1

Ben Beezy
6-11-2012
Nonprofit Management

Executive Compensation in Nonprofits: Key Issues and Recommendations

I. Introduction:

In contrast to popular notions that nonprofits are an insignificant part of the
American economy, they account for 9% percent of all salaries paid, 5.4% of the national
GDP, and $290 billion in charitable giving.
1
Although compensation to nonprofit
managers is generally lower when compared to for-profits managers,
2
many at well-
funded nonprofits are awarded considerable income. Some CEOs literally make millions
of dollars.
3
Recent scandals though have brought light to the issue of what should be
considered reasonable executive compensation. In New York State for example,
Governor Andrew Cuomo recently established a special taskforce to investigate executive
compensation after a New York Times article exposed that executives at a Medicaid-
financed health center were earning over $1 million in compensation.
4

The purpose of this paper is to provide a clearer picture of what constitutes
reasonable compensation to nonprofit executives. It offers arguments about what kind
of standards should govern nonprofit board members from federal, state, or derivative
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action. A better understanding of this and other legal doctrines will help nonprofit
directors and officers avoid legal complications that may result from setting executive

1
Financial Bootcamp. Presentation given by Rick Semtanka of Haskel & White LLP. May 14, 2012.
2
http://www.bls.gov/opub/cwc/cm20081022ar01p1.htm (Bureau of Labor Statistics, April 15, 2009).
3
http://www.usatoday.com/money/companies/management/2009-09-27-nonprofit-executive-
compensation_N.htm
4
Using Scandal to Make a Point: Cuomo and Nonprofit Executive Salaries.
WRITTEN BY RICK COHEN. CREATED ON WEDNESDAY, 10 AUGUST 2011 14:56. Nonprofit
Quarterly.
5
This is when a member of a nonprofit sues that organization.
2
compensation too high. This paper will also provide some recommendations that can
help nonprofits avoid legal complications.
II. Executive Compensation: A Basic Framework
A. Relevant Law:
The key distinction between a for-profit and nonprofit is that there cannot be any
private inurement in a nonprofit. The 501(c)(3) tax code states that an organization that
is eligible for tax-exempt status is one where no part of the net earnings of which inures
to the benefit of any private shareholder or individual.
6
Many nonprofits violate this
condition when paying excessive compensation to its managers. It is worthy to note that
compensation includes all economic benefits, such as pensions, use of nonprofit assets,
severance, etc.
7
The reigning standard by which state and federal governments judge
whether executive compensation is appropriate is whether it is just and reasonable.
8

This standard is an objective standard, which asks whether an ordinary person would find
the compensation to be appropriate.
Another standard that state and federal governments could have adopted would
have been a subjective standard that would ask whether compensation was fair through
the eyes of the particular board in question. The government decided that the stricter
reasonable objective standard was necessary in order to deter nonprofits from
breaching the public trust. Thus, if a board is found to have awarded unreasonable
compensation to its managers, the IRS can revoke the tax-exempt status of the
organization or impose intermediate sanctions.
9


6
26 U.S.C.A. 501 (West).
7
See 26 C.F.R. 53.4958-4(b)(ii)(B)
8
Supra note 1.
9
http://www.irs.gov/charities/charitable/article/0,,id=123298,00.html (describes intermediate sanctions).
3
The IRS attempts to deter setting excessive compensation for executives by
requiring specific disclosures in its mandated Form 990. In particular nonprofits must
disclose: 1) the number and list of independent voting members on the governing body of
the nonprofit; 2) whether the nonprofit has a written conflict-of-interest policy; and 3)
whether the nonprofit's officers, directors or trustees, and key employees are required to
disclose interests that could give rise to conflicts.
10

Realizing the difficulties of setting reasonable compensation, the IRS created a
safe harbor for nonprofits that can be used to defend against IRS inquires. If
compensation is paid within the parameters of the safe harbor, the organization creates a
rebuttable presumption that the compensation package paid to the executive is
reasonable.
11
The safe harbor is listed in Treasury Regulation section 53.49586 and 26
Code of Federal Regulation section 53.49586 which states the following parameters: 1)
the compensation arrangement is approved in advance by an authorized body of the
applicable tax-exempt organization composed entirely of individuals who do not have a
conflict of interest; 2) the authorized body obtained and relied upon appropriate data as to
comparability prior to making its determination; and 3) the authorized body adequately
documented the basis for its determination concurrently with making that determination.
If these three criteria are met, then the Internal Revenue Service may rebut the
presumption only if it develops sufficient contrary evidence to rebut the probative
value of the comparability data relied upon by the authorized body.
12


