Nonprofit Compensation Policy: What You Need to Know

Wednesday, May 18, 2022

Nonprofits have a reputation for failing to pay their employees as much as for-profit organizations. Paying less is often considered an attempt to keep the overhead expenses to a minimum. However, the outlook on nonprofit overhead is changing!

By providing fair and competitive compensation, nonprofits are able to better retain their employees, which saves money in the long run by decreasing recruitment and onboarding costs.

And at the heart of fair compensation lies the need for a nonprofit to implement a nonprofit compensation policy. In this article, we’ll dive into what this policy is and why it’s essential for your nonprofit to have one. Here are the general topics we’ll cover:

• What is a nonprofit compensation policy?
• Requirements regarding compensation for nonprofit employees
• What’s included in your nonprofit compensation policy?
• Nonprofit compensation policy sample
• Setting strategic compensation plans for nonprofits

Before we dive in too deep, let’s make sure we’re all on the same page about the general definition of a nonprofit compensation policy.

What is a nonprofit compensation policy?

Nonprofit compensation policies outline the process of deciding how salaries and other compensation benefits are determined for staff members at the organization. Specifically, this policy outlines the procedure to decide the salary of executive members.

Sole proprietors are generally paid through draws on the company income. The income generated through that business is considered to be an extension of the business owner themselves and salaries paid to employees are considered an expense. However, nonprofits operate a bit differently.

According to nonprofit accounting guidelines, as a registered 501(C)(3), nonprofits must reinvest the funds they earn back into the organization. That means the funds belong to the organization rather than to the executive. Thus, the leaders and other staff members must take a salary that is agreed upon as a part of the organization’s overhead expenses.

As it can cause conflict to ask the executive director to choose their own salary at a nonprofit, the nonprofit compensation policy outlines a clear process for doing so without causing any conflicts of interest.

Requirements regarding compensation for nonprofit employees

As mentioned earlier, 501(C)(3) requirements for nonprofits mean that the organization cannot use generated revenue for the benefit of the owners or shareholders. Instead, those funds need to be reinvested back into the organization.

Therefore, there are specific requirements for nonprofit compensation set by the IRS that this policy helps to ensure when salaries are determined. It requires that salaries:

• Are considered reasonable, but not excessive. Generally, this is the greatest concern for the executive director’s salary. Unfortunately, there are people who will try to take advantage of the tax exemption status of nonprofits and set up false organizations to earn additional money. This requirement prevents this fraudulent behavior and preserves the integrity of nonprofits like yours.
• Include benefits and bonuses as a part of overall compensation. When compensation is recorded and reported, it must be done so in its entirety, including any benefits and bonuses provided for staff members. This holistic approach considers all organization expenses relevant to compensation to ensure everything is properly accounted for.
• Are reported transparently on an annual basis. On your nonprofit’s Form 990, you’re required to disclose the salaries of the five highest-paid employees to communicate this compensation with the IRS and ensure they’re in line with the other requirements. Keep in mind that this is also a public document, so the highest-paid employees’ salaries are also publicly available.

It’s highly recommended that the board of directors at your nonprofit plays a part in setting compensation for executives. That conversation should be revisited on an annual basis. Then, the executive director can follow the guidelines in the compensation policy to set the salaries of the other staff members.

Executive director compensation

Your nonprofit compensation policy should have provisions and processes outlined to ensure the compensation of your executive director is reasonable but not excessive.

The recommended process to determine the right compensation is to conduct research on the compensation for other executives for other organizations. This comparative research should be done for other executives who work with:

• Similar types of organizations
• Similar-sized organizations
• Organizations in the same general region

If you were to compare the salary of an executive director at a nationally renowned organization like the Red Cross versus your local dog shelter, you’ll likely find they’re quite different!

Comparative research should be done between similar organizations so that your organization’s executive director can show they’re paid at a reasonable level.

Penalties for excessive compensation

When we hear about nonprofits paying their executives a high amount of money, our minds often immediately jump to corruption. However, this corruption is precisely what the IRS and state governments are trying to prevent by creating stipulations around the idea of compensation.

Your nonprofit compensation policy should help prevent your nonprofit avoid any assumptions of corruption because it helps your organization remain compliant.

If the IRS does find that an organization has issues with excessive compensation among the highest-paid employees, that nonprofit may face heavy penalties.

If the IRS flags potential violations and excessive compensation, the organization may be required to undergo:

• An official IRS inquiry or a nonprofit audit to further examine the situation
• Further investigation from the state level
• Payment of heavy fines

To avoid these penalties, your nonprofit should always ensure the processes laid out in your nonprofit compensation policy are clear, follow the rules, and encourage you to leave a paper trail that you can use to back up your decisions to the IRS if necessary.

Penalties don’t only come from the IRS. If you overpay your staff members, you likely don’t have the funds to effectively run your nonprofit’s programming. Calculate your nonprofit’s program efficiency ratio. If your ratio is below 75%, it’s a sign you might be paying your employees too much rather than allocating the necessary resources toward your mission and programs. Strike the balance between paying your employees what they deserve and ensuring you have the funds to continue pursuing your mission.

