Nonprofit Board Governance and Compensation: How to Set Pay Without Triggering Intermediate Sanctions

Before 1996, the IRS had exactly two options when a tax-exempt organization overpaid an insider: do nothing, or revoke the organization’s tax-exempt status entirely. Revocation was a nuclear option that punished the organization (and its beneficiaries) for the actions of one person, so the IRS almost never used it. Congress recognized the gap and enacted IRC 4958 as part of the Taxpayer Bill of Rights 2, creating a middle path: excise taxes that land on the person who received the excess benefit and on the managers who approved it, without destroying the organization itself. That middle path is why the rules are called “intermediate sanctions.” The concept is straightforward, but the governance process required to stay on the right side of it trips up nonprofits constantly. This guide covers how boards should structure that process from start to finish.

What are intermediate sanctions, and why do they exist?

The term “intermediate sanctions” describes the penalty regime under IRC 4958 because the excise taxes sit between the two extremes the IRS had before 1996. On one end: ignoring excessive compensation entirely. On the other: revoking the organization’s exemption under IRC 501, which would terminate the charity’s ability to receive tax-deductible donations and could shut it down. Intermediate sanctions target the individual who benefited from the transaction, not the organization, making enforcement proportionate and practical.

The regime applies to organizations described in IRC 501(c)(3) and 501(c)(4). It covers any transaction in which a disqualified person receives an economic benefit from the organization that exceeds the value of what they provided in return. Compensation is the most common trigger, but the rules also reach property sales, loans at below-market rates, rental arrangements, and any other transfer of economic value. The IRS evaluates the total benefit received, not individual line items, so a salary that looks reasonable on its own can still produce an excess benefit when you add the retirement contributions, housing allowance, car, club memberships, and other perks.

Who’s a “disqualified person”?

The definition under IRC 4958(f)(1) reaches further than most board members expect. A disqualified person is anyone who was in a position to exercise substantial influence over the organization’s affairs at any time during the five-year period ending on the date of the transaction. The statute and regulations at Treas. Reg. 53.4958-3 specifically include:

• Officers, directors, and trustees of the organization, regardless of whether they receive compensation
• Key employees, meaning the top management and administrative officials by function (not just title), including the CEO, CFO, COO, and anyone who manages a discrete segment of the organization’s activities
• Substantial contributors, meaning anyone who contributed or bequeathed more than $5,000 in a year if that amount is more than 2% of the organization’s total contributions for that year
• Family members of any of the above: spouse, siblings, children, grandchildren, great-grandchildren, and the spouses of all those relatives
• 35%-controlled entities, meaning any corporation, partnership, trust, or estate in which any combination of the above persons holds a 35% or greater ownership or beneficial interest

The “substantial influence” test is fact-specific. The regulations list factors that weigh in favor of substantial influence: the person founded the organization, their compensation is based on the organization’s revenues, they control a significant portion of the organization’s capital, or they manage a discrete segment of operations. A major donor who holds no formal title but whose preferences consistently drive board decisions could qualify. The five-year lookback means a founder who resigned from the board three years ago and now negotiates a consulting contract is still a disqualified person for purposes of that contract.

What’s an “excess benefit transaction”?

An excess benefit transaction under IRC 4958(c) occurs when the organization provides an economic benefit to a disqualified person that exceeds the value of what the person provides in return. For compensation, the question is whether total pay exceeds what the organization would need to pay to attract someone of comparable qualifications for the same role at a comparable organization.

“Total compensation” means everything. The IRS adds up base salary, bonuses, severance, retirement plan contributions (employer match, defined benefit accruals), deferred compensation, housing allowances, car allowances, below-market loans, personal use of organization property, club memberships, insurance premiums beyond what is standard, and any other economic benefit the organization provides. If the executive director receives a $200,000 salary, a $25,000 retirement contribution, a $12,000 car allowance, and use of a $500,000 organization-owned condo for two weeks per year, the IRS evaluates the entire package against comparables, not just the W-2 amount.

