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Reasonable Compensation for Key 508 Employees

A 508’s key employees are classified as “disqualified persons” by the IRS and are subject to special restrictions. A disqualified person is any person who was in a position to exercise substantial influence over the affairs of the applicable tax-exempt organization at any time during the lookback period. It is not necessary that the person actually exercise substantial influence, only that the person be in a position to do so. Key employees include those who hold top-level positions such as the CEO; CFO; Executive Director, or other highly compensated employees–those who earn over a threshold amount; and substantial contributors.

The IRS says that a key employee who works for a nonprofit can only be paid a reasonable amount. Any amount above the reasonable threshold is an excess benefit that can result in IRS sanctions. An excess benefit is any kind of transaction in which an insider receives an economic benefit from an exempt organization that exceeds the fair market value of what the organization receives in return.

508s would love to have concrete guidelines about how much is reasonable. Unfortunately, there aren’t any. The IRS simply says that compensation is reasonable if the amount paid would ordinarily be paid for:

  • comparable services
  • by comparable enterprises (whether nonprofit or for profit), and
  • under comparable circumstances.

In other words, you have to look at what other people doing similar jobs for similar organizations are paid. Your 508 and a comparable organization should be competing for the same pool of talent.

Comparable compensation data. The single most important element in determining whether an employee’s compensation is reasonable is comparable compensation data—that is, data about how much compensation is paid by similar organizations for people working in comparable positions.

Comparable services. In determining whether one person’s services are comparable to another’s, you should consider such factors as the type of work and skills involved, whether the job is full time or part-time, the size and scope of the organization, the number of employees managed, the budget or assets managed, and whether the person manages multiple functions or departments.

Comparable enterprises. In determining whether another nonprofit (or profit) organization is comparable to your own, you should consider whether it is similar in:

  • size—by budget, revenues, number of employees, and persons served, and
  • mission—for example, a small private school should not be compared to a hospital or performing arts group.

Comparable circumstances. Consider such circumstances as whether the organization is located in a similar geographic area—for example, whether it is urban or rural, and whether the cost of living is similar.

Other factors. Other factors can be considered as well. Depending on the circumstances, these may include:

  • the nonprofit’s geographic location
  • economic conditions
  • the employee’s duties and past performance history
  • the amount of time the employee spends on the job
  • the person’s compensation history
  • the employee’s background, skills, education, and experience
  • whether the employee has actual written job offers from other organizations, and
  • how much other employees at the nonprofit are paid, and the availability of similar services in the nonprofit’s geographic area.

A rent study of nonprofit CEO compensation by Charity Navigator, a nonprofit that evaluates and rates charities, found that, other than comparable compensation data, the most important additional factors are the nonprofit’s size, mission, and location. The study reported that:

  • Nonprofits with total budgets greater than $13.5 million paid higher than average compensation, while those with under $3.5 million paid less than average.
  • Nonprofits in the Northeast and Mid-Atlantic regions paid above average compensation, while those in the South, Southwest, Midwest, Mountain West, and Pacific West paid less than average.
  • Nonprofits whose mission were in the areas of the arts, culture, humanities, public benefit, and health paid more than average compensation, while those involved with animals, the environment, human services, and international affairs paid less than average.

If this all sounds pretty subjective, that’s because it is. The compensation nonprofits pay their employees for doing similar jobs can vary widely.

There are a lot of resources for compensation data reports for nonprofits compiled by geographic region, sector, budget, type of organization, and so on. You can find many options online (like Guidestar) although you will probably have to pay for the report. It’s good assurance though that you have done your required compensation analysis in case the IRS ever asks.

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“The I.R.S. examined 1.4 million individual income tax returns in 2010, about 1 percent of the total number filed. In 2018, the latest year with available data when Republicans started making these claims, audits decreased to 370,000, or about 0.2 percent… The budget office estimated increasing I.R.S. funding would return enforcement to its 2010 levels. Doing so would result in about 1.2 million more audits; of those, 583,000 would target people making less than $75,000.”

The New York Times, “Fact-Checking the Misleading Claim About 87,000 Tax Agents”, November 6, 2022

“…For example, you educate believers on national issues that are central to their belief in the Bible as the inerrant Word of God. Specifically, you educate Christians on what the bible says in areas where they can be instrumental including the areas of sanctity of life, the definition of marriage, biblical justice, freedom of speech, defense, and borders and immigration, U.S. and Israel relations. The bible teachings are typically affiliated with the Republican party and candidates. This disqualifies you from exemption under IRC Section 501(c)(3).”

Stephen A. Martin, IRS Director, Exempt Organizations, Rulings and Agreements

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