How Large Can a Nonprofit’s Salaries Be?

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A common misperception of the nonprofit world is that people who work in it are always hugely underpaid. The truth is more complex.

Nonprofits compete with each other as well as for-profit employers for qualified candidates. If the organization has the means to offer an especially good candidate a high salary to lure him or her away from another job, it may be in the best interest of the organization to do so.

From a legal standpoint, most nonprofit salaries are unlikely to draw significant attention from state or federal authorities. The rules governing salaries, whether under state law or IRS guidelines, can be complex once examined in detail. In general, tax agencies are unlikely to scrutinize salaries so long as they are “reasonable.”.

What, precisely, does reasonable mean here? The answer is unfortunately quite vague. One way to understand it is to consider when a salary might be considered excessive.

Excessive pay is one of several red flags the IRS may use when it examines a nonprofit to determine if it is being run for the private benefit of an individual rather than for a legitimately nonprofit purpose.

The size of an employee’s salary relative to the income of the organization offers a starting point for examining this question. In the crudest terms, if all the tax-exempt donations to a nonprofit are simply being turned into an individual’s salary, the IRS will start asking tough questions and likely will levy fines against the organization and may also rescind the organization’s tax-exempt status.

On the other hand, a large organization with a substantial budget and numerous employees is more likely to have clear justification for paying its executives a higher wage. In such cases, not only are the high earners likely to have qualifications that justify their high salary, but they also take home a reasonably small slice of the organization’s overall operating budget.

If the IRS challenges a nonprofit organization for the appropriateness of wages, the burden rests on the organization to prove that the wages are reasonable. However, tax regulations provide a “safe harbor” that shifts the burden of proof to the IRS. The safe harbor applies if the organization follows the right process in setting its salaries. Among other things, it requires salary decisions to be made by disinterested policy makers who have done appropriate research into comparable wages and have documented their work. If the organization’s salary process fits within the safe harbor, then wages are presumed to be reasonable, and the IRS bears the burden of proving they are not.

The safe harbor process should be followed by all nonprofit organizations, but a very high percentage of them do not. The rules are complex, and legal counsel is helpful in assuring that this regulatory benefit applies. The Church Law Center of California supports the work of religious and secular nonprofits. We counsel leadership teams on how to sustainably operate within the scope of state and federal rules. To schedule an appointment call us today at (949) 892-1221 or reach out through our contact page.

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