Nonprofits may pay their executives competitive salaries, but every dollar has to meet a federal reasonableness standard. The IRS rules on nonprofit executive compensation measure pay against what similar organizations would pay for similar work under similar circumstances, and compensation that exceeds that benchmark triggers excise taxes starting at 25% of the excess amount.1Internal Revenue Service. Exempt Organization Annual Reporting Requirements: Meaning of Reasonable Compensation The penalties fall on individuals — the executive who received the pay and the board members who approved it — and in severe cases the organization can lose its tax-exempt status.
What Reasonable Compensation Means
Reasonable compensation is the value ordinarily paid for like services by like enterprises under like circumstances.2Internal Revenue Service. Intermediate Sanctions – Compensation In plain terms: look at what the market pays for the job. Relevant factors include the organization’s size and budget, the complexity of its programs, the geographic labor market, and the qualifications the role demands.
When pay exceeds the value of the services, the overpayment is called an excess benefit transaction. Internal Revenue Code Section 4958 governs these transactions and imposes excise taxes on the individuals involved, not on the organization itself.3Office of the Law Revision Counsel. 26 USC 4958 – Taxes on Excess Benefit Transactions The law looks at the economic substance of the deal, not intent. A board that overpays by accident faces the same rules as one that overpays deliberately.
The Rebuttable Presumption Process
The single most important step a nonprofit board can take when setting executive pay is to follow the rebuttable presumption process. When an organization satisfies three specific requirements, the IRS presumes the compensation is reasonable, and the burden of proving otherwise shifts to the government.4Internal Revenue Service. Rebuttable Presumption – Intermediate Sanctions Organizations that skip the process end up carrying that burden themselves.
The three requirements are independent approval, comparability data, and contemporaneous documentation.
Independent approval means an authorized body — usually the board or a board committee — approves the pay in advance. Every member involved must be free of conflicts of interest. They cannot personally benefit from the arrangement, be under the executive’s control, or receive pay the executive approves.5eCFR. 26 CFR 53.4958-6 – Rebuttable Presumption That a Transaction Is Not an Excess Benefit Transaction
Comparability data means the body gathers and relies on appropriate information about what similar organizations pay for similar roles before making its decision.
Contemporaneous documentation means a written record created at or near the time of the decision, showing the terms approved, who was present and how they voted, what data was used, and how it was obtained.4Internal Revenue Service. Rebuttable Presumption – Intermediate Sanctions If the board sets pay above or below the range indicated by the data, the record must explain the reasoning. Explanations offered later carry no weight.
Gathering Comparability Data
Acceptable data sources include compensation surveys from independent firms, salary information from similarly sized organizations (nonprofit and for-profit) in the same field, and actual written offers from competing employers trying to recruit the executive.5eCFR. 26 CFR 53.4958-6 – Rebuttable Presumption That a Transaction Is Not an Excess Benefit Transaction
Geography and mission complexity both matter. An executive director in Manhattan operates in a different labor market than one in rural Kansas. Leading a $200 million hospital system is a different job than leading a $2 million community arts organization, even when both carry the CEO title.
Many organizations engage an independent compensation consultant to produce a formal study, which both satisfies the comparability requirement and gives the board a defensible record. Organizations that cannot afford a consultant can use Form 990 data from comparable nonprofits, which is publicly searchable online. What matters is documenting what data was reviewed, where it came from, and how the board applied it.
Who Counts as a Disqualified Person
Section 4958 applies only to transactions with “disqualified persons,” a broader category than most people expect. It covers anyone who was in a position to exercise substantial influence over the organization at any point during the five years before the transaction.3Office of the Law Revision Counsel. 26 USC 4958 – Taxes on Excess Benefit Transactions Voting board members and C-suite officers are the obvious examples.
Less obvious: family members of disqualified persons carry the same label, as do entities in which a disqualified person holds more than 35% ownership or control. A former executive director who left two years ago remains a disqualified person for transactions within the five-year window. Founders, major donors, and anyone who manages a significant portion of operations may also qualify depending on the facts. The test is influence, not title.
The Excise Taxes for Getting It Wrong
When the IRS finds that a disqualified person received more than reasonable compensation, the penalties land on people, not the organization. The disqualified person owes an initial excise tax of 25% of the excess benefit.3Office of the Law Revision Counsel. 26 USC 4958 – Taxes on Excess Benefit Transactions If an executive received $400,000 when $300,000 was reasonable, the excess benefit is $100,000 and the initial tax is $25,000.
That is just the opening figure. If the disqualified person does not correct the excess benefit within the taxable period, a second tax of 200% of the excess benefit applies.6Office of the Law Revision Counsel. 26 USC 4958 – Taxes on Excess Benefit Transactions In the same example, that adds $200,000 on top of the initial $25,000. The taxable period runs from the date of the transaction until the IRS mails a notice of deficiency or assesses the tax, whichever comes first.
Board members and other managers who knowingly approved the excessive pay face their own tax: 10% of the excess benefit, capped at $20,000 per transaction.3Office of the Law Revision Counsel. 26 USC 4958 – Taxes on Excess Benefit Transactions This is another reason the rebuttable presumption process matters so much. A manager who relied on comparability data and an independent approval process has a strong defense against the “knowing” element.
