Reasonable Compensation for Nonprofit Executives: IRS Rules

Reasonable compensation for nonprofit executives is whatever a similar organization would ordinarily pay for similar services under similar circumstances, measured against the executive’s full compensation package rather than base salary alone.¹ The rule comes from IRC Section 4958 and applies to 501(c)(3) charities, 501(c)(4) social welfare organizations, and 501(c)(29) CO-OP health insurance issuers; private foundations are governed separately.² Boards that follow a specific three-step approval process can shift the burden of proof to the IRS; boards that don’t face excise taxes that fall on the executive and on the approving directors personally, not on the organization.

How the IRS Defines Reasonable Pay

The regulation borrows the standard used for business expense deductions under IRC Section 162: pay is reasonable if it matches what would ordinarily be paid for like services by like enterprises under like circumstances.¹ In practice the IRS weighs the executive’s actual duties, the organization’s size and budget, the complexity of operations, the executive’s qualifications and experience, and the geographic labor market. A CEO of a $50 million national health charity is measured against that market, not against the executive director of a local volunteer group.

A pay package approved by a state or local government body is not automatically reasonable for federal tax purposes. The IRS runs its own analysis.¹

What Counts in the Compensation Package

The comparison runs against total compensation. That includes base salary, bonuses, deferred compensation and the rate at which it accrues, severance agreements, housing allowances, insurance premiums, and fringe benefits. A cap on a bonus or incentive formula is itself a factor that weighs toward reasonableness.¹

Certain benefits are “disregarded” and do not need to be justified as part of the reasonableness calculation:

Standard fringe benefits excluded from income under IRC Section 132, such as employee discounts and working condition fringes; liability insurance premiums are not disregarded and must be counted.
Expense reimbursements paid through an arrangement that meets the IRS requirements for an accountable plan.
Benefits provided to volunteers or members when the same benefit is available to the general public for a membership fee or contribution of $75 or less per year.
Benefits received solely because the person belongs to a charitable class the organization serves as part of its exempt purpose.

Everything else on the ledger, from the executive’s cell phone stipend to accrued deferred pay, goes into the total the board must defend.¹

Which Executives the Rule Covers

Section 4958 applies to “disqualified persons,” meaning anyone who held substantial influence over the organization at any point during the five years before the transaction. Voting board members, the CEO or president, the COO, and the treasurer or CFO qualify automatically. Founders, substantial contributors, and anyone whose pay is tied to revenue from activities they control generally qualify under a facts-and-circumstances test.³

Family members are pulled in too: spouses, siblings and half-siblings, children (including adopted), grandchildren, great-grandchildren, ancestors, and the spouses of any of them. So are entities in which disqualified persons and their families collectively own more than 35 percent of the voting power or profits interest.³⁴ Rank-and-file employees earning under the IRC 414(q) highly compensated employee threshold ($160,000 for 2026), who are not otherwise disqualified and not substantial contributors, fall outside the definition.

The Rebuttable Presumption of Reasonableness

The single most useful tool available to a nonprofit board is the rebuttable presumption. When the board satisfies three conditions, the IRS can only overturn the compensation decision by producing enough contrary evidence to overcome the data the board relied on. Without the presumption, the IRS just runs a facts-and-circumstances analysis with no built-in advantage to the organization.⁵

Advance Approval by an Independent Body

The compensation must be approved in advance by an authorized body made up entirely of people without a conflict of interest. “In advance” is literal: the vote happens before the pay is paid.⁶ A board member has a conflict if they have a financial stake in the outcome, a family relationship with the executive, or a business relationship that could influence their judgment. The executive whose pay is being set should not participate, and anyone who recuses should be noted in the minutes.

Appropriate Comparability Data

The approving body must obtain and rely on relevant data before voting. Acceptable sources include compensation surveys from independent firms, salary information from similar organizations of comparable size, location, and mission, written job offers from other employers, and appraisals from independent compensation consultants. The data has to cover the full package, not just base salary.⁶

Small organizations get a break. If annual gross receipts are under $1 million, the board can satisfy the comparability requirement with data from just three comparable organizations in the same or similar communities providing similar services. Gross receipts can be averaged over the three prior tax years, and if the organization controls or is controlled by another entity, their receipts must be combined for the safe harbor test.⁷

Contemporaneous Documentation

The board must document the basis for its decision at the time the decision is made. Minutes should identify everyone present, describe the comparability data reviewed, explain the reasoning behind the approved figure, and note any recusals. The records must be prepared before the later of the next board meeting or 60 days after the final vote.⁶ Miss that window and the presumption is lost, no matter how strong the substantive analysis was. This is where many boards stumble; the work gets done and the paperwork does not.

