February 2, 2026

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Most small companies probably base their compensation policies on a simple analysis of the market: when hiring a new key employee, a company will likely determine how much money it can afford to spend on compensation, decide how much it will take to get the quality employee the company wants, and set the salary rate and benefits accordingly.

While a 501(c)(3) nonprofit will likely make similar considerations, did you know that “excessive compensation” can result in penalty taxes (called “excise taxes”) under federal law? Read on to understand what constitutes “excessive compensation” for certain employees of nonprofits, the consequences of such excesses, and what your organization can do to set a compensation policy that complies with the law.

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What is an excess benefit transaction, who does it apply to, and what are the penalties?

The penalties for excess benefit transactions, which include excessive compensation to certain employees, directors, or officers of nonprofits (called “disqualified persons”), are found in the Internal Revenue Code.¹ Below are short summaries of the parts of the law you need to know. And to learn more about excess benefit transactions, check out Napa Legal’s series on the topic here.

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Excess Benefit Transactions

An excess benefit transaction is any transaction where a disqualified person receives an economic benefit, and the value of that benefit exceeds the value of what the disqualified person provided. Put simply, if the disqualified person is receiving more for a service than the fair market value of that service, this is an excess benefit transaction.

If an excess benefit transaction occurs, the disqualified person is subject to a 25% tax on the excess benefit. Additionally, any manager of the organization (an officer, director, or trustee) who participated knowingly in the transaction, may be subject to a 10% tax on the excess benefit (capped at $20,000 and jointly shared among all knowing participants). So if the reasonable market value of a particular executive’s salary is $150,000 and he is paid $250,000, the tax would be applied to the $100,000 excess benefit. This equates to a $25,000 tax on the disqualified person, as well as a $10,000 tax on any participating manager. The statute also identifies cases where additional taxes may be due. In addition to the financial burden of the tax, the excess benefit transactions also need to be reported to the IRS. This becomes part of the public record about your organization and can harm the organization’s reputation.

Here’s the takeaway: if your organization engages in any economic transaction with any disqualified person, the benefit the disqualified person receives needs to reflect the fair market value of his services (or less). Applied to compensation, this means any disqualified person being paid by the organization must receive a wage that reflects no more than the market value of his services. Any excess benefit is subject to severe tax consequences.

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Disqualified Persons

The term “disqualified person” refers to several types of people and entities related to a nonprofit. The term will mainly refer to anyone who, within the five years leading up to the transaction, was in a position “to exercise substantial influence over the affairs of the organization.” A family member and certain other affiliates of one of these people also count as disqualified persons. Practically, the IRS has clarified that disqualified persons include a nonprofit’s members of the board of directors, its president or other executive or operating officers, and its treasurer and/or chief financial officer.² Note that an organization cannot get around an employee’s status as a disqualified person by changing that employee’s title; it is the actual role of the employee and not his title that makes him a disqualified person. If you have any employee, officer, or director positions where you are not sure whether they are disqualified persons, speak to your attorney or accountant.

Note that, to be safe, many organizations include certain “key employees” in this policy, even if it is unclear whether those employees exercise the influence necessary to fit the definition of “disqualified person.” These organizations will often apply the compensation policy to any employee whose salary is above a certain threshold.

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What can my organization do to avoid excess benefit transactions when setting employee compensation?

Fortunately, there are very clear ways that an organization can protect itself and ensure that it is not providing excessive compensation to an employee who is a disqualified person. An IRS regulation lays out the steps that a nonprofit organization may take to create a rebuttable presumption that its transactions are not excess benefit transactions.³ A rebuttable presumption means that, if these steps are taken, the compensation will be considered not excessive, unless the government provides evidence that it is excessive despite the steps taken.

Further, an organization should make sure that, after determining a range for reasonable compensation for a position, the total compensation given to the employee will not exceed the range. So if, for example, your organization pays a variable bonus annually, you should ensure that the base salary plus anticipated bonus still falls within the reasonable range.

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Conflicts of Interest

First, the compensation arrangement must be pre-approved by the board of directors, which must exclude any individual with a conflict of interest from voting. If the person being compensated is on the board, that person must not participate in deliberations about or vote on the compensation arrangement.  

There are additional conflicts of interest that are possible. For example, if another director works for the disqualified person, receives compensation from him, or otherwise has a financial interest in the transaction, that director also must be excluded from the vote.

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Comparability Data

Second, the organization must conduct some research and assemble comparability data. This means researching other organizations of similar size that offer similar services and comparing the compensation those organizations pay an employee in a similar position. The regulation specifies that a small organization (one that receives less than $1 million per year in gross receipts) has sufficient comparability data “if it has data on compensation paid by three comparable organizations in the same or similar communities for similar services.” For larger organizations, more data will be required.