10
Thomas Lee Hazen & Lisa Love Hazen, Punctilios and Nonprofit Corporate Governance-A
Comprehensive Look at Nonprofit Directors' Fiduciary Duties, 14 U. Pa. J. Bus. L. 347, 367-68 (2012).
11
Brent T. Wilson, Compensation and Private Inurement in Charitable Organizations: How Much Is Too
Much?, 54 Advocate 23, 24 (2011).
12
Treasury Regulation section 53.49586 and 26 Code of Federal Regulation section 53.49586.
4
Many states, including California, have adopted additional regulations for
nonprofits incorporated in their jurisdictions. California Government Code 12586(g) or
popularly known as the California Nonprofit Integrity Act provides that the board of
directors of a charitable corporation or an authorized board committee must review and
approve compensation of its top managers including the CEO and CFO to assure that it is
just and reasonable. The review and approval process is supposed to begin upon
hiring, and whenever the term of employment is renewed or extended, or if compensation
is modified. Separate review and approval is not required if a modification of
compensation extends to substantially all employees. Similar procedures are required if a
nonprofit decides to team with another nonprofit or corporation.
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B. Enforcement:
The IRS is probably the most feared entity that can probe a nonprofit because it
has the power to revoke a nonprofits tax-exempt status, but recent scandals in executive
compensation have resulted in more involvement by state attorneys general.
Additionally, disgruntled directors or organization members are bringing more derivative
suits against nonprofit boards to enforce policies.
Nonprofit statutes typically give their state attorneys general the authority to
police nonprofits. The California Nonprofit Integrity Act provides the attorney general
with a broad set of powers to monitor the states incorporated nonprofits. In 2010, for
example, in a highly publicized situation involving the near dissolute foundation for the
Museum of Contemporary Art (MOCA) in Los Angeles, former Attorney General and
current Governor Jerry Brown explored holding the directors who approved controversial

13
Nonprofit Board Standard of Care, Risk Management, and Audit Committee Responsibility by David
Tate, Esq., San Francisco, California, http://davidtate.us, tateatty@yahoo.com, May 19, 2011, Page 4 of 19.

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expenses accountable even though they did not gain personally. Brown required
corrective actions forcing MOCA board members to receive additional training in
educating them about their fiduciary duties.
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In fact, many states attorneys general are
lobbying legislatures to grant them with more power to regulate nonprofits. Bills in the
Massachusetts and Oregon state legislatures were introduced that would have given their
state attorneys general oversight to approve nonprofit executive compensation if passed.
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The rationale behind this movement is that nonprofits should be heavily scrutinized
because they receive special benefits from the state. As more scandals are exposed, states
are likely to follow in Californias footsteps and pass stricter regulations.
Another way excessive executive compensation is challenged is through member
derivative suits. In the for-profit context, shareholders have the opportunity to sue the
company for breaches of fiduciary duty. In California, members of an organization can
do the same.
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Many of the derivative suits filed though have not been against
philanthropic nonprofits.
17
Also, directors have little to fear from such suits because
most attorneys will not take such cases because of the limited ability to be awarded
attorneys fees by a judge. Further, directors have certain statutory and common law
immunities that would protect them from such suits as well.