What the Presumption Actually Buys You

For fixed payments set in advance by contract, the IRS can only use evidence of facts that existed on the date the contract was signed. For variable or non-fixed payments, the IRS can consider facts through the date of each payment.⁶ Boards have a strong incentive to structure pay as fixed contractual amounts where they can, because the IRS cannot use hindsight to second-guess arrangements locked in up front.

Penalties When Compensation Is Deemed Excessive

If the IRS decides a disqualified person received more than fair market value, the overpayment (“excess benefit”) triggers taxes on the recipient and on the board members who approved it.

The executive owes an initial excise tax of 25 percent of the excess benefit.² If the excess benefit is not corrected within the taxable period, an additional 200 percent tax kicks in. The taxable period runs from the date of the transaction until the earlier of the date the IRS mails a deficiency notice for the 25 percent tax or the date that tax is assessed.⁸ Combined, an executive could owe 225 percent of the overpayment in taxes and still have to return the money.

Any organization manager who knowingly participated in approving an excess benefit transaction owes a separate 10 percent excise tax on the excess benefit, capped at $20,000 per transaction.² The tax does not apply if the manager’s participation was not willful and was due to reasonable cause. A board that ran a real comparability analysis and reached a wrong answer has a defense; a board that approved a number without reviewing data does not.

Where more than one person is liable for the same tax, whether multiple disqualified persons or multiple managers, they are jointly and severally liable. The IRS can collect the full amount from any one of them rather than splitting it evenly among yes votes.⁹

Correcting the transaction means paying the organization cash equal to the excess benefit plus interest at or above the applicable federal rate, compounded annually, and doing so before the taxable period closes to avoid the 200 percent add-on.¹⁰ Intermediate sanctions were built as an alternative to revoking exemption, but revocation remains possible, and self-correction before the IRS finds the problem is treated more favorably than correction after an examination has already started.

The Reporting Trap That Creates Automatic Excess Benefits

One rule catches organizations even when the dollar amount would have been defensible. If the organization provides an economic benefit to a disqualified person without clearly indicating at the time of payment that it is treating the benefit as compensation, the executive’s services do not count as consideration in the reasonableness analysis. The entire benefit becomes an excess benefit automatically, regardless of what the market would have paid for the work.¹

The organization shows intent by reporting the benefit as compensation on the appropriate federal tax form (W-2, 1099, or Form 990) when originally filed, or on an amended return filed before the IRS begins examining either the organization or the disqualified person for that year. A reasonable cause exception exists for reporting failures, but the organization has to show significant mitigating factors and that it acted responsibly before and after the failure.¹ Every economic benefit flowing to a disqualified person needs to land on a tax form. Undocumented perks, unreported use of organization property, and off-the-books payments create liability on their own terms.

The New-Hire Exception

Section 4958 does not apply to fixed payments under an initial contract with a person who was not a disqualified person immediately before signing.¹¹ When an organization recruits an outsider into a leadership role, the pay set in that first employment agreement is shielded for the original term of the contract.

The shield is narrow. A fixed payment must be an amount specified in the contract or set by a fixed formula, with no discretion over whether to pay or how much. If the organization can terminate the contract without the other party’s consent and without a substantial penalty, the arrangement is treated as a new contract from the earliest date termination could take effect. Renewals and more-than-incidental changes to the payment also create a new contract that gets tested under the normal reasonableness standards.¹¹

What Boards Should Do

Set executive pay in advance, on a written record, with a conflict-free committee reviewing real comparability data for the full package, and put the minutes together within 60 days. Report every economic benefit on the right tax form when it is paid. Structure pay as fixed contractual amounts where possible so the IRS cannot use later events against you. If a review turns up an overpayment, correct it with interest before the IRS asks about it. These are the steps that put the burden of proof where the statute lets a careful board put it: on the government.

1
eCFR. 26 CFR 53.4958-4 – Excess Benefit Transaction
2
Office of the Law Revision Counsel. 26 USC 4958 – Taxes on Excess Benefit Transactions
3
eCFR. 26 CFR 53.4958-3 – Definition of Disqualified Person
4
Internal Revenue Service. IRC Section 4946 – Definition of Disqualified Person
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Internal Revenue Service. Rebuttable Presumption – Intermediate Sanctions
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eCFR. 26 CFR 53.4958-6 – Rebuttable Presumption That a Transaction Is Not an Excess Benefit Transaction
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GovInfo. 26 CFR 53.4958-6 – Rebuttable Presumption That a Transaction Is Not an Excess Benefit Transaction
8
Internal Revenue Service. Exempt Organizations CPE Technical Instruction Program – Excess Benefit Transactions
9
Office of the Law Revision Counsel. 26 U.S. Code 4958 – Taxes on Excess Benefit Transactions
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eCFR. 26 CFR 53.4958-7 – Correction
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Internal Revenue Service. Initial Contract Exception – Intermediate Sanctions