Nonprofit executive director salary: intermediate sanctions, nonprofit CEO compensation and the data the IRS expects

Every row below comes from section 4958 of the Internal Revenue Code, its Treasury regulations at 26 CFR 53.4958-1 through 53.4958-7, section 4960, or the IRS instructions for Form 990. The citation sits on the row so you can open the source rather than take our word for it.

Section 53.4958-6(a) lists the three conditions in the order they have to happen. The sequence matters more than boards expect. Approval has to be in advance, the data has to be obtained and relied on prior to making the determination, and the documentation has to be concurrent with the decision. A board that sets a number in June and finds supporting data in September has satisfied none of the three, no matter how good the September data is.

Conflict of interest has a precise definition here, and it is broader than the usual reading. Under 53.4958-6(c)(1)(iii) a member is free of conflict only if all five of the following are true: they are not the disqualified person or a family member of one, they are not in an employment relationship subject to the direction or control of any disqualified person benefiting from the arrangement, they do not receive compensation subject to approval by such a person, they have no material financial interest affected by the arrangement, and they are not on the other side of a reciprocal approval. The second and third items catch a staff member serving on the board, and the fifth catches two executives who approve each other.

There is a clean way to handle the executive being present. Under 53.4958-6(c)(1)(ii) an individual is not treated as included on the authorized body if they meet with the other members only to answer questions and otherwise recuse themselves, are not present during debate and do not vote. Answering questions is fine. Sitting through the debate is not.

One thing the presumption is not: a requirement. Section 53.4958-6(e) says that the absence of the presumption creates no inference that a transaction is an excess benefit transaction. Skipping the process does not make your pay unreasonable. It just means that if the question is ever asked, you are arguing the merits from scratch instead of making the IRS dislodge your data.

Sources: 26 CFR 53.4958-6(a), 53.4958-6(c)(1)(i), 53.4958-6(c)(1)(ii), 53.4958-6(c)(1)(iii), 53.4958-6(e).

Section 53.4958-6(c)(2)(i) says an authorized body has appropriate data if, given the knowledge and expertise of its members, it has information sufficient to determine whether the compensation arrangement in its entirety is reasonable. It then lists what relevant information includes, and says plainly that the list is not exhaustive: compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions; the availability of similar services in your geographic area; current compensation surveys compiled by independent firms; and actual written offers from similar institutions competing for the person.

The regulation then does something unusual and very useful. It works through five examples, and the first two use the identical survey to reach opposite results. That pair is the clearest statement anywhere of what the IRS is actually looking for, and it is not the price of the data.

Read Examples 1 and 2 together and the rule falls out. In both, the board buys a national survey of the same job title. In Example 1 the survey reports one undifferentiated range and the decision fails. In Example 2 the same survey breaks the data down by the size of the institution, in terms of both the number of people it serves and its revenues, and by geographic area, and the decision passes. Nothing changed except segmentation. A wide national range for a job title is not evidence about your organization. A segment matched to your size and your market is.

That is the same discipline behind any defensible salary band, and it is why federal wage data published by occupation and metro area does real work here: it is segmented by geography and occupation before you touch it, it is current, and the source and date travel with every figure. If you are choosing between paid sources, the trade-offs are laid out in our comparison of salary survey providers.

Sources: 26 CFR 53.4958-6(c)(2)(i), 53.4958-6(c)(2)(iv) Examples 1 to 5.

This is the most useful paragraph in the whole regulation for a small nonprofit, and it is routinely left out of guidance aimed at boards. Section 53.4958-6(c)(2)(ii) provides that for organizations with annual gross receipts, including contributions, of less than $1 million, the authorized body will be considered to have appropriate data as to comparability if it has data on compensation paid by three comparable organizations in the same or similar communities for similar services. That is the entire requirement.

Example 5 shows how informal this is allowed to be. A local repertory theater with gross receipts ranging from $400,000 to $800,000 over three years set its artistic director pay using data from a telephone survey of three unrelated performing arts organizations of similar size in similar communities. A board member drafted a brief written summary of what the calls produced. The regulation states that the information obtained in that telephone survey is appropriate data as to comparability. Three phone calls and a memo, done before the vote, cleared the bar.

Two cautions before you rely on it. First, the safe harbor covers compensation arrangements, not property transfers. Second, the regulation adds that no inference is intended about whether circumstances falling outside the safe harbor meet the requirement, which cuts both ways: being over $1 million does not mean three comparables are automatically insufficient, and being under it does not mean three badly chosen comparables are automatically fine. Comparable still has to mean comparable, in size, in community and in the services performed.