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Document the Organization’s Determination

Third, the organization must adequately document the basis of the board’s determination that the compensation is not excessive. This documentation should include:

• The terms of the transaction;

• The date the board approved the transaction;

• The members of the board who were present during the debate and who voted on the transaction;

• The comparability data and how it was obtained; and

• Any actions taken by any members of the board who had a conflict of interest related to the transaction.

These steps should be taken any time the board needs to approve compensation (or any other economic transaction) related to a disqualified person.  

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What does an appropriate compensation policy look like for a 501(c)(3) nonprofit?

To comply with these provisions and avoid an excess benefit transaction when approving compensation for your executives and key employees, your organization should have an official compensation policy in place. While a full compensation policy will be several pages long and will be specific to your organization’s size and particular needs, here are some elements that a good compensation policy for a nonprofit will include:

• An introduction explaining the purpose of the policy to protect the organization against excess benefit transactions.

• A reminder of the standards of conduct to which the board of directors is held (either by law or the organization’s bylaws) when making decisions regarding compensation.

• A list of the types of compensated positions in your organization (directors, officers, key employees) that trigger the requirements of the agreement. Depending on the size and structure of your organization, that list might look something like this:

This policy applies to the review and approval of the compensation of directors, officers, the executive director or chief operating officer, the treasurer or chief financial officer, key employees, and highest compensated employees of the Corporation (collectively, the “Designated Employees”; individually, a “Designated Employee”)). For purposes of this policy, a “key employee” is any employee whose annual reportable compensation is more than $150,000 and a “highest compensated employee” is any employee (other than an officer or key employee) whose annual reportable compensation is more than $100,000.

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The steps that the organization must take to create a rebuttable presumption that the compensation is not excessive (as discussed above, this means approval of the compensation arrangement in advance by the board, gathering of comparability data from similarly situated organizations, documentation for the basis of the board’s determination, and documentation explaining how any board members with conflicts of interest were handled). Based on the laws explained above, the following sample language for this portion of your compensation policy might be a helpful starting point:

The board of directors (the “Board”) shall review and approve compensation for the Designated Employees based on the following process:

a. Compensation shall be reviewed and approved by the Board, provided that directors with a conflict of interest with respect to the compensation arrangement shall abstain from voting on the applicable compensation matter.

b. The Board shall make an affirmative determination that the compensation is reasonable to the organization based on information sufficient to determine whether the value of services is the amount that ordinarily would be paid for like services by similar organizations, whether tax-exempt or taxable, under similar circumstances. Relevant information includes, without limitation, compensation levels paid by similarly-situated organizations, both tax-exempt and taxable, for functionally comparable positions; the availability of similar services in the geographic area of the organization; current compensation surveys compiled by independent firms; and actual written offers of employment from similar institutions competing for the services of the compensated person. If the organization has average annual gross receipts of less than $1 million for the prior three tax years, the Board will have appropriate comparability information if it has information on compensation paid by three comparable organizations in the same or similar communities for similar services. (See Treas. Reg. § 53.4958-4(b).)

c. The review and approval of the Board of compensation arrangements shall be promptly recorded in the minutes of its meeting and shall include the following:

i. The terms of the compensation and the date approved;

ii. The names of the directors who were present during the discussion and those who voted on the approved compensation;

iii. The comparability data obtained and relied upon, and how it was obtained;

iv. Any action taken with respect to consideration of the compensation by a director who had a conflict of interest with respect to the compensation arrangement; and

v. If the reasonable compensation is higher or lower than the range of comparability data obtained, the basis for the decision. The minutes from the meeting shall be reviewed and approved by the Board as reasonable, accurate, and complete within a reasonable time after the review and approval of the compensation.

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Conclusion

After you have read through this introduction, what should your next steps be? First, check whether your organization currently has a compensation policy. If it does, make sure that the compensation policy addresses the issue of avoiding excess benefit transactions.

If your organization does not have a compensation policy or the one you have is not adequate, start thinking through the issues presented here. Look at all the paid positions in your organization (directors, officers, and key employees) that legally qualify as “disqualified persons,” as well as any other positions that may exercise “substantial influence” over the affairs of the organization to decide which positions should be covered by the policy. From there, you may want to speak to an attorney to create a policy that will protect your organization.

By understanding these principles, following them, and creating a comprehensive compensation policy, you will be well on your way to ensuring that you avoid the costly mistake of entering into excess benefit transactions when compensating your directors, officers, or employees.

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¹ 26 U.S. Code § 4958.

² 26 C.F.R. § 53.4958-3.

³ 26 CFR § 53.4958-6