Compensation for nonprofit executives, especially CEOs, is one of the most scrutinized aspects of nonprofit governance. While nonprofit organizations are mission-driven and tax-exempt, they still operate in a competitive market for leadership talent. The IRS allows nonprofits to pay reasonable compensation for services rendered, but the line between “reasonable” and “excessive” can be narrow. For boards and executives, understanding how nonprofit CEO pay is structured, approved, and regulated is essential to maintaining compliance and public trust.
The Legal Framework for Executive Compensation
Nonprofits, including 501(c)(3) public charities and private foundations, are prohibited from distributing profits to insiders. This is known as the “private inurement” rule, which provides that no part of the organization’s earnings can benefit private individuals beyond reasonable compensation for services. The IRS enforces this through Section 4958 of the Internal Revenue Code, which governs “intermediate sanctions.” If an executive is overcompensated, both the recipient and the board members who approved the pay can face significant excise taxes and penalties, and in extreme cases, revocation of the nonprofit’s 501(c)(3) exempt status.
To determine what is “reasonable,” an authorized decision making body of the nonprofit, such as a compensation committee comprised of independent directors, are expected to follow a three-step process:
- Ensure independence. The members of the decision making body must not have a conflict of interest with respect to the interested director or the transaction or be in a position to receive any possible personal benefit from the outcome.
- Obtain comparable data. Before making a determination, the decision making body must review compensation levels of similar positions at organizations of comparable size and scope within the same geographic region and sector.
- Document the process. The decision making body must concurrently make its determination and record in detail how the decision was made, including the supporting data sources, in meeting minutes.
When these steps are followed, it creates a rebuttable presumption that the compensation is reasonable, which shifts the burden of proof to the IRS if questions arise later.
What Goes Into CEO Compensation
Nonprofit CEO pay often includes more than a base salary. Boards must consider the total compensation package when evaluating and demonstrating reasonableness, which may include:
- Base salary
- Performance bonuses or incentive pay
- Health, dental, and retirement benefits
- Life insurance or disability coverage
- Expense accounts, car allowances, or other noncash benefits
- Housing or relocation assistance
- Deferred compensation or severance arrangements
Each element must be justified based on the executive’s responsibilities, experience, and the complexity of the organization. Larger nonprofits or those operating in sectors such as healthcare or higher education may necessitate higher compensation due to the demands of managing extensive operations and compliance requirements.
Benchmarking and Data Sources
The IRS Form 990, which all tax-exempt organizations must file annually, provides public access to compensation data for key employees. Boards frequently use this data, along with national surveys from Guidestar by Candid or peer organization published reports, state and regional surveys from state nonprofit associations, and publications like the Chronicle of Philanthropy or the Nonprofit Times, to compare similar positions.
It is also important to consider local and sector-specific benchmarks. For example, a CEO leading a regional arts nonprofit is not likely to earn the same as a CEO overseeing a large healthcare foundation, even if both organizations are similar in age or staff size. The goal is to demonstrate that decisions about pay are based on data and mission alignment rather than personal preference.
The Role of the Board
The board of directors is ultimately responsible for approving CEO compensation consistent with their fiduciary duties of care and loyalty. As noted above, to ensure independence, many nonprofits use a compensation committee to set CEO compensation while others rely on the full board in executive session without the CEO present. The nonprofit’s board should rely on its conflict of interest policy to ensure no directors with a personal or financial interest participate in determining CEO compensation.
Boards should also conduct an annual performance review of the CEO, connecting compensation to measurable outcomes such as fundraising growth, program impact, and operational efficiency, as well as periodically refresh their reasonableness analysis with updated comparability data. This approach reinforces accountability and ensures that pay aligns with the nonprofit’s success and mission.
IRS and State Oversight
IRS oversight focuses on whether compensation is “reasonable” under Section 4958. If the IRS determines that an executive received an excess benefit, the executive may be required to repay the excess and pay an excise tax of 25 percent. If the issue is not timely corrected, an additional tax of up to 200 percent may apply and the nonprofit’s tax-exempt status may be jeopardized. Board members who knowingly approved the excessive pay can also face personal penalties.
In California, the Attorney General’s Registry of Charitable Trusts adds another layer of oversight by reviewing nonprofit filings and investigating potential cases of misuse of charitable assets, such as through excessive compensation. Maintaining transparency through accurate and timely Form 990 filings can help reduce scrutiny and build confidence among donors and regulators.
Transparency and Public Perception
Even when executive compensation complies with legal requirements, public perception matters. Donors, the media, and the public often have strong opinions about what nonprofit leaders should earn. A salary that seems excessive compared to the organization’s size or mission can lead to reputational harm or reduced donations.
Many organizations address this by providing context in annual reports or public communications that highlight the CEO’s responsibilities, impact, and the reasoning behind compensation decisions. Clear communication helps reinforce trust and demonstrate that pay is tied to performance and mission outcomes.
Common Pitfalls
Some of the most common mistakes that lead to scrutiny or penalties include:
- Failing to gather adequate comparability data
- Allowing the CEO or insiders to influence the compensation process
- Omitting elements of compensation, such as deferred pay, from board review
- Failing to contemporaneously document the compensation process
- Ignoring changes in IRS or state reporting requirements
These pitfalls can be avoided by implementing a written compensation policy and reviewing it regularly with legal counsel.
Final Thoughts: Balancing Fairness and Stewardship
Nonprofits rely on strong, capable leadership to fulfill their missions. Offering fair and competitive pay helps attract and retain talented executives. At the same time, boards have a fiduciary duty to safeguard charitable assets. By following IRS guidelines, documenting decisions carefully, and maintaining transparency, boards can ensure compensation remains fair, defensible, and aligned with the nonprofit’s mission. In doing so, they not only comply with the law but also strengthen the foundation of ethical governance.
NOTE: The information contained herein is not intended to be legal advice and the reader should know that no Attorney-Client relationship or privilege is formed by the posting or reading of this article which is also not intended to solicit business.
Casey Summar, Managing Partner, The Law Firm for Non-Profits,1812 W Burbank Blvd, #7445, Burbank, CA 91506