Your not-for-profit organization is probably assisted by volunteers who aren't financially compensated. But your staff — including executives — are almost certainly paid a commensurate salary and benefits for their work. Compensation issues are always tricky, but they're made more so by tax and legal requirements for nonprofits. Setting executive pay is particularly fraught because if your nonprofit isn't careful, it could be penalized or even lose its tax-exempt status.
Tax-exempt organizations are required to report new hires to the appropriate authorities in their state. In addition, they must adhere to federal and state laws regarding minimum wages. Currently, the federal minimum wage is $7.25 per hour. But many states and municipalities impose higher minimum wage requirements that supersede the federal rate.
In fact, about half of all states boosted their minimum wage rates for hourly workers after 2021. And more than a dozen states have scheduled increases to take effect in 2023. The minimum wage rate will reach as high as $15 per hour in some states.
Similarly, nonprofits are bound by federal overtime pay rules. Generally, qualified hourly workers must be paid time-and-a-half when working over 40 hours per week. State requirements vary and can be intricate, so consult with a local tax adviser and keep abreast of changes in the law.
Wages and compensation, such as bonuses, that you pay employees are deductible by your organization. This includes pay for every employee from the CEO down to part-time staffers.
Wages are subject to payroll tax, even though your organization is tax-exempt. Thus, both employees and your nonprofit have tax responsibilities.
For 2022, the 6.2% Social Security portion of federal payroll tax applies to the first $147,000 of wages. Amounts above this wage base aren't subject to the tax. However, the 1.45% Medicare portion of federal payroll tax applies to all wages, including those above $147,000.
As with for-profit ventures, your nonprofit must remit payroll tax promptly. Failure to do so may result in penalties, plus interest, on the back taxes you might owe.
The law limits how much nonprofits can pay their highest-earning employees, such as CEOs and executive directors. You may pay them only a "reasonable" amount for services actually rendered. Any amount the IRS deems to be "unreasonable" is nondeductible and could result in penalties.
Unfortunately, there are no hard-and-fast rules for determining reasonable compensation. Obviously, if an employee shows up for work only to collect a paycheck, that's a problem. But most cases involve hard-working executives and boards whose judgments in setting compensation may be challenged.
When setting executive compensation, your board should consider the following:
To ensure that you consider all relevant factors, assemble an independent body to process the data and make recommendations. Then have your board review the entire compensation package. It's essential to keep detailed minutes of board discussions about compensation in the event an IRS challenge arises.
The Tax Cuts and Jobs Act (TCJA) added more burdens to nonprofits trying to set reasonable compensation. Under the TCJA, tax-exempt organizations are assessed a hefty excise tax if they pay more than $1 million in remuneration to certain "covered employees." This excise tax rate is equal to the corporate tax rate — currently, a flat 21%.
Note that "remuneration" includes wages paid that are subject to federal income tax withholding, such as salary and bonuses, plus amounts included in gross income under a nonqualified deferred compensation plan. A "covered employee" is defined as one of an organization's five highest-compensated employees (HCEs) who received $100,000 or more in reportable wages.
As long as you observe all applicable laws, your nonprofit generally can pay employees what you feel they deserve. But if you're unsure about potential risk or whether you're inviting IRS scrutiny, contact us.
Get in touch today and find out how we can help you meet your objectives.
