Compensation, Governance and Compliance Best PracticesBy Magdalena M. Czerniawski | Matthew Estersohn | November 8, 2021
The remarks below are a summary of a webinar that partners Magdalena Czerniawski and Matthew Estersohn hosted on September 21. Watch the recording on-demand.
Some of the most critical decisions that nonprofit organizations and their boards of directors make involve the selection, evaluation and compensation of executive staff. While there is room for a wide variety of practice in hiring, the IRS and state regulators have guidelines around compensation to protect charitable assets from mismanagement.
Excess Benefit Transactions
The IRS scrutinizes payments to any individuals who are able to exercise substantial influence over the affairs of a 501(c)(3) tax-exempt organization, including directors, officers, their family members and entities they control. Payments to any of these people or entities that exceed the value of the consideration received by the organization may be classified as excess benefit transactions by the IRS. Once that happens, the transaction is subject to penalties, which may include excise taxes for both the organization and its managers who knowingly approve the transaction. Excess benefit transactions are also required to be reported on an organization’s Form 990 and may subject the organization to significant reputational risk with the public.
To avoid these issues, an organization must ensure that executive compensation is reasonable and commensurate with the value received by the organization. IRS rules include a rebuttable presumption of reasonableness that, if followed, establishes that executive compensation is reasonable. However, the following three conditions must be met:
The compensation arrangement was approved in advance by an independent, authorized body.
Prior to making the determination, the authorized body obtained and relied on appropriate data as to comparability.
The authorized body adequately documented the basis for its determination in a timely manner.
Below are a few best practices that will help organizations meet these requirements:
Independent Board. Independence is a key element of the approval process. Boards can demonstrate independence by implementing and following a conflict of interest policy. Some organizations may have a Compensation Committee or the Executive Committee approve executive compensation. In these instances, all members of the committee should ensure they are independent with respect to the organization and individuals being compensated.
Approve all compensation in advance. While it may seem obvious, compensation is required to be approved in advance and the board cannot retroactively approve compensation arrangements. The advance approval should also include any retirement agreements to justify that retirement amounts are reasonable for services rendered rather than a parting gift. If there are other perks, such as tuition payments or car allowances, all of them should be part of the approval process at the same time as they all constitute compensation.
Compensation studies. While there are numerous compensation studies available (and compensation of competitors is freely available on Form 990), the organization should ensure the comparability data used is appropriate—that it is for functionally comparable and similarly situated organizations. While for-profit salary comparisons are not prohibited, be sure to document a reasonable justification for using for-profit industry data.
Employment agreement. Compensation under IRS rules includes all elements of a compensation package, not just salary. Bonus, retirement contributions, housing allowances and other benefits should all be considered. Organizations should consider having written employment agreements with all executive staff that memorialize the terms of employment.
Document compensation approval. In contemporaneous minutes, organizations should keep documentation of compensation approval, including the terms of the salary, date of approval, comparability data, actions of anyone having a conflict, and the vote outcome.
Conflicts of Interest
Assuring decisions are being made by informed and independent board members is an important component of governance. Organizations can protect their board members by implementing a conflict of interest policy and ensuring it is regularly monitored and enforced. Certain state regulators, including those in New York, require a conflict of interest policy be followed, but this is a good practice for all. The conflict of interest policy should define circumstances that constitute a conflict, include procedures for disclosing a conflict, require that a conflicted person recuse themselves from a portion of the deliberations as well as a vote, and require documentation of conflicts and resolutions.
Organizations should require board members and senior leadership to disclose any conflicts or potential conflicts at least annually. For new board members or new hires, organizations should have those individuals complete the disclosures during onboarding.
The review of conflict of interest disclosures should be done at a board level rather than delegated to a staff member as the decision of how to resolve a potential conflict should be done by board members. Often, this task is assigned to the board secretary or Audit Committee.
While not required, we often recommend that staff who are involved in the procurement process complete annual conflict of interest disclosures. We also recommend that organizations provide a list of their largest vendors to the board so board members can answer the disclosure forms with complete information available.
Related Party Transactions
When an organization enters into transactions with related parties, it should determine in advance that the transaction is fair, reasonable and in the organization’s best interest. Often this is done by a vote of independent board members, while following the organization’s conflict of interest policies.
While related party transactions are not inherently prohibited (board members who leverage their networks and connections to benefit the organization and its mission is a good thing), it is important to give extra attention to the risks involved, including reputational risk. Serious caution is needed by organization managers to ensure that charitable assets are used appropriately and with all necessary care.
About Magdalena M. Czerniawski
Magdalena M. Czerniawski, CPA, MBA, is a Partner at Marks Paneth LLP and a member of the firm’s Nonprofit, Government & Healthcare Group. With over 15 years of nonprofit industry experience, she provides tax services to a wide array of nonprofits, including charitable organizations, schools, social welfare organizations, affordable housing entities, professional associations, private foundations, healthcare organizations and hospitals. In addition to providing tax compliance services, Ms. Czerniawski also provides tax planning and advisory services.... READ MORE +
About Matthew Estersohn
Matthew Estersohn, CPA, is a Partner in the Nonprofit, Government & Healthcare Group at Marks Paneth with nearly 15 years of experience in providing accounting, auditing, tax and consulting services for the nonprofit industry. He has planned, coordinated and conducted audits for a wide range of nonprofits, including human service organizations, educational and cultural institutions, membership organizations and private foundations. He also specializes in Single Audits for organizations that receive federal funding. Mr. Estersohn has... READ MORE +