Determining Reasonable Compensation for Nonprofit Employees

Some of the most frequently asked questions concerning establishing a nonprofit organization are: Is it possible to employ paid workers? If so, how much can an organization pay their employees?

You are about to start a nonprofit and you’re starting to realize that at some point you’re going to have to hire people; but would it be possible to offer a compensation package? The simple answer is: Yes. Nonprofit organizations are allowed by state law and the IRS to provide reasonable salaries to its officers, employees or representatives for any service rendered to advance the organization’s causes. However, state laws impose tight restrictions against a not for profit organization’s distributing profits to shareholders, as well as against paying commissions and bonuses to employees.

Many nonprofits employ people, some by the hundreds and others by the handful supplemented by volunteer work. Many individuals employed in nonprofit organizations are compensated well for their work. In fact, organizations such as these attract talented people by offering competitive salaries.

How to Pay Nonprofit Employees

So, exactly how much can you pay your employees? There is no simple, straightforward answer to this question, as the IRS does not actually provide specific compensation costs. The IRS does, however, require that organizations restrict the amount to what is termed “reasonable compensation.” The IRS defines reasonable compensation as the value that would ordinarily be paid for like services by a like enterprise (whether for profit or nonprofit) under like circumstances.

In order to determine whether an employee’s services are similar to another’s, nonprofit organizations must compare:

  • Services rendered –
    • Type of work and skills involved in the completion of duties
    • Whether he/she works full time or part time
    • The organization’s size and scope
    • Number of employees managed
    • Budgets or assets managed
    • Whether he/she fulfills multiple functions or departments

In order to determine whether an organization is similar to yours, you must compare:

  • Company’s size
    • Budget
    • Revenue
    • Number of personnel
    • Persons your organization serves
  • Mission – for example, a research institute’s mission varies greatly from that of a labor union

In order to determine whether your organization shares similar circumstances with another, you must compare:

  • Organization’s industry or purpose
  • Geographical location – whether it is in an urban or rural setting
  • Economic conditions – cost of living

Other things to consider when determining reasonable compensation include:

  • Employee’s duties and past performance history
  • Amount of time the employee spends on the job
  • Employee’s compensation history
  • Employee’s background, skills, education and experience
  • How much others employees at the nonprofit are paid
  • Availability of similar services in the nonprofit’s geographic area
  • Whether the employee has actual written job offers from other organizations

Items included in the reasonable compensation include all forms of cash and non-cash compensation, including salary, compensatory and fringe benefits, and the employee’s salary.

If your nonprofit pays a staff member too much, you may be required to pay an excise tax, and in addition, you can lose your tax-exempt status.

Benefits for Employees

While employees of nonprofit organizations cannot receive bonuses and commissions since they cannot receive any personal gain from the donations raised by the organization, NPOs might consider providing sick pay, paid vacation leaves, medical and dental insurance, retirement plans, educational aid, or a flexible work schedule.


Nonprofits, similar to for profit businesses, are required to withhold certain taxes from employees’ paychecks:

  • Federal income tax withholding (FITW)
  • Social Security and Medicare taxes (FICA)
  • Federal unemployment taxes (FUTA)

On the other hand, organizations that have obtained 501(c)(3) status are different, making them exempt from federal income tax (FITW). These organizations are not required to withhold FITW or FUTA taxes.

However, 501(c)(3) organizations are still required to withhold social security and Medicare, unless the employee is paid less than $100 in a calendar year, or the organization is a church or an organization controlled by a church that is opposed to paying social security and Medicare taxes for religious reasons. Organizations must then file Form 8274 for this exemption.

While 501(c)(3) organizations are still required to pay state and local taxes, they may be able to obtain exemptions from those by checking their eligibility with their local tax bureau and to verify the process to receive exemptions.