Non-compensation transactions also count. If the organization buys property from a board member at an inflated price, or rents office space from a director’s LLC at above-market rates, the excess over fair market value is an excess benefit. Revenue-sharing arrangements (such as paying a development director a percentage of funds raised) receive heightened scrutiny because they can produce compensation far in excess of what’s reasonable if fundraising results spike.

What excise taxes apply when the line is crossed?

IRC 4958 imposes three layers of personal tax, and none of them can be shifted to the organization.

The disqualified person who received the excess benefit pays an initial tax of 25% of the excess amount. If the IRS determines that total compensation of $350,000 was $100,000 above what was reasonable, the initial tax is $25,000. That tax is reported on Form 4720 and is not deductible.

If the disqualified person does not correct the excess benefit within the “taxable period” (which runs from the transaction date to the earlier of the IRS mailing a notice of deficiency or assessing the initial tax), an additional tax of 200% of the excess benefit applies. In the same example, that is $200,000 on top of the $25,000 initial tax.

Organization managers (any officer, director, or trustee) who knowingly participated in approving the excess benefit transaction owe a tax of 10% of the excess, capped at $20,000 per transaction. “Knowingly” includes actual knowledge that the compensation was excessive, awareness that it might be excessive, or constructive knowledge based on information that was available. A manager who relies in good faith on a professional opinion (a compensation study, legal counsel’s written advice) is generally protected from the “knowing” standard.

“Correction” means the disqualified person repays the excess benefit amount to the organization, plus interest at the applicable federal rate. Correction eliminates the 200% second-tier tax but does not wipe out the 25% initial tax. The math makes early correction overwhelmingly preferable: $25,000 in initial tax versus $225,000 in combined taxes if the correction window closes.

How does the rebuttable presumption of reasonableness work?

The rebuttable presumption is the single most important procedural protection available to a nonprofit board. When all three requirements of Treas. Reg. 53.4958-6 are met, the burden of proof shifts from the organization to the IRS. Instead of the board having to prove compensation was reasonable, the IRS must prove it was not. In practice, the IRS rarely pursues an excess benefit case against an organization with a well-documented presumption in place.

Requirement 1: Approval by an independent body. The compensation must be approved by an authorized body composed entirely of individuals who have no conflict of interest with respect to the transaction. The authorized body can be the full board (with conflicted members recused), a compensation committee, or an executive committee, as long as every voting member is independent. “Independent” means the member does not have a financial interest in the transaction: they are not the person being compensated, they are not a family member of that person, they do not receive compensation from that person, and they are not involved in business transactions with that person that could create a reciprocal benefit. The person whose compensation is being set must not be in the room during deliberation or voting.

Requirement 2: Reliance on appropriate comparability data. Before voting, the independent body must obtain and consider appropriate comparability data. What qualifies depends on the organization’s size and budget:

• For organizations with annual revenue under $1 million, the regulations explicitly state that comparability data may include compensation paid by three comparable organizations in the same or similar communities for similar services. This is a lower bar than what larger organizations face.
• For larger organizations, the body should review Form 990 compensation data from organizations of similar budget size, geographic region, and mission complexity (available through GuideStar/Candid), published compensation surveys (ERI Nonprofit Compensation, Bureau of Labor Statistics, National Council of Nonprofits surveys), and, for complex packages, an independent compensation study.
• Documented written offers from other organizations are relevant comparability data when the offers come from genuinely comparable employers.

Two common errors undermine comparability. First, using for-profit benchmarks without adjustment. For-profit executive packages routinely include stock options, restricted stock, and profit-sharing that have no nonprofit equivalent; unadjusted for-profit data skews high. Second, using national data for an organization in a low-cost market, or comparing against organizations that are significantly larger or smaller.

Requirement 3: Contemporaneous documentation. The basis for the decision must be documented at or before the time of the vote. The minutes or a written report should record the terms of the compensation arrangement (each component), the date of the approval, the members present, the comparability data reviewed, how the body interpreted the data, the actions taken regarding any conflicts of interest (disclosure, recusal), and the result of the vote. “Contemporaneous” is strictly interpreted. If the board votes in January and writes up the analysis in May when the auditor asks for it, the documentation requirement is not met.

