Tax on Excess Compensation: Essential Guide for Smart Management

If you work for a nonprofit, hospital, university, or religious organization, you’ve probably heard the term “excess compensation” thrown around during budget meetings. Here’s the thing: tax on excess compensation within tax-exempt organizations isn’t just bureaucratic noise. It’s real money that can hit your organization—and sometimes individual executives—if the rules aren’t followed. And honestly? Most people get this wrong because the IRS rules are murky, the penalties are steep, and nobody wants to admit they’re unsure about what “reasonable” actually means.

Let me be direct: excess compensation happens when a tax-exempt organization pays an employee (usually a key person like an executive director, hospital CEO, or university president) more than what the IRS considers “reasonable” for the job. The organization loses its tax-exempt status for that year, gets hit with excise taxes, and the executive may owe back taxes plus penalties. It’s the kind of problem that keeps nonprofit CFOs up at night.

This guide walks you through what excess compensation really is, how the IRS catches it, and—most importantly—how to avoid it without underpaying your talent.

What Is Excess Compensation in Tax-Exempt Organizations?

Think of it this way: a tax-exempt organization gets a huge benefit from the government—no federal income tax, no state income tax in most cases, potential property tax exemptions. In exchange, the IRS expects the organization to serve the public good, not enrich its insiders.

Excess compensation is when an employee receives pay that exceeds what would be reasonable for someone doing that job in the same market. It’s not about absolute salary amounts (a hospital CEO making $500,000 might be fine; a small nonprofit director making $150,000 might not be). It’s about context.

The IRS calls this the “intermediate sanctions” rule, codified in Section 4958 of the Internal Revenue Code. Here’s what triggers it:

• An employee (“disqualified person”) receives compensation that’s unreasonable for the work performed
• The organization approved the compensation without proper diligence
• The compensation wasn’t disclosed to the board or wasn’t reviewed using benchmarking data

The sneaky part? The organization itself can lose its tax-exempt status. The executive might owe excise taxes. And both parties face audit risk. It’s not a “slap on the wrist” situation.

The “Reasonable Compensation” Test: How the IRS Judges

The IRS doesn’t have a magic formula. Instead, they use what’s called the “rebuttable presumption of reasonableness.” Basically, if your organization can prove it followed proper procedures, the IRS has to assume the compensation is reasonable—unless they can prove otherwise.

Here’s how the IRS actually evaluates compensation:

1. Market Data: What do similar organizations pay for similar roles in your geographic area and industry? (This is huge. You need actual benchmarking data.)
2. Scope of Responsibilities: Is the person managing a $50 million budget or a $5 million budget? Are they hiring and firing? Building programs from scratch?
3. Complexity of the Organization: A university president’s role is more complex than a small food bank director’s role. The pay should reflect that.
4. Prior Salary History: Did the person take a pay cut to work for your nonprofit? That’s a red flag for excess compensation.
5. Fundraising Success: Did this executive bring in major gifts or grants? That can justify higher pay—but only if you document it.

The IRS looks at Form 990 filings (the nonprofit tax return) and compares compensation across similar organizations. They use databases like GuideStar and specialized compensation surveys. If your executive’s pay is in the top 10% for similar roles but you have no documentation showing why, you’re in trouble.

Here’s the real talk: “reasonable” is subjective. That’s why documentation is everything. A $200,000 salary might be reasonable for one executive and excessive for another—depending on the evidence you collect.

Who’s Actually at Risk?

Not every employee is subject to the excess compensation rules. The IRS focuses on “disqualified persons,” which typically includes:

• Executive directors, presidents, or CEOs
• Chief financial officers and controllers
• Medical directors at hospitals
• Provosts at universities
• Board members who also receive compensation
• Major donors or their family members in leadership roles
• Consultants who are effectively running the organization

Lower-level staff—even well-paid ones—are generally safer. But here’s the catch: if a program director is making $300,000 and there’s no benchmarking to support it, they could be flagged.

The highest-risk situations involve:

• Rapid salary increases (more than 20-30% in a year without clear justification)
• Compensation that jumps after a major gift or fundraising success (the board thinks “we can afford it now”—but that’s not how the IRS sees it)
• Related-party transactions (paying a board member’s spouse or adult child a premium salary)
• Deferred compensation plans that aren’t properly documented
• Bonuses tied to fundraising without clear, pre-approved metrics

And here’s something most organizations miss: the risk isn’t just to the employee. It’s to the organization’s tax-exempt status. The IRS can revoke your 501(c)(3) status if excess compensation is deemed “substantial.”

The Real Consequences: Penalties & Excise Taxes

Let’s talk numbers, because this is where people get scared—rightfully so.

If the IRS determines compensation is excessive, here’s what happens:

1. The Organization: Excise tax of 25% on the excess amount (the difference between what was paid and what’s deemed reasonable). If the organization doesn’t correct it within a set period, the penalty jumps to 200%.
2. The Executive: Excise tax of 25% on the excess amount, plus potential income tax on the disallowed portion.
3. The Board Members: If they knowingly approved the excess compensation, they can face a 10% excise tax (capped at $20,000 per year).