14
http://articles.latimes.com/2010/apr/16/entertainment/la-et-moca-20100417.
15
Supra note 10, 409.
16
http://www.runquist.com/article_cabar1099.htm.
17
Id. It seems like homeowners against homeowners associations have brought most suits. See Lamden
v. La Jolla Shores Clubdominium Homeowners Assn. (1999) 87 Cal.Rptr.2d 237, 21 Cal.4th 249, 980 P.2d
940.
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III. Should the Business Judgment Rule Apply the Same Way to Nonprofits as For-
Profits?
In light of recent executive compensation scandals and new financial laws that
attempt to enhance government oversight over financial industry executives, new policy
debates have developed about whether nonprofit boards should have the same legal
protections as for-profits. Nonprofit and for-profit board members would likely face
liability for breaching the duties of care, loyalty, and disclosure, if found to have
prescribed excessive compensation in an inappropriate manner.
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Nonprofit and for-
profit board members must be found to have discharged their fiduciary duties in order to
escape liability. However, there is some debate as to whether the business judgment rule
the chief defense used to counter a suit for breaching a fiduciary duty which says that
courts will not second guess a boards business decisions applies to nonprofit board
members as well.
A. Arguments Against:
Although there is a lack of consensus among state courts, and the California
Supreme Court has yet to rule on the issue, it seems likely that nonprofit board members
are protected by the business judgment rule. The question remains though as to what
extent. One of the main cases that addresses this issue is the Minnesota Supreme Courts
decision in Janssen v. Best & Flanagan.
19
In that case, the board of directors of the
Minneapolis Police Relief Association (MPRA) made an unlucky investment in a
company and consequently lost around $15 million. Certain members of the MPRA
brought a derivative suit on behalf of MPRA against the law firm Best & Flanagan

18
Wests Ann.Cal.Corp.Code 7231.
19
662 N.W.2d 876 (Minn. 2003).
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alleging attorney malpractice with respect to the investment.
20
One of the key issues was
whether the law firm, as special counsel to nonprofit, could use the business judgment
rule as a defense. The Court adopted the same rationales for the business judgment rule
to nonprofits. It accepted that courts are ill equipped to evaluate all business decisions,
and should foster a policy that encourages board members to serve and take risks.
However, the decision left open as to which version of the business judgment rule
should be applied. For instance, courts may set an easier standard for plaintiffs to pierce
the business judgment rule defense.
21
Generally, courts require plaintiffs to prove that
defendant board members were grossly negligent in their business decisions in order to
bypass the business judgment rule. Because courts have not yet addressed whether this
should be the accepted standard, it is conceivable that courts could allow plaintiffs to
pierce the business judgment rule by proving just ordinary negligence, which is a much
lower standard.
22

There are several policy reasons being offered for why an ordinary negligence
standard would be desirable. One reason is that because nonprofits are given resources
and benefits that would otherwise be returned to the public through taxes, they should be
held to a higher level of accountability when managing those funds.
23
In respect to
donation driven nonprofits, donors do not have an exit option for their investment.
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Once donations are given, donors do not have the option to recover them. This is contrast
to for-profit counterparts who can divest their equity stake if the business they invested in

20
Id. at 880.
21
Mark Fellows, Note: A Business or A Trust?: Janssen v. Best & Flanagan and Judicial Review of for-
Profit and Nonprofit Board of Director Decisions, 30 Wm. Mitchell L. Rev. 1503, 1517 (2004).
22
Id.
23
Denise Ping Lee, The Business Judgment Rule: Should It Protect Nonprofit Directors?, 103 Colum. L.
Rev. 925, 948 (2003).
24
Id.
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makes a poor business decision. In this way, nonprofit stakeholders have less power to
check a nonprofits leadership.
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There is also the worry that because directors and officers are hard to remove
there is a greater risk that nonprofits will tolerate an unnecessary level of incompetence.
Law Review author Denise Ping Lee believes that the single most important reason why
the business judgment rule should not be applied to nonprofits is that the nonprofit
sector lacks comparable market mechanisms to control director misbehavior.
26
In
essence, because the market supplies more available information about corporate
processes due to transparency laws, for-profit stakeholders are better informed. They can
then chose to place more accountability on for-profit directors and officers who will then
be more cautious in their dealings. Shareholder voting, proxy votes, and potential for
takeovers, constantly keep for-profit directors in check. Therefore, Ping asserts that
tougher judicial and statutory standards should be imposed to ensure a basic level of care
on the part of nonprofit directors.
B. Arguments For:
Assertions making it easier to sue nonprofit directors and officers are generally
balanced against the ability of nonprofits to attract competent or exceptional directors and
officers. If legal standards are lowered to make it easier to sue nonprofit directors and
officers, then candidates will likely turn away to government or private sectors. This is
especially relevant for directors and officers overseeing social enterprise efforts because
more business decisions about operations have to be made. It is argued that just like their
for-profit counterparts, nonprofit directors and officers should be able to take risks to

