The thought of being fined by the Internal Revenue Service and losing donors, grants, and even 501(c)(3) status is alarming for any nonprofit. Yet in recent years, numerous reports have revealed financial improprieties at some charities, often revolving around excessive executive pay.
For example, Goodwill Omaha was criticized for paying its executive director, Frank McGree, close to $1 million in 2014. When the news broke, the charity lost many donors, and McGree resigned.
The head of the Florida Coalition Against Domestic Violence, Tiffany Carr, received more than $760,000 in 2017, which was striking compared with the average salary of $35,000 for workers at domestic-violence organizations at that time.
Many negative consequences can stem from overpaying your top executive.
Fair and Reasonable
Candid’s latest “Nonprofit Compensation Report” found that executive pay at charities in 2016 ranged from nearly $20,700 to more than $1.3 million. This variation can be explained by the organization’s size and the IRS’s vague guidelines for setting nonprofit salaries.
U.S. federal law states that charities should offer “fair and reasonable compensation,” defined as “the value that would ordinarily be paid for like services by like enterprises under like circumstances.” A nonprofit’s trustees are responsible for deciding what they consider fair and reasonable. But these instructions leave room for a great deal of interpretation and allow boards to try to justify the executive salary they choose.
The IRS does, however, suggest steps nonprofits should follow to ensure that their executive director is paid a fair salary:
The board of directors should designate an independent body to approve or reject the proposed compensation package. These must be individuals “who do not have a conflict of interest concerning the transaction.” In other words, they must be completely impartial and have no other interest that could influence their decision.
The independent body should collect comparable data on executive pay that will help them understand the industry norm. This information should come from organizations with a similar mission in a similar geographic area. They could use sources such as Candid to search for 990s that include this data.
The independent body should document its entire process, explaining how and why decisions were made. This documentation should indicate that the comparable data played a role in the final decision, include a list of the members involved, and prove that none had a conflict of interest. Appropriate evidence may include meeting minutes, a roster of members, and validation that members of the independent committee acted in a voluntary — rather than paid — capacity.
Benchmarks to Compare Salaries
While the IRS guidance is helpful, it can also be subjective. It’s unrealistic to assume all executive directors will be paid the same amount since each nonprofit and mission is unique. For example, according to Candid, the average executive salary at general and rehabilitative health charities was $288,504 in 2016, compared with $88,137 for food, agriculture, and nutrition groups.
Compensation can vary even among charities in the same field, depending on their size and cash flow. In 2016, the average executive salary was about $57,600 for health nonprofits with a budget of $500,000 or less and rose to nearly $480,000 for those with a budget of at least $5 million. According to research conducted in 2010, the base pay for nonprofit executives “increases in direct proportion (in most cases) to every $1,000 of operating expenses.”
It’s also important to consider whether your executive’s pay is fair and reasonable within the context of the organization. Jan Masaoka, head of the California Association of Nonprofits, offers a few tips for how to figure that out.
Compare the salary of other employees to that of your top leader. The gap should be appropriate.
Ensure the executive salary fits within your charity’s budget. Executive directors should be paid what they’re worth, but their salary should not be a financial burden for your organization.
Be strategic. When setting executive compensation, it’s more important to look at the individual’s expected contributions in the upcoming year than to observe his or her past performance. This is where annual executive evaluations and goal-setting can be helpful because you can ensure that the leader is still a good fit for your organization and that he or she is completing work that is appropriate for his or her salary.
Consequences for Excessive Pay
If the IRS can prove that a nonprofit’s executive compensation is not fair and reasonable, the agency may take a series of actions based on the level of wrongdoing. They may:
Fine the organization. This is the most likely result, and the penalty varies depending on the situation. The executive director or trustees may have to pay a fine equal to the amount that exceeds fair and reasonable or — at the very least — pay an excise tax.
Revoke the nonprofit’s tax-exempt status. This most commonly occurs when a charity fails to file with the IRS for three consecutive years. When this happens, the organization automatically loses its 501(c)(3) status. If the group chooses to reapply, it would have to pay a fee to have its tax-exempt status reinstated.
Because the charitable sector is so vast, offending organizations are unlikely to be pursued by the IRS. But here are several scenarios in which an investigation could occur, according to the Foundation Group, a company that provides compliance services to nonprofits.
Complaints and public scandals. If the public begins to complain about a charity’s financial decisions, the IRS is more likely to look into the situation. Matters become worse if the scandal receives media attention, which can cause donors to panic, too.
Problematic 990s and payroll tax returns. Required financial documentation is mandatory for nonprofits. This can either prove that an organization is trustworthy or reveal suspicious financial behavior. If the IRS observes any discrepancies in financial reports, it may investigate.
Random audits. Occasionally, the IRS will choose to randomly audit a nonprofit. If the organization has been honest about its finances and used donations appropriately, there should be no cause for concern. Even so, the process can take time and resources.
No nonprofit wants to contend with situations like these, but losing support from donors can be even more devastating. According to a 2015 Chronicle survey of 1,000 adults, only 13 percent of Americans believe charities do “a very good job of spending money wisely.” Among the rest, 37 percent reported salaries and administrative costs as the main sources of irresponsible spending.
To improve public opinion about nonprofits and retain your donors, be mindful that your treatment of those at the top can have an outsize impact on perceptions of accountability and ultimately can help or harm your ability to meet your mission.
Julia Van Patter is a second-year masters of public administration student in the School of Public and International Affairs at North Carolina State University, where Amanda J. Stewart is assistant professor of public administration.