Compensating a nonprofit organization’s board members often meets with skepticism, though federal law does not impose an outright ban on paying directors for their time or services. While volunteer service is the widely accepted model, navigating this area requires strict adherence to federal and state regulations. These rules prioritize the organization’s public benefit mission over any private gain. Compliance demands establishing clear policies and processes to ensure any financial transaction involving an insider is justifiable, transparent, and defensible to regulators and the public.
The Fundamental Rule of Nonprofit Board Service
The baseline expectation for nonprofit board members is volunteer, uncompensated service, aligning with the organization’s public service mission. Directors assume a fiduciary duty, requiring them to act with care and loyalty solely in the best financial and programmatic interests of the nonprofit. This governance role involves strategic oversight, financial accountability, and ensuring the organization remains faithful to its stated purpose.
This governance function is distinct from the operational roles performed by compensated employees, such as the Executive Director. Staff manage day-to-day operations and implement the board’s strategy, while directors are responsible for setting it. A person may hold both a compensated staff position and a board seat, but they are compensated only for their executive duties, not for their governance role. Compensating a director for governance can complicate the appearance of independent oversight, which is why uncompensated service is the sector’s default standard.
Legal Constraints on Compensation
The primary restriction on compensation is the federal prohibition against “private inurement.” This rule dictates that no part of a tax-exempt organization’s net earnings may benefit any individual with a personal interest in the organization. Since board members are considered “insiders,” any payment to them is subject to intense regulatory scrutiny. Even a minimal amount of impermissible private inurement can result in the revocation of the organization’s tax-exempt status.
To avoid violating this rule, any compensation paid to a board member must meet the standard of “reasonableness” for the services rendered. The Internal Revenue Service (IRS) imposes excise taxes, known as intermediate sanctions, on “disqualified persons” who receive an “excess benefit transaction.” This transaction occurs when the economic benefit provided by the nonprofit exceeds the fair market value of the services or property received in return.
The disqualified person, often an officer or director, is subject to an initial tax of 25% of the excess benefit. Organization managers who approved the transaction can also face penalties. Determining reasonableness involves a facts-and-circumstances test, comparing the proposed compensation to what similarly situated organizations pay for comparable services.
Nonprofits can establish a “rebuttable presumption of reasonableness” by relying on comparable data and having the compensation approved by an independent body of the board. This process shifts the burden of proof to the IRS if the agency later challenges the payment, providing a strong defense against claims of excessive compensation.
Distinguishing Compensation from Reimbursement
It is essential to differentiate between paying a director for service and reimbursing them for out-of-pocket expenses incurred on the organization’s behalf. Reimbursement for necessary expenses, such as travel, mileage, meals, and lodging related to board meetings or organizational business, is generally permissible. These payments are not considered compensation because they prevent the director from suffering a personal financial loss due to their service.
For reimbursements to be non-taxable and legally acceptable, they must be part of an “accountable plan” requiring strict documentation. Directors must submit expense reports that include receipts, the business purpose, and the time and place of the expenditure. If a board member receives a flat stipend or allowance without providing proper documentation, the IRS may treat the payment as taxable compensation, subjecting it to reporting requirements and scrutiny.
Paying Board Members for Professional Services
A separate scenario arises when a board member possesses specialized skills and provides professional services that fall outside their governance duties. For example, a director who is an attorney or accountant may be hired to provide legal counsel or conduct an audit. This is permissible, but the transaction must be structured as an “arms-length transaction” to ensure the organization’s interest is protected.
The board must demonstrate that the services were necessary and executed at fair market value, similar to what any independent third party would charge. To validate fair market value, the organization should document that it solicited competitive bids or used comparable market data to justify the rate paid. The director providing the service must not be involved in the discussion or vote to approve the contract, strictly adhering to conflict of interest protocols.
Essential Governance and Conflict of Interest Procedures
Conflict of Interest Policy
Sound governance requires the adoption and rigorous enforcement of a written Conflict of Interest (COI) Policy, especially when considering any financial transaction with a director. This policy serves as the organization’s internal control mechanism. It helps identify, disclose, and manage situations where a director’s personal or financial interests could influence a board decision. The policy must clearly define what constitutes a financial interest and outline the steps for handling a potential conflict.
Review and Documentation Process
When a transaction involving a director is reviewed, the interested director must fully disclose the nature of their financial interest to the board. The interested party must then recuse themselves from the discussion and be absent when the board votes on the matter. A majority of the disinterested, independent board members must review the transaction, confirm its necessity, and determine by vote that it is fair and reasonable. All steps of the disclosure, discussion, and voting process must be meticulously documented in the official board minutes for regulatory review.
Transparency and Reporting Requirements
Compliance requires public transparency through mandatory reporting to the IRS. Tax-exempt organizations must disclose all compensation paid to officers, directors, and trustees on their annual information return, IRS Form 990. Since this form is a public document, compensation details are available to donors, grantmakers, and the general public.
The compensation reported includes salary, fees, bonuses, and non-taxable benefits paid by the organization and any related entity. Any director who receives compensation must have that payment listed in Part VII of Form 990. This public disclosure acts as an accountability measure, reinforcing the need for the board to ensure compensation decisions are justifiable.