25
Id.
26
Id. at 958.
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increase economic growth for their respective organization. If directors and officers are
more likely to be held liable, fewer risky business decisions will be made, and may
stymie the growth of their nonprofit.
As debates about director and officer liability in the nonprofit context continues,
the trend seems to be that courts are upholding protections for nonprofit directors and
officers the same way they would for for-profits. In Oberbillig v. West Grand Towers
Condominium Assn, the Iowa Supreme Court held that the business judgment rule
applied to nonprofits.
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A key part of its decision was looking to other state courts that
have adopted the rule in similar ways.
28
However, it seems likely that state legislatures
will follow Californias lead by passing statutes to ensure that boards and officers meet
additional obligations.
IV. Effective Governance and Management To Prevent Suits and Probes
A. Board Selection:
One of the best prophylactic measures an organization can take is to select a
competent and diverse group of board members. One of the key tasks of a board is
setting executive compensation. A diverse board comprised of people with different
backgrounds will enable more lively debate that will hopefully guide a board away from
rubber stamping every proposal. Similarly, nonprofits should have procedures to
ensure that members do not become entrenched in the organization. A process should be
established to make sure that new board members are entering and old ones exiting. An
involved and diverse board will be more likely to prevent excessive executive
compensation and attaching legal liability.

27
807 N.W.2d 143
28
Id. at 155.
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B. Written Policies and Committees:
Robust and comprehensive written policies that describe how compensation to
officers will be determined is extremely important in protecting the board. Not only does
it codify standards for the organization, but also helps the organization fall into the IRS
safe harbor described in Part II of this paper. Charitylawyerblog.com states, A
Compensation Policy should serve as a long-term policy on executive compensation. It
should articulate how the organization links pay to performance, strategy, values and
mission.
29
Thus, a comprehensive policy not only helps insulate that organization from
government scrutiny, but is also meant to align the general strategy of the nonprofit with
its goals.
To ensure that all procedures are successfully executed, the nonprofit should
designate a specific committee to evaluate all relevant information when creating a
compensation plan. The CharityLawyer blog has even recommended that management
should be blocked from participating in any committee meeting or decision in order to
make the committee as independent as possible.
30
In general, nonprofits should look to
best practice guidelines in crafting governance mechanisms that will help prevent
substandard compensation decisions.

C. Incorporate Somewhere Else:
While nonprofits still have to comply with IRS requirements to receive tax-
exempt status, they can make strategic moves to protect themselves from strict state
regulations, especially in the growing context of state oversight of nonprofit board

29
http://charitylawyerblog.com/2011/03/08/setting-nonprofit-executive-compensation/.
30
Supra note, 29.
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decision-making. Since the California Nonprofit Integrity Acts passage and the
likelihood of other states following in its footsteps, boards must make strategic decisions
about how to deal with these added regulations. Naturally, addressing these regulations
will increase compliance costs and consume valuable time from board members
schedules. For-profits have dealt with this by mainly incorporating in Delaware, which is
perceived to have better legal and tax structures towards corporations. Strategically
speaking, it may be time for Californias nonprofits to look to a state like Delaware to
take advantage of its General Corporation Law. Doing so will help boards avoid the
onerous requirements placed by stringent state statutes, and provide them with more legal
protection by incorporating in a jurisdiction where laws governing directors and officers
liability are more beneficial.
V. Conclusion
Although no perfect measure exists that will fully insulate board members from
issues involving executive compensation, there are several procedures that can be
implemented to make sure the process is done to prevent impropriety. Nonprofits should
focus on developing a competent board with a wide set of procedures to benefit from the
IRS safe harbor, and avoid investigations by state attorneys general or upsetting
stakeholders. Finally, directors and officers should be aware that legislatures and courts
are in the process of deciding a body of law that may have different implications for
nonprofits as opposed to for-profits, and should institute best practices to prepare for
stricter legal impositions.