Sources: 26 CFR 53.4958-6(c)(2)(ii), 53.4958-6(c)(2)(iii), 53.4958-6(c)(2)(iv) Example 5.

Condition three is the cheapest of the three to satisfy and the one most often lost after the fact. Section 53.4958-6(c)(3) sets out exactly what the written or electronic records of the authorized body must note, and then puts a clock on when they must exist.

The requirement people trip over is the fifth one. If the authorized body decides that reasonable compensation is higher or lower than the range of the comparability data it obtained, it must record the basis for that determination. Boards regularly pay above the range for a genuinely good reason, a hard to fill role, an unusual scope, a person who runs three programs that sit in different survey categories, and then write minutes that say only that the compensation was approved. The reason existed. It just was not written down, and under this regulation an unwritten reason is the same as no reason.

On timing, concurrent has a definition: records must be prepared before the later of the next meeting of the authorized body or 60 days after the final action, and then reviewed and approved by the body as reasonable, accurate and complete within a reasonable time period after that. A board that meets quarterly gets whichever is later, so the next meeting usually governs. A board that approves compensation by written consent and does not meet again for six months is on the 60 day clock.

Sources: 26 CFR 53.4958-6(c)(3)(i), 53.4958-6(c)(3)(ii).

The percentage heuristic fails in both directions, which is why the regulation does not use it. A $600,000 organization running a clinical program with licensed staff and a federal grant needs an executive who can carry that, and the market rate for that person is not a function of the budget. A $40 million foundation with three employees can pay far above any sensible percentage without a single comparable organization agreeing the number is reasonable. Percentages measure the size of the denominator. Section 4958 asks about the job.

We worked through the arithmetic and the real reason the rule of thumb persists in what percentage of a nonprofit budget should go to the executive director salary. The short version is that the percentage is an output of a defensible decision, never an input to one, exactly as the ratio between an owner salary and distributions turns out to be in S corporation reasonable compensation, which runs on the same substance over form logic.

This is the rule that turns small housekeeping failures into tax liability, and it has nothing to do with whether anyone was overpaid. Section 53.4958-4(c)(1) states that an economic benefit is not treated as consideration for the performance of services unless the organization clearly indicates its intent to treat the benefit as compensation when the benefit is paid, and that it does so only by providing written substantiation that is contemporaneous with the transfer. If it fails, the services the person performed are not treated as consideration for that benefit at all.

Follow the logic to its end. An excess benefit is the amount by which the value provided exceeds the value of the consideration received. If the services do not count as consideration for an unreported perk, the consideration is zero, so the entire value of the perk is an excess benefit. A $250 a month unreported car allowance paid to an executive director earning well below market is a $3,000 excess benefit for the year, and the 25 percent tax runs on the $3,000.

Substantiating it is easy. Reporting the benefit as compensation on an original federal tax information return, a Form W-2, a Form 1099 or the Form 990 itself, is contemporaneous written substantiation. So is the recipient reporting it as income on their own original return, or an amended return filed before an IRS examination begins. An approved written employment contract executed on or before the date of the transfer works too, as do minutes meeting the documentation requirement showing the authorized body approved the transfer as compensation. Benefits excluded from gross income under chapter 1, such as employer-provided health coverage and contributions to a qualified plan under section 401(a), do not need this treatment, though they still count when you test whether total compensation is reasonable.

Which is the other half of the point. Compensation for reasonableness purposes is not salary. Section 53.4958-4(b)(1)(ii)(B) counts all forms of cash and noncash compensation including bonuses, severance and deferred compensation, payments to welfare benefit plans providing medical, dental, life insurance, severance and disability benefits, taxable and nontaxable fringe benefits other than those described in section 132, expense allowances that are not reimbursements under an accountable plan, and the economic benefit of a below-market loan. If you benchmark base salary against the market and quietly add a package on top, you have benchmarked the wrong number. The same discipline applies to any salary structure where total cash and benefits differ across grades.

Sources: 26 CFR 53.4958-1(b), 53.4958-4(b)(1)(ii)(B), 53.4958-4(c)(1), 53.4958-4(c)(2), 53.4958-4(c)(3).

For a fixed payment, the facts and circumstances considered are those existing on the date the parties enter into the contract. The regulation then adds a sentence that is unusually protective: in no event shall circumstances existing at the date when the payment is questioned be considered in making a determination of the reasonableness of the payment. A three year contract signed when the market was hot is not retested against a cooler market two years later. Hindsight is expressly out.