What’s included in your nonprofit compensation policy?

Different organizations often have slightly different items in their compensation policies, but they generally have a common outline to them. A nonprofit compensation policy often includes the following information:

• Overview or philosophy: Most nonprofits include an overview section on the first page of their policy, discussing the purpose of the document, how to read it, and sometimes the values the organization holds regarding compensation in general.
• Information about who is affected by the policy: Some organizations include information about compensation for all of their staff members in their compensation policy while others simply provide information about their executives. This section of your policy will cover the description of the roles that are covered by the policy process.
• Compensation structure and elements: Because your Form 990 requires you to report all aspects of your compensation, your organization can discuss the various elements of your compensation plan in this section of the policy, including any retirement funds, paid time off, bonuses, other benefits, and, of course, salary.
• Procedure for approving compensation: As we mentioned, you should outline the process of how you’ll compare compensation information from other organization executives and how board members are involved in the process. For instance, if you require a vote on final compensation decisions, you might require two-thirds of board members to agree or a simple majority.
• Comparability data information: This section will discuss how you’ll use the data that you collect from other organizations regarding their compensation information. Sometimes this section is lumped into the “procedure for approving compensation” section, but other times, it’s noted separately.
• Schedule of compensation deliberations: Compensation isn’t a stagnant item for your organization. Instead, it undergoes changes and adjustments with inflation, organizational growth, and other factors. Therefore, your organization should list a general schedule for how often you’ll review compensation for relevant members.

Generally, it’s best to contact a lawyer and a financial advisor to help you determine the best information to include in your compensation policy and to look over your policy after you’ve completed it.

Nonprofit compensation and conflict of interest policies

In addition to your organization’s nonprofit compensation policy, you should also make sure to have your conflict of interest policy. While this is a different policy, it does overlap with our compensation policy as both ensure organizations remain compliant and prevent fraud.

Conflict of interest policies are set to prevent leaders from gaining individual benefits from the organization’s public funds.

For example, if an executive also works as a consultant for another company and signs the nonprofit up with services from that other company. If the executive gains financially from the agreement, it would likely be considered a conflict of interest.

If anything goes wrong or the IRS identifies a risk of overcompensation, the first thing they look for is any conflict of interest at the nonprofit.

Nonprofit Compensation Policy Sample

Now that you understand what is included in your nonprofit compensation policy, you might be asking, “but what does this document actually look like?”

Below is a template that shows the general outline of the policy. Keep in mind that this template shows your policy all on a single page while they’re actually usually much longer than one page. Don’t fret if you draw up a multi-page document for this compensation policy.

If you’d like to see other versions of nonprofit compensation policies, check out the following examples:

• The Fuller Center Manual Compensation Policy Template
• Sample Nonprofit Compensation Policy from National Council of Nonprofits

Keep in mind as you read through these samples and explore this template, keep in mind that all information in this article, images, and resources provided should not be considered legal advice or used as such. It’s always best to consult with a lawyer when compiling official policies and documentation for your nonprofit.

Setting strategic compensation plans for nonprofits

In a study cited in a Forbes article, 45% of nonprofit staff members who responded indicated that they would be looking for new employment over the next 5 years. In addition, 49% of those who responded shared that the organization didn’t pay enough and 19% shared that nonprofits don’t offer long-term career opportunities.

This creates a huge problem for the nonprofit sector as employee retention is vital for organizational growth and success. Therefore, as you’re considering your nonprofit compensation policy, don’t forget to consider your organization's overall staff retention strategy as well.

Remind staff members of the holistic approach to compensation such as the benefits you offer, paid time off, culture, and salary. Be sure each element of this compensation package is competitive with other positions they could be looking at.

In addition, when staff members do leave, be sure to conduct an exit interview so you can ask staff members why they decided to leave. Include compensation questions in this interview so you can see where your organization falls in the total compensation offered in comparison to your competitors.

Wrapping Up

Effective compensation will factor into your employee retention rate and help save your organization money in the long run. However, it can be challenging to ensure you’re paying enough while preventing excessive compensation among your staff, especially your executives.

If you need help setting compensation policies to remain compliant, consider discussing the matter with nonprofit finance professionals. Our Jitasa J-SAT team will be happy to help! We’ll help walk through what you need in your nonprofit compensation policy as well as how to do the necessary research to determine the best holistic compensation plans for your employees.

To learn more about compensation and general nonprofit financial management, check out the following resources:

• Nonprofit Financial Management | Best Practices to Know. Managing your finances can seem challenging, but this guide will walk you through the best practices that all nonprofit teams need to know.
• Nonprofit Statement of Activities | A Comprehensive Guide. A key financial document where you’ll record your compensation for employees is your statement of activities. See why it’s so important in this comprehensive article.
• Nonprofit Audits: A Complete Guide to Financial Auditing. Over-compensating executives can result in an audit, but audits aren’t an inherently bad thing! Learn more about financial auditing for nonprofits.

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