Yes, A Nonprofit Board of Directors Can Be Paid! Part 2: Determining Reasonable Compensation
As discussed in the previous post of this two-part blog series, it’s a common misconception that those serving on the board of a nonprofit organization cannot be paid for their service whatsoever. However, this is not true at least under California law as well as under federal law. In addition to state laws governing nonprofit corporations and associations (discussed in the prior blog post), there are IRS rules and guidelines affecting 501(c)(3) nonprofit organizations, which will be explained here.
Important note: This and the previous blog post refer to laws that are specific to California nonprofit benefit corporations. Laws applicable to other types of nonprofit corporations, such as religious corporations, are not discussed here.
Compensation Must be “Reasonable”
In a nutshell, per federal laws and IRS guidelines for 501(c)(3) nonprofit organizations, compensation of directors (among other compensated individuals or entities) must be “reasonable.” There are guidelines concerning what is “reasonable,” which we will summarize below. Additionally, there are some strict tax regulations that govern what are considered “excess benefit transactions,” or in other words, compensation arrangements that exceed what’s considered reasonable or justifiable for Section 501(c)(3) tax-exempt organizations, also discussed in more detail below.
The Rebuttable Presumption Test and Determining “Reasonable” Compensation
A rebuttable presumption test is used by the IRS to determine whether a payment is “reasonable” or up to fair market value. An organization must meet the following three requirements to pass the test:
Organizations have compensation arrangements approved by their governing board or another body authorized by the board or the organization’s governing documents (e.g. bylaws) to make compensation decisions.
The board or the committee or other body authorized to make compensation decisions relies on comparable data to determine compensation amounts.
There is documentation of said data and any other information or factors used by the decision-making body to determine compensation.
“Comparable data” here includes compensation paid by similar organizations, information based on geographic area and similar services, and more. Note that it is permissible to look at compensation rates of similar jobs in the private sector (or government sector), especially if these jobs require similar credentials, entail similar responsibilities, and/or are located in the same region. The exact requirements for meeting the comparable data condition is determined by organization size. Please see pages 272-273 of An Introduction to I.R.C. 4958 (Intermediate Sanctions) for details.
If an organization complies with all the requirements above, then it meets the rebuttable presumption test.
It is important to note that an organization can still comply with IRS rules even if it can't check all the boxes for a rebuttable presumption test. In that case, the IRS guidance is to “try to implement as many steps as possible, in whole or in part, in order to substantiate the reasonableness of benefits as timely and as well as possible” and the IRS will evaluate the facts and circumstances to determine whether compensation is “reasonable.” For example, when hiring for a very specialized role, the organization may struggle to find rates of compensation for such a position in the same geographic area (especially if the organization is located in a rural area). It then may be considered “reasonable” to broaden the scope of comparison to other regions.
“Excess Benefit Transactions” and the IRS Form 990
The organization should be cautious to avoid running afoul of IRS rules regarding “excess benefit transactions.” Excess benefit transactions are essentially intra-organizational transactions which exceed “reasonable” compensation (i.e. in excess of fair market value) in a compensation arrangement with a “disqualified person.” Per IRS rules, a “disqualified person” is anyone with the ability to exercise substantial influence over an organization’s affairs. All directors and officers are considered “disqualified persons” according to the IRS, whereas most employees and contractors are not. Someone who is not a director or officer might be considered “disqualified” if they hold a lot of control over the organization; however, usually such a person would be considered an officer.
In sum, there should be no excess benefit transactions if a rebuttable presumption test, as described above, is conducted thoroughly and carefully, because all compensation would be “reasonable.”
In the event that an organization does engage in an “excess benefit transaction,” then such a transaction needs to be corrected within 90 days and reported on the IRS Form 990 Schedule L. The person receiving the “excess benefit” compensation may be required to pay a tax. For more information, please refer to the IRS’s 2021 Instructions for Schedule L ("Transaction with Interested Persons") of the Form 990 and pages 85 to 90 of the 2021 Instructions for Form 990 from the IRS. It is also advisable to consult with an attorney or CPA familiar with nonprofit organizations.
For a more general resource on governance practices for 501(c)(3)s, including the topic of compensation, please read the IRS Guide for “Governance and Related Topics.” In a similar vein, organizations should utilize the IRS’s Sample Conflict of Interest Policy to craft their own conflict of interest policy. Carefully adhering to the conflict of interest policy will go a long way in avoiding running afoul of IRS rules for nonprofits.
In summation, organizations should:
Keep track of all the directors, officers, and any other key individuals who are defined as “interested persons” under California Corporations Code Section 5227. Ensure they do not compose more than 49% of your Board.
Conduct a rebuttable presumption test to determine whether the amount of compensation of directors, officers, and key employees is “reasonable” (i.e. not in excess of fair market value). If any compensation is unreasonable, synonymous with exceeding fair market value, it is an “excess benefit transaction” and must be reported on Schedule L of the Form 990. An excess benefit transaction must be corrected within 90 days.
Consult with an attorney or CPA familiar with nonprofit organizations as soon as possible if you think your organization has engaged in an excess benefit transaction.
If these steps are not properly followed, organizations and affiliated disqualified persons may risk steep fines or revocation of tax-exempt status, among other state or federal sanctions.
If all of those steps are followed, organizations should not worry about paying directors for their work.
Disclaimer: Please remember that the law is complicated and it changes. So this blog post is intended as an informational resource but it might not cover all the relevant points for your specific situation and it should not be relied upon as legal advice. Before making radical changes to your organization’s policies on compensation, please contact me to set up a consultation or speak with another attorney who is familiar with laws applicable to nonprofit organizations in your state. An attorney can help your organization navigate governance and compensation practices among other legal issues.