How Much Can a Nonprofit Organization Pay Its Employees?

Many people who work in nonprofit organizations are volunteers who generously donate their time and effort for a good cause. Their primary incentive is the opportunity to participate and contribute to the organization's mission and to serve. But a nonprofit organization can also have a paid staff, like any other business. And while the members of the board of directors of a nonprofit generally volunteer, the executive officers of a nonprofit can have a salary and benefits. Paying the officers and staff does not take away the tax-exempt status of the nonprofit organization.

Nonprofit organizations do not have profit sharing plans since the profits are reinvested in the nonprofit's activities. But employees of a nonprofit organization can receive benefits such as vacation time, sick pay, medical and dental insurance, and retirement plans.

As pointed out by Dwight Ueda in Salary.com, base salaries in the strongest nonprofits can rival salaries in for-profit corporations. And the strongest nonprofits often do benchmarking studies of their compensation in order to attract and retain the best talent, including the top executive.

But while nonprofit organizations can pay competitive salaries and benefits, they must be reasonable. As explained by Patrick Ferraro in GuideStar, if the IRS considers that compensation is in excess of what is reasonable, sanctions can be imposed on the person receiving the salary and the managers in the nonprofit organization who approved the salary.

According to the IRS, reasonable compensation is what would be paid for similar services by similar enterprises in similar circumstances. So reasonable compensation depends on various factors including the type of work the person performs, the person's duties and responsibilities, experience and abilities, education and other requirements, and the location, since similar positions can have different compensation levels in different parts of the country, based on cost of living and other factors.

Compensation is presumed to be reasonable unless proven otherwise. As long as the nonprofit organization meets certain requirements in how it determines compensation, it is up to the IRS to determine that the compensation is excessive. The requirements are that the compensation is approved by an authorized body of the organization, appropriate data is used for comparing compensation, and the basis for the determination is documented.

For nonprofit organizations with gross receipts of less than $1 million per year, appropriate data would be the compensation for similar positions paid by three comparable organizations. Larger organizations would need a more detailed analysis, such as a compensation study by a third party.

If the IRS determines that a nonprofit organization is paying excessive compensation or benefits, it can impose intermediate sanctions instead of revoking the organization's tax-exempt status. The sanctions can be applied to "disqualified persons" who receive the compensation. These include board members, substantial contributors, executive officers, and their family members. These disqualified persons could be subject to a 25% excise tax on the excess compensation. And the managers who approved the compensation could be liable for a 10% excise tax on the excess compensation.

According to the IRS, even though an organization is tax-exempt, federal income tax must be withheld from the salaries and wages paid to its employees. And social security and Medicare taxes generally must also be withheld. Salaries and wages paid to employees of a 501(c)(3) corporation are subject to social security and Medicare taxes unless the employee is paid less than $100 in a calendar year. Church or church-controlled organizations that are opposed to paying social security or Medicare taxes for religious reasons can file for an exemption.

Sources:

Dwight Ueda, Nonprofits, Salary.com

Patrick Ferraro, Best Practices in Nonprofit Compensation, GuideStar

Publication 15-A, Employer's Supplemental Tax Guide, IRS