Adoption of final regulations for the Internal Revenue Service (IRS) Intermediate Sanctions (Internal Revenue Code (IRC) 4958) in 2002 prompted many 501 (c)(3) and (c)(4) organizations to formally designate a board-level committee with specific responsibility for oversight of the compensation of their most senior-level executive position(s). This governance structure was a practice adopted long ago by most for-profit and publicly-held organizations. This structure also satisfied one of three criteria stipulated by the IRS for affording a nonprofit organization the ‘Presumption of Reasonableness’ for its pay practices. The Form 990 and requested information in Schedule J provides still more evidence of an expectation of formal governance and oversight of executive pay.
While not every organization has a need for a compensation committee specifically dedicated to this subject, the need for independent board members and the proper process to govern pay is nearly universal for any tax-exempt organization that pays its senior-most executive(s). It is not unusual to find an executive committee of the board or some similar subset of the board fulfilling this role. This arrangement may have been in place for many years prior to the Intermediate Sanctions, revised Form 990 and the increased scrutiny toward executive pay practices of nonprofit and for-profit organizations alike.
In some of these organizations without a committee dedicated to compensation, longstanding methods of ‘handling’ executive pay may have failed to keep pace with the growth in size and complexity of the organization and/or IRS requirements. Generally, these organizations are categorized as having no compensation committee. The symptoms are often fairly obvious: There is little or no evidence of any policy or process for executive compensation decision-making; there are no external sources of compensation practices for comparable organizations; and there are no meaningful minutes of board discussions and decisions about pay. The oversight of executive compensation is simply a part of the annual chorus of required board votes: “Do I hear a motion? A second? All those in favor.”
Almost as troubling is another scenario in which a board compensation committee has been created, but the commitment of the organization or individual members to the committee’s role is inadequate. Admittedly, many board members assigned to the committee are often volunteers and they are frequently selected for their interest in the organization’s mission—not for their expertise in executive compensation. Nonetheless, two different causes create what can be considered as, “a compensation committee in name only.”
The first cause is a committee with members having little to no understanding of executive compensation in the nonprofit sector and little or no interest in learning any more about it. These individuals often fail to engage in the discussions and decisions that directly impact the leadership of the organization. Careful consideration of competitive pay practices, thoughtful discussions about the organization’s beliefs about pay, effective evaluation of executive performance and related pay actions are not present. Compensation decision-making is often reduced to predictable, annual upticks in executive salary with sporadic attention to other components of pay (e.g., retirement benefits, life insurance, etc.), often without regard to the executive’s total compensation program.
The second cause is membership turnover. Significant changes in the makeup of the committee on a year-to-year basis can severely reduce its ability to be effective. Without the benefit of any compensation subject matter previously given to former committee members or continuity with past discussions or decisions, new members are a compensation committee in name only. This new group of committee members is essentially starting all over again. If past committees have left no policies or processes in place, the new members will potentially need to create a compensation strategy for their tenure.
Organizations without compensation committees, or where the committee is not properly performing the role—or performing it in name only—are at risk. Inattentive or even well-intentioned decision-making without the benefit of effective policies and processes for managing executive pay may have negative consequences. At a minimum, an opportunity for an objective assessment of the executive’s performance and the reasonableness of compensation in light of competitive practices by comparable organizations may be lost. In more serious cases, an organization may be startled by the realization that executive pay has become the focal point of embarrassment and adversity.
Above all, organizations that pay their senior executive(s) would be well-advised to consider the following recommendations:
- Formally assign responsibility for oversight of executive pay to a committee of independent board members. It may be a committee already in existence, or a new compensation committee may need to be established.
- Draft a charter describing the role and accountability of the committee. In addition to monitoring competitive pay practices for comparable organizations, consider the role the committee could play in managing the performance/evaluating the effectiveness of the executive(s) for which it is responsible.
- Establish membership guidelines for the committee. Ideally, a member should serve through two or more annual cycles of the process. In addition, committee membership and committee chair terms should be staggered to ensure adequate continuity on a year-to-year basis, but also allow the introduction of new members in the process-
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By Michael Conover
This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Spring 2015). Copyright 2014 BDO USA, LLP. All rights reserved. www.bdo.com