One of the primary responsibilities of a nonprofit board is to hire and supervise the executive director (if there is one), including setting appropriate compensation every year. Setting compensation is important for two reasons, one legal and one equitable.
Legally, the IRS doesn’t like to see executive directors being paid substantially more than people doing comparable work elsewhere, and board members can be held personally liable when it is caught; in egregious cases, the nonprofit status can be revoked.
Equitably, asking an honest executive director to set their own salary is unfair. Executive directors know how hard it is to raise funds and will often short themselves in order to save money for programs; they end up underpaid – and often don’t last as long in the position. Board members owe it to a good executive director to decide on a fair wage rather than asking the executive director to judge themselves, and then to make sure that the funds are raised to pay the salary as well as support programs. (A bad executive director should be replaced so that the organization can achieve its goals.)
According to Guidestar,
A nonprofit’s board can shield its members and the organization’s executives from intermediate sanctions and protect the nonprofit from the possibility of revocation of nonprofit status by:
1. Approving compensation in advance; the board must ensure that no one who participates in the decision has a conflict of interest concerning the transaction.
2. Basing its decision on comparability data obtained before the compensation is approved.
3. Documenting the decision-making process at the time it approves the compensation. The IRS specifies that such documentation “should include the terms of the transaction and the date of its approval, the members of the authorized body present during the debate and vote on the transaction, the comparability data obtained and relied upon, the actions of any members of the authorized body having a conflict of interest, and documentation of the basis for the determination.”
By following this process, a board establishes a rebuttable presumption of reasonableness. As the IRS notes, “The Internal Revenue Service may refute the presumption of reasonableness only if it develops sufficient contrary evidence to rebut the probative value of the comparability data relied upon by the authorized body.”
Every board that supervises an executive director should have a policy for setting compensation, if only to make sure that everyone remembers what has to happen every year. Laying out the process makes for consistency over the years, as many executive directors outlast most board members.
Sample Policy (to be tweaked to fit an organization, not copied verbatim):
The executive director of the organization shall be hired and supervised by the Board of Directors. The Board shall set appropriate compensation annually based on the duties and responsibilities of the Executive Director and annual performance evaluations. The compensation shall be set in advance, based on at least two/three sources of comparable-salary data obtained before the compensation is set. Any Board member with a conflict of interest may not participate in discussion regarding the executive director’s compensation.
The decision on compensation shall be documented at the time it is made, including the terms of the transaction and the date of its approval, the comparability data obtained and relied upon, the members of the authorized body present during the debate and voting on the transaction, the actions of any members of the authorized body having a conflict of interest, and documentation of the basis for the determination.