That protection has a matching limit. A written binding contract that the organization may terminate or cancel without the other party consent and without substantial penalty is treated as a new contract as of the earliest date such a cancellation would be effective. So is any material change, which the Form 990 instructions describe as including an extension or renewal or a more than incidental change in the amount payable. Most nonprofit employment is at will, which means many organizations are effectively entering a new contract every year and owe themselves a fresh look each time.

The same logic reaches the exit. A severance payment to a disqualified person is compensation, so it belongs inside the reasonableness analysis rather than outside it, and a board that never priced the departure has approved a number it did not benchmark. The formulas and the waiver rules that govern that payment are covered on the severance pay and severance packages page.

There is one way to get the protection up front for a bonus, in 53.4958-6(d)(2), and it is worth building into the contract. If the authorized body approves an employment contract containing a non-fixed payment subject to a specified cap, it can establish the presumption at signing provided that it first obtained comparability data indicating a fixed payment up to a certain amount would be reasonable, and the maximum payable under the contract, counting fixed and non-fixed elements together, does not exceed that amount. In practice: benchmark the total, cap the package at the benchmarked total, and the incentive design inside the cap is yours to set. Anyone building an incentive on top of a band should first read where a salary sits inside its range, because the cap has to be set against total compensation rather than against base.

Sources: 26 CFR 53.4958-4(b)(2)(i), 53.4958-4(b)(2)(ii), 53.4958-6(d)(1), 53.4958-6(d)(2).

Intermediate sanctions were added to the Code in 1996 by P.L. 104-168 to give the IRS something between doing nothing and revoking exempt status. The design choice that follows from that is the one boards should understand: the taxes fall on individuals, not on the organization.

Two details change how the numbers actually land. Correction matters enormously: the 200 percent tax applies only when the transaction is not corrected within the taxable period, and section 4961 provides a 90 day correction period after a notice of deficiency for the 200 percent tax, during which correction prevents assessment, or produces abatement or a refund if it was already assessed. And the manager tax has a real trigger. Knowing means actual knowledge of sufficient facts that, based solely on those facts, the transaction would be an excess benefit transaction. Participation includes silence or inaction where the manager was under a duty to speak or act, but a manager who opposed the transaction in a manner consistent with their responsibilities has not participated.

Sources: 26 U.S.C. 4958(a), 4958(b), 4958(d)(2), 4960(a); 26 CFR 53.4958-1(a), 53.4958-1(c)(2), 53.4958-1(d)(2)(ii), 53.4958-1(d)(3), 53.4958-1(d)(4)(i).

Nonprofit compensation is unusual in that the process, not just the number, is disclosed. Form 990 Part VI line 15 asks whether the process included the same three elements the regulation requires, and the answer is public. So is the description on Schedule O, which has to identify the positions the process covered and the year it was last undertaken for each of them.

There is a practical consequence worth planning for. The line 15 question is answered per position group, and the year the process was last undertaken has to be stated. A board that benchmarked the executive director in 2023 and has not revisited it is publishing that fact to every funder, journalist and prospective hire who opens the return. The cheapest way to keep the answer current is to make the review an annual agenda item with the data attached, which is also how the timing rules want it done, since most at-will arrangements are treated as new contracts each year.

Sources: IRS Instructions for Form 990, Part VI Section B line 15 and Schedule J Part II.

The regulation was written with universities and hospitals in mind, but it applies to a four person organization the same way, and nothing in it requires a consultant. Here is the sequence that satisfies all three conditions for a typical organization under 200 staff.

Two adjacent decisions usually surface during the same meeting. If the organization is deciding whether a role is salaried and exempt from overtime, that is a separate federal test with its own salary floor, covered in exempt vs non exempt classification and the exempt salary threshold by state, and nonprofits get no relief from either. If a contractor is doing work that looks like a staff role, the answer is in the 1099 vs W-2 tests. And when a role is posted externally, the range in the advertisement is governed by state pay transparency rules for job postings, which apply to nonprofit employers on the same terms as everyone else. On the method itself, market pricing a job and how to conduct a salary survey walk through the mechanics, and Wagelist for nonprofits shows what the board packet ends up looking like.

Sources: Internal Revenue Code sections 4958, 4960, 4961 and 501(c)(3); Treasury regulations at 26 CFR 53.4958-1 through 53.4958-7, retrieved from the Electronic Code of Federal Regulations; IRS Instructions for Form 990 and for Schedule J; section 4958 as enacted by the Taxpayer Bill of Rights 2, P.L. 104-168, and the $20,000 manager cap as amended by P.L. 109-280. This page is general information about published law, not legal or tax advice. Compensation decisions turn on your own facts, so confirm the plan with counsel or your tax adviser before the board votes.