What Is Reasonable Compensation for Nonprofits?

Reasonable compensation is the amount that would ordinarily be paid for like services by like enterprises under like circumstances, the same standard applied under IRC 162. The IRS evaluates total compensation (salary, bonuses, retirement contributions, deferred compensation, housing, car, club memberships, insurance, and any other economic benefit), not just the W-2 figure. A board that benchmarks only base salary and ignores perks is benchmarking only part of the package. If base salary sits at the 50th percentile but total compensation lands at the 90th, the comparability analysis has a hole.

The process matters as much as the number. Start by establishing a standing compensation committee (or designating the full board minus conflicted members) with a written charter that describes its authority, its independence requirements, and its annual responsibilities. The committee should meet at least once per year to review and approve executive compensation, and that meeting should be a scheduled agenda item, not an afterthought.

Before the meeting, the committee should gather current comparability data. For most organizations, this means pulling Form 990 compensation data from five to ten comparable organizations (same budget range, same region, similar mission) and reviewing at least one published compensation survey. For organizations with budgets above $5 million or complex compensation arrangements, an independent compensation study every three to five years is standard practice. The cost of a study (typically $5,000 to $15,000) is negligible compared to the potential excise tax exposure.

At the meeting, the committee reviews the comparability data, discusses the organization’s compensation philosophy, evaluates the executive’s performance, and votes on the compensation arrangement. Every component of the package should be on the table: base salary, bonus structure, retirement contributions, deferred compensation, expense reimbursement policies, fringe benefits, and any non-cash benefits. The committee should explicitly state where the approved total falls relative to the comparables and why that positioning is appropriate.

The committee secretary (or a designated note-taker) documents the entire process in the minutes, contemporaneously. The minutes should be detailed enough that a reader who was not in the room can understand what data was reviewed, how it was interpreted, who was present, who recused, and what the vote was. Attaching the comparability data as an exhibit to the minutes is best practice.

What if the board gets it wrong?

When an excess benefit is discovered after the fact, correction is the priority. The disqualified person repays the excess amount plus interest at the applicable federal rate, which eliminates the 200% second-tier tax. The 25% initial tax on the excess benefit still applies, but that is a far better outcome than the combined 225% exposure. The board should then fix the underlying process: obtain current comparability data, restructure the compensation committee if independence was lacking, and establish a documented annual review cycle. For a detailed walkthrough of the correction process and Form 990 disclosure requirements, see the nonprofit executive compensation guide.

What should I do next?

If your board does not have a written compensation-setting process, building one is the highest-priority step. Pull comparability data for your executive positions, convene an independent body, document the analysis, and vote. If you already have a process, audit it against the three requirements of the rebuttable presumption: Is the approving body truly independent? Is the comparability data current and appropriate? Are the minutes detailed enough to satisfy the contemporaneous documentation standard?

• Nonprofit executive compensation and Form 990 disclosure, the companion guide covering Form 990 Part VII and Schedule J reporting, common mistakes, and the correction process in detail
• Nonprofit Form 990 filing guide, the annual information return where executive compensation is publicly disclosed
• Starting a nonprofit: 501(c)(3) application, the exemption application process, including the governance policies the IRS expects to see at formation
• Nonprofit private foundation excise taxes, the parallel excise tax regime under IRC 4941-4945 for private foundations, including self-dealing rules that overlap with intermediate sanctions
• Nonprofit employee vs. contractor classification, a classification guide for nonprofits, because misclassifying a disqualified person as a contractor does not remove them from IRC 4958’s reach
• Nonprofit governance and conflict of interest, the conflict of interest policies and board oversight that support the rebuttable presumption
• Nonprofit fundraising event tax rules, the tax treatment of galas, auctions, and sponsorships, where board members who also serve as event sponsors may create disqualified-person transactions

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.