Example: A nonprofit director makes $250,000. Benchmarking shows similar roles in the region pay $180,000. The excess is $70,000.

• Organization owes: $17,500 in excise tax (25% of $70,000), potentially $140,000 if not corrected (200% penalty)
• Executive owes: $17,500 in excise tax plus income tax on the disallowed $70,000
• Board members who approved it: Could owe 10% excise tax

But the financial hit is just the start. There’s also:

• Legal fees to defend the audit
• Reputational damage (Form 990 is public; excessive compensation gets reported by watchdog groups)
• Loss of donor confidence
• Potential revocation of tax-exempt status (which is catastrophic for a nonprofit)

The IRS has gotten more aggressive about this. According to Investopedia’s analysis of IRS enforcement trends, intermediate sanctions cases have increased 40% over the past five years.

Documentation & Proof: Your Defense Against Audits

Here’s the good news: if you document properly, you can defend almost any compensation decision.

The IRS gives organizations a “rebuttable presumption of reasonableness” if they can show:

1. Contemporaneous Written Documentation: The board approved the compensation in writing, before paying it (not after the fact). Minutes from the board meeting where compensation was discussed.
2. Benchmarking Data: You hired a consultant or used published surveys to compare your executive’s pay to similar roles. This data must be current (within 3 years) and relevant (same geographic area, same organization size, same industry).
3. Deliberation & Decision-Making: Board minutes showing the board actually discussed the compensation, considered the benchmarking data, and made a conscious decision. “We voted to approve” is not enough. You need “We reviewed market data showing salaries of $160,000-$200,000 for similar roles, considered the executive’s 10 years of experience and successful capital campaign, and approved $190,000 as reasonable.”
4. Conflict of Interest Procedures: If the person being compensated (or a related party) was in the room during the vote, you need documented recusal. They should have left the meeting while their compensation was discussed.

Smart organizations create a compensation policy that includes:

• A formal process for reviewing compensation annually
• A requirement to obtain benchmarking data every 3 years
• Clear documentation standards
• A conflict-of-interest disclosure form
• Board approval in writing before compensation is paid

This isn’t just defensive. It actually protects your executive too. If an audit happens, documented diligence is your shield.

5 Strategies to Avoid Excess Compensation Issues

Hire a reputable compensation consultant or use services like salary databases and industry surveys. Don’t cheap out here. A $2,000 benchmarking study beats a $50,000 audit. Compare your executive’s salary to:

• Organizations of similar size in your region
• Similar roles across your industry
• Public data from Form 990 filings of comparable nonprofits

When the compensation committee or board meets to discuss salary, make sure minutes include:

• The benchmarking data reviewed
• The executive’s responsibilities and accomplishments
• The specific decision and reasoning
• Who was recused due to conflict of interest
• The vote (unanimous? Dissenting votes?)

Example language: “The board reviewed compensation data for nonprofit executive directors managing $10-15M budgets in the Northeast region. Based on benchmarking showing a range of $155,000-$210,000, and considering Executive Director Smith’s 8 years of tenure, successful $5M capital campaign, and management of 25 staff, the board approved a salary of $185,000 for the 2024 fiscal year.”

Instead of paying all compensation in salary, consider offering a tax-sheltered annuity (403(b) plan). Employees can defer up to $23,500 (2024) into a 403(b) without it counting as taxable income. This allows you to offer robust retirement benefits without inflating the “cash compensation” number that triggers excess compensation concerns.

However—and this is critical—deferred compensation must also be reasonable. You can’t pay someone $300,000 in salary plus $100,000 in deferred comp when benchmarking shows $250,000 total is reasonable. The IRS looks at total compensation, not just salary.

If your executive gets a bonus, tie it to objective metrics approved in advance by the board:

• Fundraising targets (increase annual giving by 15%)
• Program outcomes (serve 500 additional clients)
• Operational efficiency (reduce overhead by 5%)
• Financial health (maintain 6-month cash reserve)

Document the metrics before the fiscal year starts. Then, if the bonus is awarded, you have clear evidence it was earned—not arbitrary.

If you’re paying a board member, a board member’s family member, or a major donor a salary, that’s a red flag. It’s not automatically prohibited, but it requires extra scrutiny. Get a lawyer to review the arrangement and make sure:

• There’s a written employment agreement
• The compensation is clearly documented as reasonable
• The person recuses themselves from voting on their own compensation
• The arrangement is disclosed on Form 990

Tax-Sheltered Options: 403(b) Plans & Deferred Compensation

One of the smartest ways to offer competitive compensation without triggering excess compensation issues is through tax-sheltered retirement plans. Here’s how they work:

Tax-exempt organizations and public schools can offer 403(b) plans. Employees can contribute up to $23,500 per year (2024), and if they’re over 50, they can add a $7,500 catch-up contribution. The contributions reduce their taxable income, and the money grows tax-deferred.

