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Nonprofit Compensation Rules: Tips to Avoid Penalties

Posted by Concannon Miller on Thu, Oct 13, 2022

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Nonprofit Compensation Rules: Tips to Avoid PenaltiesYour nonprofit organization is probably assisted by volunteers who aren't financially compensated. But your staff — including executives — are almost certainly paid a commensurate salary and benefits for their work.

Compensation issues are always tricky, but they're made more so by tax and legal requirements for nonprofits. Setting executive pay is particularly fraught because if your nonprofit isn't careful, it could be penalized or even lose its tax-exempt status.

At a Minimum

Tax-exempt organizations are required to report new hires to the appropriate authorities in their state. In addition, they must adhere to federal and state laws regarding minimum wages. Currently, the federal minimum wage is $7.25 per hour. But many states and municipalities impose higher minimum wage requirements that supersede the federal rate.  

In fact, about half of all states boosted their minimum wage rates for hourly workers after 2021. And more than a dozen states have scheduled increases to take effect in 2023. The minimum wage rate will reach as high as $15 per hour in some states.

Similarly, nonprofits are bound by federal overtime pay rules. Generally, qualified hourly workers must be paid time-and-a-half when working over 40 hours per week. State requirements vary and can be intricate, so consult with a local tax adviser and keep abreast of changes in the law.

READ MORE: Salary Increase Budgets Jump for Nonprofit Organizations

Payroll Tax Responsibility

Wages and compensation, such as bonuses, that you pay employees are deductible by your organization. This includes pay for every employee from the CEO down to part-time staffers.

Wages are subject to payroll tax, even though your organization is tax-exempt. Thus, both employees and your nonprofit have tax responsibilities. 

For 2022, the 6.2% Social Security portion of federal payroll tax applies to the first $147,000 of wages. Amounts above this wage base aren't subject to the tax. However, the 1.45% Medicare portion of federal payroll tax applies to all wages, including those above $147,000.

As with for-profit ventures, your nonprofit must remit payroll tax promptly. Failure to do so may result in penalties, plus interest, on the back taxes you might owe.

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Evaluating Executives

The law limits how much nonprofits can pay their highest-earning employees, such as CEOs and executive directors. You may pay them only a "reasonable" amount for services actually rendered. Any amount the IRS deems to be "unreasonable" is nondeductible and could result in penalties.

Unfortunately, there are no hard-and-fast rules for determining reasonable compensation. Obviously, if an employee shows up for work only to collect a paycheck, that's a problem. But most cases involve hard-working executives and boards whose judgments in setting compensation may be challenged.

4 Considerations for Pay-Setters

When setting executive compensation, your board should consider the following:

Comparable compensation: What similar nonprofits pay their executives is an important element when determining how much you should pay yours. Online sources such as Charity Navigator and GuideStar, which compile data nonprofits provide on their Form 990 filings, can provide comparable salary information

Services and size: Factor in the type of work the executive performs, the skills that are required to do it, the size and scope of your organization, the number of employees under supervision, your budget or annual revenues, and whether the executive must juggle multiple responsibilities.

Type of organization: For comparison purposes, decide if other organizations are representative in size, charitable mission and operations. Also, consider the geographic area where comparable nonprofits are located. Compensation often is higher in metropolitan areas than in rural locations or in parts of the country where housing and other prices are more expensive.

Other circumstances: Other factors might come into play when setting compensation. These include current economic conditions, the executive's history with your organization, prior compensation arrangements, the individual's background, skills, education and experience, and how much your nonprofit's other staffers are paid.

To ensure that you consider all relevant factors, assemble an independent body to process the data and make recommendations. Then have your board review the entire compensation package. It's essential to keep detailed minutes of board discussions about compensation in the event an IRS challenge arises.

READ MORE: IRS Clarifies Rules on Excess Compensation Tax for Nonprofits

Latest Developments

The Tax Cuts and Jobs Act (TCJA) added more burdens to nonprofits trying to set reasonable compensation. Under the TCJA, tax-exempt organizations are assessed a hefty excise tax if they pay more than $1 million in remuneration to certain "covered employees." This excise tax rate is equal to the corporate tax rate — currently, a flat 21%.

Note that "remuneration" includes wages paid that are subject to federal income tax withholding, such as salary and bonuses, plus amounts included in gross income under a nonqualified deferred compensation plan. A "covered employee" is defined as one of an organization's five highest-compensated employees (HCEs) who received $100,000 or more in reportable wages.

Pay Them What They Deserve

As long as you observe all applicable laws, your nonprofit generally can pay employees what you feel they deserve. But if you're unsure about potential risk or whether you're inviting IRS scrutiny, contact us.

©  2022

Topics: Nonprofit Organizations

Concannon Miller’s unique, holistic and intimate approach to financial health sets us apart from smaller CPA firms with more limited resources as well as mega firms where mid-sized clients struggle for attention. Contact us here to talk about improving your business.

This communication is designed to provide accurate and authoritative information in regard to the subject matter covered at the time it was published. However, the general information herein is not intended to be nor should it be treated as tax, legal, or accounting advice. Additional issues could exist that would affect the tax treatment of a specific transaction and, therefore, taxpayers should seek advice from an independent tax advisor based on their particular circumstances before acting on any information presented. This information is not intended to be nor can it be used by any taxpayer for the purposes of avoiding tax penalties.

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