Reasonable Compensation for Nonprofit Organizations: How Much Is Too Much and How to Minimize Abuse

by Kaci N. Byford

AbstractTax-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........................................................................................................................ 2A. OVERVIEW OF NONPROFIT ORGANIZATIONS.........................................................................2B. NONPROFIT ORGANIZATIONS COMPARED TO FOR-PROFIT ORGANIZATIONS.........................3C. REASONABLE COMPENSATION.............................................................................................. 3D. COMPENSATION ABUSE IN NONPROFIT ORGANIZATIONS......................................................4E. EXAMPLES OF QUESTIONABLE COMPENSATION IN CHARITIES..............................................5

II. CURRENT REGULATION OF NONPROFIT ORGANIZATIONS...................................................8A. 501(C)(3)............................................................................................................................. 8B. THE NON-DISTRIBUTION CONSTRAINT & 503(B)(2) PROHIBITED TRANSACTIONS................9C. FORM 990............................................................................................................................ 9D. STATE REGULATIONS OF NONPROFIT ORGANIZATIONS.......................................................11

III. STANDARDS IN DETERMINING REASONABLE COMPENSATION.........................................121

A. ARE LARGE SALARIES IN CHARITIES EVER JUSTIFIED?......................................................14B. 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....................................................................................................... 19A. FIRST, NEW LEGISLATION AND REGULATIONS...................................................................19

1. Harsher Penalties on Nonprofits and their Board of Directors........................................192. Limits on Salary.............................................................................................................. 20

B. SECOND, ENFORCING EXISTING REGULATIONS...................................................................21C. THIRD, SELF-REGULATION BY CHARITIES..........................................................................22

1. Guidance......................................................................................................................... 222. Accreditation................................................................................................................... 22

VII. RECOMMENDATIONS......................................................................................................... 23

VIII. Conclusion........................................................................................................................ 26

I. INTRODUCTION

A. OVERVIEW OF NONPROFIT ORGANIZATIONSNonprofit 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

provide tax-exemptions for various organizations including social welfare organizations, labor

and agricultural associations, business leagues and fraternal beneficiary societies.3

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.3 Id.

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B. NONPROFIT ORGANIZATIONS COMPARED TO FOR-PROFIT ORGANIZATIONSWhile 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 COMPENSATIONAlthough 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

“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.

4 Internal Revenue Code §501, 26 U.S.C.A. § 501(c)(3).3

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 ORGANIZATIONSWhen 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

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

5 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.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 Error: Reference source not found.8 Id.

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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 CHARITIESWhen 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

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:

9 NCCS, supra note Error: Reference source not found.10 Id.

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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

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

11 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=106.14 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.

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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 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.

16 Id.17 IRS Investigation of Top Environmental Charities Called For (2004), http://www.pnnonline.org/article.php?sid=5411.18 Id.

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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 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.

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/2794/1/337.21 Id.

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B. THE NON-DISTRIBUTION CONSTRAINT & 503(B)(2) PROHIBITED TRANSACTIONSState 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

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

22 Id.23 NCCS, supra note Error: Reference source not found.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 Error: Reference source not found.29 Jonathan B. Forman, IRS lets the sunshine on tax-exempt organizations, JOURNAL RECORD, September 22, 2008, at 6A.30 NCCS, supra note Error: Reference source not found.

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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

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.

31 Id.32 Forman, supra note Error: Reference source not found.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 Error: Reference source not found.35 Forman, supra note Error: Reference source not found.36 Kertz, supra note Error: Reference source not found.37 Id.38 Id.39 Forman, supra note Error: Reference source not found.

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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 ORGANIZATIONSIn 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.

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.

40 Forman, supra note Error: Reference source not found.11

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

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

41 Laureldall Cemetery Ass’n. v. Matthews, 47 A.2d 277 (Pa. 1946). (hereinafter Laureldall).42 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 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).

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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 for-

profit 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 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

44 Kertz, supra note Error: Reference source not found.45 Id.46 Id.47 Id.48 Group Health Coop. of Pugent Sound, Inc. v. State through Dept. of Revenue, 722 P.2d 787 (Wash. 1986).

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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.

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

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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

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 DIRECTORSThe 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

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.51 Id.52 Archives: Foundation Heads Averaged $363,000 in Pay, Philanthropy News Online (1998), http://www.pnnonline.org/article.php?sid=1710.53 Id.

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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

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

54 Determining Reasonable Compensation for Foundation Directors and Trustees, (2002), http://www.cof.org/files/documents/governing_boards/trusteecomp2003.pdf.55 Id.56 Kertz, supra note Error: Reference source not found.57 Id.

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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

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

58 Id.59 Id.60 Id.61 Kertz, supra note Error: Reference source not found.62 Id.63 Kertz, supra note Error: Reference source not found.

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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

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.

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.66 Senate, supra note 68.67 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.

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A. FIRST, NEW LEGISLATION AND REGULATIONS

1. Harsher Penalties on Nonprofits and their Board of DirectorsNew 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

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 SalaryThe 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

69 Beverly Goodman, From Wall Street to Your Nonprofit’s Office, NONPROFIT TIMES (2004), http://www.nptimes.com/fme/oct04/fme_1.html.70 Allen, supra note Error: Reference source not found.

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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 monitoring and enforcement. In addition, new laws affecting charities would be met with

fierce resistance from charities and their lobbyists.

B. SECOND, ENFORCING EXISTING REGULATIONSIn 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

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).

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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

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. GuidanceCharities 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

74 Bill Zlatos, Nonprofits Salaries Drawing More Scrutiny (2004), http://www.pittsburghlive.com/x/pittsburghtrib/s_246565.html.75 NCCS, supra note Error: Reference source not found.76 Id.

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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

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

77 Senate, supra note Error: Reference source not found.78 Goodman, supra note Error: Reference source not found.

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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

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

79 Kahan, supra note Error: Reference source not found.80 Schuster, supra note Error: Reference source not found.

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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 Average

<$500K $500K- $900K

$1M-$9.9M

$10M-$24.9M

$25M-$49.9M

$50M+

Exec Dir/ CEO/ Pres

$111,501-$112,899

$54,382- $56,425

$68,939- $71,808

$97,270- $101,136

$146,977-$152,774

$219,024-$214,948

$286,970-$293,491

CFO $82,989-$82,739

$28,480-$38,173

$48,012-$48,441

$65,779-$68,923

$93,817-$94,642

$125,243-$130,143

$169,360-$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

81Mark Hrywna, NPT Salary Survey 2007 (2007), http://www.nptimes.com/07feb/special%20report.pdf.; One Size, supra note Error: Reference source not found.82 Id.

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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

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

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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.

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