Q&A #55 – What Board members are considered independent for purposes of reviewing executive compensation?
Question: I serve on the Board of Directors of a 501(c)(3) pubic charity and we are in the process of reviewing a compensation package for our Executive Director. Prior to our involvement with the organization, the Executive Director and I worked together at the same for-profit company. I still work there, but the Executive Director left the company several years ago. Do I need to abstain from this process in order to satisfy the “review and approval by independent persons” requirement in Part VI, Line 15 of the Form 990?
Answer: As with the comparability data question that we discussed in Q&A #54, the key guidance addressing independent review and approval of executive compensation for Form 990 purposes is set forth in Treas. Reg. § 53-4958-6. The key principle is that the persons reviewing and approving executive compensation should not be in a position to economically benefit from the compensation and should not be family members of the person receiving the compensation or otherwise have a business or employment relationship with this person. In other words, the persons reviewing and approving executive compensation should not have an actual conflict of interest with respect to the compensation.
Treas. Reg. § 53-4958-6 sets forth five criteria that must be satisfied to ensure that the persons reviewing and approving compensation do not have a conflict of interest:
These persons must not be “disqualified persons” benefitting from the compensation or a “family member” of the person receiving the compensation;
These persons must not be in an employment relationship subject to the direction or control of the of the person receiving the compensation (for example, if the Executive Director is your supervisor);
These persons must not be receiving compensation or payments subject to the approval of the person receiving the compensation (for example, if the Executive Director is responsible for approving payments to you or your business as an independent contractor for any entity);
These persons must not have a material financial interest affected by the compensation; and
These persons must not have an arrangement to approve compensation in exchange for having their own compensation approved.
In your case, the fact that you were previously employed by the same company as the Executive Director would not, by itself, create a conflict of interest that would require you to abstain from the review and approval process. However, you should review your organization’s conflict of interest and/or executive compensation policies to determine whether you are required to abstain as a matter of organizational policy. Further, it might be prudent to abstain regardless if your previous ties to the Executive Director could cause a perception (internally or externally) that you are not independent.
Planning Tip – Consider updating your organization’s formal executive compensation policy (or adding one if your organization does not currently have such a policy) to fully reflect the guidelines discussed above. Additionally, consider adding a separate executive compensation committee that is made up of a subset of independent Board members. This committee, rather than than the full Board, would handle the annual executive compensation review process, thus narrowing independence issues to a smaller subset of Board members. These steps will help ensure that best practices are followed and give you the appropriate documentation to answer Part VI, Line 15 of the Form 990 in the future.
As we discussed in Q&A #54, this process is not strictly mandatory, since the ultimate legal question is whether the compensation is reasonable (and therefore not in violation of the “excess benefit transaction” rules). However, following the process for independent review of executive compensation provides crucial protection against potential violations of the excess benefit transaction rules. Just as importantly, this process is critical for demonstrating a nonprofit organization’s commitment to transparency and accountability, and therefore the trust of your donors and the public.
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