From a compensation perspective, this is valuable. You can offer:

• $150,000 in salary
• $20,000 in 403(b) matching
• Health insurance and other benefits

Total package: $170,000+, but the “cash compensation” number the IRS focuses on is $150,000. It’s a smart way to offer robust pay without looking excessive on paper.

Some tax-exempt organizations offer deferred compensation plans under Section 457(b). These allow executives to defer income to future years—useful if you want to offer higher total compensation but spread the tax hit.

Example: Instead of paying $250,000 in year one, you pay $200,000 in salary and $50,000 in deferred comp to be paid in retirement. The deferred portion isn’t taxed until it’s paid out, and it doesn’t inflate the current-year compensation number as much.

But here’s the catch: the IRS still looks at total compensation (salary + deferred comp) when determining reasonableness. You can’t use deferred comp to hide excess compensation. It has to be reasonable in total.

For more on how these plans work and strategic uses, see our guide on maximizing tax-sheltered annuities.

Here’s a win: health insurance premiums, retirement plan contributions, and certain other fringe benefits are generally not counted as “compensation” for excess compensation purposes. So offering robust health coverage, life insurance, and professional development doesn’t inflate the compensation number the IRS scrutinizes.

Pro Tip: Document all benefits offered. If the IRS questions compensation, you can show the total package is reasonable even if the salary alone seems high. A $180,000 salary + $30,000 in benefits + $20,000 in 403(b) match looks much more reasonable than a $180,000 salary alone.

Frequently Asked Questions

What’s the difference between excess compensation and reasonable compensation?

– Reasonable compensation is what the IRS considers fair market value for the work performed. It’s based on benchmarking data, the person’s experience, and the complexity of the role. Excess compensation is anything above that threshold. The difference is taxed and penalized.

Can a nonprofit executive ever make $500,000 or more without triggering excess compensation issues?

– Absolutely. A large hospital, university, or national nonprofit might reasonably pay a CEO $500,000 or more. The key is documentation. If benchmarking shows similar organizations pay $450,000-$550,000 for that role, then $500,000 is reasonable. The IRS isn’t saying executives can’t earn high salaries; they’re saying the salary must be defensible with data.

What happens if we discover we’ve been paying excess compensation for years?

– This is scary but manageable. Contact a tax attorney immediately. You may be able to file an amended Form 990 and correct the compensation going forward. Voluntary disclosure to the IRS is often better than waiting for an audit. The penalties are steep, but self-correction is viewed more favorably than being caught. Don’t delay.

Does the “rebuttable presumption of reasonableness” really protect us?

– It does, but only if you follow the rules. You need contemporaneous written documentation (board minutes, benchmarking reports) created before the compensation was paid. If you do benchmarking after the fact or have sloppy board minutes, the presumption doesn’t apply. The IRS then gets to argue the compensation is unreasonable, and you’re on your heels defending it.

Are bonuses treated differently from base salary?

– Not really. Bonuses count as compensation. The IRS looks at total compensation (salary + bonuses + deferred comp). If your base salary is $150,000 but you regularly pay $50,000 bonuses, the IRS sees $200,000 total compensation. Bonuses must be reasonable and documented just like salary.

What if a board member thinks the compensation is unreasonable but votes for it anyway?

– That board member could face personal liability. If they knowingly approve excess compensation, they can be hit with a 10% excise tax. This is why conflict-of-interest policies matter. If the executive is in the room during compensation discussions, they should recuse themselves. Board members should feel empowered to push back if they think compensation is too high.

How does excess compensation affect Form 990 filing?

– Form 990 requires disclosure of compensation for the five highest-paid employees. If the IRS flags excess compensation during an audit, the organization has to file an amended Form 990. This becomes public record, and watchdog groups like Charity Navigator and GiveWell flag it. The reputational damage can be significant, even if the financial penalties are manageable.

Can we use salary surveys from websites like Glassdoor or PayScale instead of hiring a consultant?

– Not ideal. While those sites have data, they’re not specific enough for nonprofit compensation benchmarking. The IRS prefers data from compensation consultants, industry surveys, or Form 990 filings of comparable organizations. If you’re audited and your only documentation is a Glassdoor printout, the IRS will argue it’s not reliable. Spend the $2,000-$5,000 on a proper benchmarking study. It’s worth it.

Does the excess compensation rule apply to volunteer board members?

– No. If a board member is truly a volunteer (receives no compensation), the rule doesn’t apply. But the moment they receive any payment—even a small honorarium—they become “disqualified persons” subject to the rule. Many nonprofits pay board members a small amount ($500-$2,000 per year) to cover expenses. That’s fine, but it must be documented and reasonable.

What’s the statute of limitations for excess compensation audits?

– The IRS typically has three years to audit a Form 990 (six years if there’s substantial underreporting of income). So if you paid excess compensation in 2021, the IRS could theoretically audit through 2024 (or 2027 if they claim substantial underreporting). This is why good documentation is a long-term investment.