The rules for setting up nonprofit organizations are based on state statute and therefore differ from state to state. Currently, neither state nor federal law provides for a monetary cap on executive compensation, and the arm of the IRS reaches only as far as the reporting and disclosure aspect of compensation and profit.
The Private Benefit Doctrine
Initially those contributing to charities took it for granted that nonprofits would regulate themselves with regard to executive pay. What came to be known as the "private benefit doctrine" articulates what those making contributions to the nonprofit assumed: that charities should not be run for private gain but for promoting the organizational mission. After several private and public studies it became clear that this was not always the case, and a more detailed checks and balances system was called for.
The United States Treasury defines "reasonable compensation" for nonprofit executives as being commensurate to "the amount ordinarily paid for: (1) like services; (2) by like enterprises; (3) under like circumstances." In 2007, the IRS issued a "List of Good Governance Practices" as well as a checklist to aid executives in establishing procedures to meet the burden of proof set by the IRS rules.
How to Determine Reasonableness
Information and software that can help nonprofits analyze comparability data can be accessed through several sources that specialize in tracking nonprofit activity, such as GuideStar, ERI, and SalariesReview. According to GuideStar, one of the top providers of nonprofit data and analysis, "reasonableness" can best be determined by analyzing the pay levels of similar organizations, current "compensation surveys" put together by independent firms, and "actual written offers" from similar organizations to the executive.
Keeping Detailed Records
The "List of Good Governance Practices" also provides steps to ensure a ready rebuttal should there be any reporting issues from the IRS. The nonprofit should keep detailed records of who decides the amount of compensation and the data used when determining the amount of compensation. It should also have predetermined guidelines as to how and when to document the decision. Bottom line: Detailed record keeping is imperative.
Proposed Salary Caps
Recently, media attention has put some nonprofit execs in the hot seat with regard to their compensation. A 2010 New York Times article notes several nonprofits, for example The Boys and Girls Club and the American Heart Association, as having CEOs making in the upper-six figures. Such reports have induced several lawmakers to recommend salary caps for nonprofit executives. Governor Chris Christie of New Jersey, in an effort to rein in state government spending, has approved a provision in that state's budget that would include a pay cap for nonprofit executives should their organization contract with the state. However, other groups, mainly consultants for nonprofits, believe an arbitrary salary cap will adversely affect the nonprofit community by hindering the recruitment of talented leadership.