Look to the right peers when setting executive compensation

For organizations of any type, leadership matters. As a not-for-profit, you want to attract the best and brightest executives, individuals with a deep understanding of the not-for-profit sector and the skills to successfully operate and grow your organization. Your executive compensation package is part of what makes your positions competitive in the marketplace, enabling you to bring in and retain the right personnel. But as you well know, it’s not as simple as offering up the ritziest package you can muster: Executive compensation is also a topic that’s fraught with regulation.

Executive compensation is an area of concern for regulators, including both the IRS and state attorney generals. Other stakeholders, such as government funders, significant contributors, members, and the media, also play a role in a not-for-profit organization’s compensation choices. Not-for-profits that are exposed as paying excessive compensation to their executives can face severe detriments to future funding or the removal of board members. In the worst cases, they jeopardize the entire existence of their organization.

So how can your organization protect itself from these hazards while still offering a competitive compensation package? In the context of a tax-exempt organization, no amounts of the net earnings or assets of the organization can benefit a private person. What can you offer to executives that’s robust enough to compensate them for successfully running the organization while keeping your not-for-profit safe from bad press and regulatory action?

What compensation is reasonable?

Tax-exempt organizations must ensure their executive compensation packages are “reasonable.” Since this term is somewhat subjective, Internal Revenue Code Section 4958 contains a safe harbor available to 501(c)(3) organizations (excluding private foundations) and 501(c)(4) organizations. Other exempt organizations should consider adopting the standards set forth in Section 4958 as best practices for establishing compensation approval and processes.

Under the Section 4958 safe harbor, compensation is presumed to be reasonable (that is, it meets the requirements for what’s called the “rebuttable presumption of reasonableness”) if the organization meets all of the following three requirements prior to the actual payment of compensation:

• The compensation is approved by an authorized board or board committee that is composed of independent individuals, that is, individuals that have no conflict of interest regarding the compensation arrangement at issue.
• The board or board committee relies on appropriate comparability data (more on that below) to set the compensation amount.
• The process for setting the compensation amount is contemporaneously documented.

As long as a not-for-profit organization meets these three requirements, it’s the IRS that must bear the burden of proving the compensation is unreasonable should the package be challenged.

What is comparable data?

The IRS challenged comparability data in its Colleges and Universities Compliance Project Final Report, issued April 25, 2013. In this report, the executive compensation component of the examinations focused mainly on compliance with Section 4958, which provides that organizations may pay no more than reasonable compensation to their disqualified persons (officers, directors, trustees, and key employees).

Most of the private colleges and universities the IRS examined attempted to meet the rebuttable presumption standard, but about 20% failed because of problems with the comparability data. These problems included:

• Comparable institutions weren’t similarly situated because their schools differed in at least one of the following areas: location, size, revenue, total net assets, or number of students.
• Their compensation studies neither documented the selection criteria for the institutions included nor explained why those institutions were deemed comparable to the school relying on the study.
• Their compensation surveys didn’t specify whether the amounts reported included only salary or salary plus all other compensation, as required by Section 4958.

Appropriate comparability data for purposes of establishing the rebuttable presumption of reasonableness comes from appropriate peer group selections.

Peer groups

Through the IRS' Colleges and Universities Compliance Project, we’ve learned the focus is on peer group selection for comparability data. All organizations — not just colleges and universities — need to focus on peer groups. An appropriate peer group is one that represents similar organizations with similar executive-level positions (that is, the duties conducted by the executive are similar). Both not-for-profit for for-profit entities may be included in the peer group selection.

In establishing an appropriate peer group, the board or board committee must take steps to define the criteria for the peer group selection, identify the data sources that will provide the appropriate comparables, and ultimately make sure the recommended compensation is competitive and reasonable. Criteria that should be considered include:

• The complexity of the executive’s roles
• The size of the organization
• The talent market, when specialized education or experience is needed
• Geographic location

Some positions may require you to “customize” the selected peer group. For example, you may need to include investment or development executives if the role you’re evaluating will include similar responsibilities.

Peer group data can be gathered from published surveys, custom surveys performed by a third party, or compensation information provided on other organizations’ Form 990 filed with the IRS. Keep in mind that a data source that suits one organization might not suit another. For some, published surveys may be appropriate and a good comparable. However, if the position is unique or a specific skill set is necessary, a custom survey may be needed.

Pointers and best practices

Your compensation study should be a written document that includes the methodology for the analysis, the findings (which should address total compensation, including benefits, pension contributions, etc.), business judgment factors, and opinion as to the reasonableness of the proposed compensation package. If a consulting firm performed the study, it should also include certification of the consulting firm’s qualifications to provide the opinion as a valuation expert.

It’s important that your not-for-profit’s board or board committee reevaluate the data sources used and the peer group selection on a regular basis. How often you reevaluate your data sources will vary based on how rapidly the job duties, size of your organization, or other factors change. This reevaluation should also be documented and should include an explanation of any changes needed or reasons to continue relying on the existing comparability data.

Step forward with confidence

While it’s true executive compensation can be a challenging issue, not-for-profit organizations can pay competitive salaries and benefits while protecting themselves and their reputation. In addition to ensuring your total compensation package is reasonable, all organizations should also establish compensation approval processes that follow the safe harbors of Section 4958, including the documentation and establishment of appropriate peer groups.

For questions on the compensation approval process, comparability studies, or best practices for documentation and compensation, contact one of our not-for-profit or valuations professionals.