schuster).
72
Id.
73
“One Size Fits All” Doesn’t Work For Foundation Standards (2006),
http://www.pnnonline.org/article.php?sid=6513. (hereinafter One Size).
74
Bill Zlatos, Nonprofits Salaries Drawing More Scrutiny (2004),
http://www.pittsburghlive.com/x/pittsburghtrib/s_246565.html.
21
from the IRS, and the number continues to grow each year.75 In addition, there are many others
who are not required to file such as organizations with less than $5,000 in gross receipts and
religious organizations.76 Congress needs to appropriate more money in order to keep up with
the growing number of NPOs.
C. THIRD, SELF-REGULATION BY CHARITIES
1. Guidance
Charities clearly favor options for self-regulation over more IRS-enforced regulations and
laws. This preserves their independence and allows them to tailor compliance and guidelines in
accordance with their specific nonprofit environment. Most charities do not overpay employees
and feel they should not be punished with more regulations because of the bad acts of other
organizations. There are various places where charities can look for guidance when setting
compensation or reviewing current compensation. Previous court cases involving reasonable
compensation issues provide examples of standards for many different situations. The website of
the American Institute of Philanthropy and Charities Review Council has posted numerous
articles on compensation and suggest guidelines organizations can follow to help prevent
compensation abuse. The Economic Research Institute conducts salary surveys and sells
products designed for nonprofits to manage compensation. The information is there; it is up to
the charity itself to seek, consider and use it.
2. Accreditation
Another suggestion is to set up programs where nonprofit organizations can pay to get
advice, take classes and have their financial information reviewed in order to obtain an
75
NCCS, supra note 1.
22
accreditation. Accreditation could help charities prevent abuse and raise their standards of
accountability. Leon Panetta, the former Chief of Staff in the Clinton Administration, has
suggested a “National Council on Nonprofit Accreditation.”77 Individual states could also set up
their own accreditation organizations for the nonprofits in their state. The Maryland Association
of Non-Profits awards a “Seal of Excellence” to groups that exceed regulatory minimum
requirements and do better than legally required in monitoring their operations.78 Accreditation
programs would preserve the independence of the charities and relieve some of the burden on the
IRS. Form 990s are available to the public but are sometimes hard to understand and interpret.
With accreditation programs the public could see which organizations were accredited, and this
could encourage participation since the public tends to donate more to charities they believe are
trustworthy. Some are skeptical of the value of accreditation programs on a cost-benefit basis.
According to the IRS more than 80% of NPOs have an annual budget of less than $500,000 and
the benefits of getting accredited may not justify the costs for the smaller organizations who are
less likely to commit compensation abuse.79
VII. RECOMMENDATIONS
When charities pay excessive compensation, it hurts the public, the intended beneficiaries
of the organization, the organization committing the abuse and the nonprofit sector as a whole.
Initially the problem seems to be in determining what is considered reasonable compensation,
since the definition is vague and means vastly different things in every situation. However, there
are various sources available to charities to help them make these determinations. The real
76
Id.
Senate, supra note 64.
78
Goodman, supra note 69.
77
23
problem seems to be in preventing and catching the abuse that happens. Due to growing concern
about excessive compensation the IRS developed new intermediate sanctions and Form 990s, but
many feel there needs to be more done. Several solutions have been proposed and examination
of the current and proposed solutions shows there are problems with all. The issue comes down
to determining what to do about nonprofit compensation abuse, if anything at all. Are the new
regulations worth the money they would cost and the additional burdens they would place on
nonprofits?
Compensation abuse does exist in nonprofit organizations, but studies seem to show that
while the abuse is highly publicized and usually involves huge amounts of money, abuse may
only occur in a small percentage of the nonprofit sector.80 A salary survey of the 2006-2007
compensation year showed that larger charities paid their executives more money than smaller
charities paid their executives. However, the larger charities percentage of compensation to
giving was among the lowest.81 Table 2 below shows a 2006-2007 salary survey of charities.82
If the percentage of abuse within charities really is small when compared to the nonprofit sector
as a whole, it would be dangerous to impose new regulations and harsher penalties as this might
shrink the nonprofit sector as a whole.
Table 2. Survey of Average Salaries in Nonprofit Organizations, 2006-2007
Overall
<$500K
Average
Exec Dir/ $111,501- $54,382-
$500K$900K
$68,939-
$1M$9.9M
$97,270-
79
$10M$25M$50M+
$24.9M
$49.9M
$146,977- $219,024- $286,970-
Kahan, supra note 65.
Schuster, supra note 71.
81
Mark Hrywna, NPT Salary Survey 2007 (2007), http://www.nptimes.com/07feb/special%20report.pdf.; One Size,
supra note 73.
82
Id.
80
24
CEO/
Pres
CFO
$112,899
$56,425
$71,808
$101,136
$152,774
$214,948
$293,491
$82,989$82,739
$28,480$38,173
$48,012$48,441
$65,779$68,923
$93,817$94,642
$125,243- $169,360$130,143 $173,961
Program
Director
$61,858$62,727
$31,919$33,203
$43,949$44,163
$58,358$60,456
$67,877$69,237
$91,054$94,598
$118.837$126,206
Some time needs to be given to the new sanctions and new Form 990 to see the impact
they will have on curbing compensation abuse. The IRS should continue to review and enforce
as much as possible, with the new Form 990 providing more disclosure of compensation
organizations are paying. The IRS should also continue to develop an electronic data and filing
system which would help with review of charities’ information. Congress and the IRS should
suggest that charities develop programs of self-regulation through guidelines, self-reporting and
accreditation. Nonprofit organizations should realize that it is best for them to regulate
themselves and evaluate their current compensation system. The public donates more to
trustworthy nonprofits, and self-regulation can allow organizations to distinguish themselves
from those committing abuse.
Nonprofit organizations should look to the many resources available for evaluating and
setting compensation: cases, websites, salary surveys, compensation levels and comparability
data. After setting compensation charities should do internal reviews each year to determine if
their compensation levels are still appropriate. Charities should provide explanations along with
their compensation decisions to show the public that they do operate for their tax-exempt
purpose, but at the same time have to run a successful organization. Nonprofits should give
25
reasons for their compensation decisions, explain position duties and responsibilities, and report
individual accomplishments and performance. If the public sees why a certain employee is
making a certain amount of compensation it could make their opinion of the organization more
favorable. More effort needs to be put into creating accreditation groups so nonprofits can
complete classes and financial reviews and obtain accreditation. This would not only help
organizations make the right decisions, but it would allow the public to see which organizations
are making an effort and have obtained accreditation status.
VIII. CONCLUSION
Compensation abuse in charities does exist and should not be overlooked, but maybe the
percentage is so small that it does not justify the cost or resources it would take to implement
further solutions right now. Nonprofits should realize that it is in their best interest and in the
interest of the nonprofit sector as a whole, to self-regulate and prove their worth to the public.
The nonprofits who are not overpaying executives should be able to distinguish themselves from
those that are committing compensation abuse. There will always be people in organizations that
make bad decisions and abuse their power. It would be impossible to prevent all the abuse, and
too much regulation will punish even those organizations who are not overpaying. It could have
a detrimental effect on the entire nonprofit sector and reduce the number of nonprofits and the
benefits they provide.
26