Paying people fairly: salaries, stipends and the excess-benefit rules

This guide is for boards deciding whether, and how much, to pay a founder, an executive director, a board member or anyone else close to the charity. Paying people is normal and often necessary. Charities need skilled staff, and nobody should have to work for free forever. But when the person being paid has influence over the charity, federal tax law asks the board to show that the deal is fair. After reading, you'll know what "reasonable" pay means, who counts as an insider, the three steps that give the board strong protection, and what your Form 990 asks.

The basic rule: no private benefit

A 501(c)(3) charity must not be run for the benefit of private interests, such as its founder or the founder's family. In the IRS's words, "no part of the net earnings" may benefit "any private shareholder or individual." This is called private inurement (see the glossary).

That doesn't mean insiders can't be paid. It means pay and other deals with insiders must be fair: what the charity gives must not be worth more than what it gets back.

Who counts as an insider

The tax law calls insiders disqualified persons (glossary). The IRS defines one as anyone "in a position to exercise substantial influence over the affairs" of the charity at any time during the lookback period, which the regulations set as the five years ending on the date of the transaction. They don't have to use that influence, only be in a position to.

The regulations say these people are in that position:

• voting board members
• the president, CEO or chief operating officer, or whoever has ultimate responsibility for running the organization, whatever their title
• the treasurer or chief financial officer, or whoever has ultimate responsibility for the finances

Their family members count too, and so do businesses they control. The IRS defines control as owning more than 35% of a corporation's voting power, more than 35% of a partnership's profits, or more than 35% of a trust's beneficial interest. So a contract with a board member's spouse's company needs the same care as paying the board member directly.

What "reasonable" pay means

The IRS defines reasonable compensation as "the value that would ordinarily be paid for like services by a like enterprise under like circumstances." In plain words: what similar organizations pay for similar work.

Count everything, not just salary. The IRS lists items that are added up when judging whether pay is reasonable, including:

• salary, fees, bonuses and severance
• deferred and noncash pay
• most fringe benefits, such as insurance premiums
• the interest a person saves on a below-market loan from the charity

The charity must also make clear, at the time, that a benefit is meant as pay. The IRS says it does that with written records made at the time: a signed contract, or reporting the benefit on a Form W-2, Form 1099 or Form 990. A benefit that isn't documented as pay isn't treated as payment for services, so the whole of it can end up treated as an excess benefit. Don't let an insider quietly use the charity's car or card.

What happens if pay is too high

An excess benefit transaction (glossary) is one where a disqualified person gets more value from the charity than the charity gets back. Section 4958 of the tax code, known as intermediate sanctions, taxes it. According to the regulations and the Form 4720 instructions:

• the person who received the excess benefit owes a tax of 25% of the excess
• if it isn't corrected in time, they owe a further tax of 200% of the excess
• any organization manager, such as a board member, who knowingly approved it owes 10% of the excess, up to $20,000 per transaction, unless their participation wasn't willful and was due to reasonable cause

To correct it, the person repays the excess plus interest. The IRS may also revoke the charity's exemption in serious cases, whether or not these taxes apply. The taxes fall on the people, not the charity, and the charity must not pay them on the person's behalf.

The three-step safe harbor

The best protection is the rebuttable presumption. If the board follows three steps, the IRS presumes the pay is reasonable. It can only challenge it with enough contrary evidence to outweigh the board's comparability data.

1. Independent approval in advance. The board, or a committee it authorizes, approves the pay before it starts. Nobody with a conflict of interest takes part. The person being paid, and their family, leave the room for the discussion and vote.
2. Comparability data. Before deciding, the board gets and relies on real data about what similar organizations pay for similar roles. The regulations give examples: pay at similar organizations, both taxable and tax-exempt, for comparable jobs; independent compensation surveys; and written job offers the person has from similar organizations. For organizations with annual gross receipts under $1 million, the regulations say data on what three comparable organizations in the same or similar communities pay for similar services is enough.
3. A written record at the time. The minutes record the terms, the date of approval, who was present for the discussion and vote, the comparability data relied on and how it was obtained, what any conflicted member did, and why the board decided as it did. The regulations say the record must be prepared before the later of the board's next meeting or 60 days after the decision, and then approved by the board.

Our compensation approval minute template walks through each step. Use it with your conflict of interest policy and the meeting practices in running board meetings.

Stipends for board members

A stipend (glossary) is a fixed payment for service, rather than a salary. Paying board members is allowed, but a board member is a disqualified person, so a stipend is compensation and should go through the same three steps. Paying back real, documented expenses is different from a stipend. Keep both clearly separate in your books.

Rent, contracts and loans with insiders

The same rules cover any deal with a disqualified person, not just pay. If the charity rents space from a board member, or buys services from a business an officer controls, the price should be fair market value and the board should approve it using the three steps.

Be especially careful with loans to insiders. The interest an insider saves on a below-market loan counts as compensation. Form 990 filers must report loans to and from interested persons in Schedule L, Part II, each one separately regardless of amount, if it's still outstanding at year-end. The simplest policy is not to lend money to insiders at all. State nonprofit law may also limit such loans, so check yours.

What Form 990 asks

If you file the full Form 990, according to its instructions:

• Part VII lists every current officer, director and trustee, whatever they're paid, plus key employees paid over $150,000, the five highest-paid other employees over $100,000, and some former insiders over $100,000.
• Schedule J is required if anyone listed in Part VII received more than $150,000 in reportable and other compensation, or if a former insider is listed.
• Part VI, line 15 asks whether the process for setting the top official's pay included independent approval, comparability data and contemporaneous records: the same three steps.
• Part IV, line 25a asks whether the charity engaged in an excess benefit transaction. If yes, the charity describes it in Schedule L, Part I, and the Form 4720 instructions require it to file Form 4720.

These answers are public, so donors and journalists can read them.

Before you pay anyone

If you're about to hire your first staff member, see hiring your first employee for payroll and taxes, and employee or contractor? for how to classify the role. Our guide to board duties explains the board's wider responsibility.

Compensation checklist

• We know who our disqualified persons are, including family and controlled businesses
• Our conflict of interest policy is adopted and signed each year
• We gather comparability data before any pay decision for an insider
• The person being paid leaves the room for the discussion and vote
• The minutes record the terms, data, who was present and why we decided
• The minutes are written up by the next meeting or within 60 days, whichever is later, then approved
• Every benefit meant as pay is documented as pay
• We don't lend money to insiders, or we've had advice first