Correcting an Excess Benefit
The disqualified person can avoid the 200% second-tier tax by correcting the transaction. Correction means undoing the excess benefit to the extent possible and putting the organization in a financial position no worse than if the executive had been dealing at the highest fiduciary standards.7Internal Revenue Service. Intermediate Sanctions – Excess Benefit Transactions
In practice, that means repaying the excess amount plus interest at no less than the applicable federal rate, in cash or cash equivalents. If the original transaction involved property, the person can return the property itself, valued at the lesser of its fair market value on the date of return or on the date of the original transaction. If the property has lost value, the disqualified person makes up the difference in cash.7Internal Revenue Service. Intermediate Sanctions – Excess Benefit Transactions Correction should happen within the taxable period. Partial payments reduce the 200% tax proportionally.
The Trap of Unreported Compensation
Organizations that provide an economic benefit to a disqualified person but never report it as compensation on Form W-2, Form 1099, or Form 990 face a distinct problem. The IRS treats the entire unreported benefit as an automatic excess benefit transaction, regardless of whether total compensation would have been reasonable.8Internal Revenue Service. Automatic Excess Benefit Transactions Under IRC 4958
The logic: without contemporaneous substantiation that the organization intended to treat the benefit as compensation, it cannot later claim the benefit was part of a reasonable package. Common examples include personal use of organization-owned vehicles, below-market loans, housing allowances that were never reported as taxable income, and expense reimbursements that fail accountable plan rules. Even if the total pay would have been fine, the reporting failure alone triggers Section 4958 penalties on the unreported portion. The simple defense is to report every form of compensation on the appropriate tax form when it is paid.
The Separate Tax on Pay Over $1 Million
Section 4960 operates alongside Section 4958 but works differently. It imposes a flat 21% excise tax on the organization itself when a covered employee receives more than $1 million in remuneration during a single tax year.9GovInfo. 26 USC 4960 – Tax on Excess Tax-Exempt Organization Executive Compensation The same 21% tax applies to excess parachute payments to departing executives, which arise when separation-contingent payments total at least three times the executive’s average annual compensation over the preceding five years.
Remuneration for this purpose includes wages, deferred compensation subject to Section 457(f), and taxable fringe benefits.10Internal Revenue Service. Excise Tax on Excess Tax-Exempt Organization Executive Compensation Pay from related organizations counts toward the $1 million threshold when one controls the other or both are under common control.
The 2026 Expansion of Covered Employees
For tax years beginning after December 31, 2025, the One Big Beautiful Bill Act sharply expanded who counts as a “covered employee” under Section 4960. Previously, only the organization’s five highest-compensated employees counted. Under the new rule, any individual employed by the organization at any point after December 31, 2016, is a covered employee permanently, regardless of current position or whether they still work there.11Office of the Law Revision Counsel. 26 USC 4960 – Tax on Excess Tax-Exempt Organization Executive Compensation Once someone becomes a covered employee, they stay one for all future tax years.
The practical effect is significant. Organizations that used to track only their top five earners now need to monitor compensation for every current and former employee who worked for them at any time since 2017. Deferred compensation that vests in a year when a former executive’s total crosses $1 million will trigger the tax even if the person left years earlier. The limited-hours and nonexempt-funds exceptions remain in place, but the limited-services exception has been eliminated. Organizations with substantial deferred compensation arrangements for former senior staff should review their exposure.
Public Disclosure on Form 990
Every tax-exempt organization filing Form 990 must report compensation for its officers, directors, trustees, key employees, and five highest-compensated employees in Part VII.12Internal Revenue Service. About Form 990, Return of Organization Exempt from Income Tax The returns are public. Donors, journalists, and watchdogs can look up what any nonprofit pays its leaders.
When any listed individual’s total compensation exceeds $150,000, the organization must also complete Schedule J, which breaks pay into base salary, bonuses, incentive pay, deferred compensation, retirement contributions, and nontaxable benefits.13Internal Revenue Service. Instructions for Schedule J (Form 990) Schedule J also asks whether the organization used comparability data and whether it had an independent compensation committee. Answering “no” does not automatically trigger a penalty, but it signals to the IRS that the organization did not follow the rebuttable presumption process.
Loss of Tax-Exempt Status
Excise taxes are not the worst outcome. The IRS retains authority to revoke a nonprofit’s tax-exempt status entirely when excess benefit transactions are severe enough. The legislative history of Section 4958 specifically provides that intermediate sanctions may be imposed in lieu of, or in addition to, revocation.
In deciding whether to revoke, the IRS weighs the size of the excess benefit relative to the organization’s overall charitable activities, whether multiple excess benefit transactions occurred, whether the organization put safeguards in place to prevent recurrence, and whether the transaction was corrected. Self-discovery and voluntary correction before the IRS finds the problem count in the organization’s favor. Correction only after an examination, standing alone, is not enough.
Revocation is rare and generally reserved for organizations where insider enrichment has effectively displaced charitable purpose. The possibility still exists, which is why the rebuttable presumption process is not optional for any organization serious about its mission. Market-rate pay with proper documentation and independent board oversight carries almost no revocation risk. Executive suites run without oversight face a different problem entirely.