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Nonprofit Tax Risk & Strategy Series (Part 3): Compensation & Private Benefit: What the IRS Really Looks For

Compensation is one of the most sensitive areas of nonprofit tax compliance—and one of the most frequently reviewed by the IRS.
While nonprofit organizations are permitted to compensate their leaders and staff, that compensation must be reasonable, properly structured, and well-documented.
When it is not, it can raise concerns about private benefit and excess benefit transactions, both of which carry significant compliance risk.

📊 The Core Principle: No Private Benefit
Tax-exempt organizations must operate for a public purpose—not private interests.
This means that no part of the organization’s net earnings can improperly benefit insiders, including:
• Officers
• Directors
• Key employees
• Individuals with substantial influence
This concept is commonly referred to as private inurement.
Even unintentional violations can trigger IRS scrutiny.

🔹 What the IRS Evaluates
The IRS looks beyond the amount of compensation and evaluates whether it is:
• Reasonable for the services provided
• Determined through an independent process
• Supported by appropriate documentation
Compensation includes more than salary. It may also involve:
• Bonuses
• Deferred compensation
• Fringe benefits
• Use of organizational assets
All forms of compensation must be considered together.

🔹 Common Areas of Risk
Excessive Compensation
Compensation that exceeds what would be paid for similar services in comparable organizations may be treated as an excess benefit transaction.
This can result in excise taxes and corrective actions.

Lack of Independent Approval
Compensation decisions should be made by individuals who are independent and free of conflicts of interest.
When insiders participate in setting their own compensation, it raises concerns about objectivity.

Limited or No Documentation
Even reasonable compensation can create risk if there is no documentation to support it.
The IRS expects to see:
• Board or committee approval
• Use of comparability data
• Written records of the decision

Unreported Benefits
Compensation is not limited to salary.
It may include:
• Housing allowances
• Expense reimbursements
• Personal use of organizational assets
Failure to properly report these benefits can lead to incomplete disclosures on Form 990.

Informal Arrangements
Handshake agreements or informal arrangements can create significant risk.
All compensation and benefit arrangements should be:
• Clearly defined
• Properly documented
• Reviewed periodically

📌 The Most Important Concept: Process Matters
One of the most important concepts in this area is the rebuttable presumption of reasonableness.
An organization can strengthen its position by demonstrating that compensation was approved through a structured process that includes:
• Independent decision-makers
• Use of appropriate comparability data
• Contemporaneous documentation
The IRS evaluates not only the outcome, but also how the decision was made.

📊 Why This Matters
Issues related to compensation and private benefit can lead to:
• Excise taxes on excess benefit transactions
• Required correction of payments
• Increased IRS scrutiny
• Reputational risk
Because compensation is disclosed on Form 990, it is also subject to public review.

📊 A Practical Approach
Organizations can reduce risk by:
• Establishing formal compensation review procedures
• Using independent data to benchmark compensation
• Ensuring decisions are made by disinterested board members
• Documenting all approvals and supporting data
• Reviewing compensation arrangements regularly
A structured and well-documented process is essential.

📌 Final Thought
Compensation is not just about how much is paid—it is about how decisions are made.
Even well-intentioned arrangements can create risk if they are not properly structured, documented, and disclosed.
A thoughtful, well-documented approach helps protect both the organization and its mission.

🔜 In Part 4, we’ll explore another area of IRS focus:
Related party transactions—and how to structure them properly.

IRS Audit Triggers for Nonprofits (Part 4): Related Party Transactions the IRS Reviews Closely

Transactions involving insiders are one of the most common areas of IRS scrutiny for nonprofit organizations.
Even when these transactions are appropriate, they must be properly structured, documented, and disclosed.
Understanding how the IRS evaluates related party transactions is critical to reducing audit risk.

📊 What Are Related Party Transactions?
Related party transactions generally involve individuals or entities that have a close relationship with the organization, including:
• Officers
• Directors
• Key employees
• Family members of insiders
• Entities controlled by insiders
These relationships are disclosed on Form 990, Schedule L, and in some cases, other parts of the return.

🔹 Why the IRS Focuses on These Transactions
The IRS reviews related party transactions to ensure that nonprofit organizations are not providing private benefit to insiders.
These transactions are not prohibited—but they must be:
• At fair market value
• In the organization’s best interest
• Properly approved and documented
⚠️ Lack of transparency is often what triggers scrutiny—not the transaction itself.

🔹 Common Audit Triggers
Business Transactions with Insiders
Payments to companies owned or controlled by board members or officers are closely reviewed.
Examples include:
• Consulting agreements
• Vendor contracts
• Service arrangements
⚠️ These must be at arm’s length and supported by appropriate documentation.

Loans to or from Insiders
Loans involving insiders can raise concerns, particularly if:
• Terms are not clearly documented
• Interest is below market rates
• Repayment terms are unclear
⚠️ These transactions are specifically disclosed on Form 990.

Leases and Use of Property
Leasing arrangements with insiders—such as office space or equipment—must be carefully structured.
The IRS evaluates whether:
• The terms reflect fair market value
• The arrangement benefits the organization

Family Relationships
Transactions involving family members of insiders may also be considered related party transactions.
⚠️ These relationships must be identified and disclosed where required.

Incomplete or Missing Disclosures
One of the most common audit triggers is failing to fully disclose related party transactions.
This includes:
• Omitting transactions from Schedule L
• Providing incomplete information
• Inconsistent reporting across the return

📌 The Most Common Issue: Lack of Process
Many organizations do not have a formal process for identifying and reviewing related party transactions.
As a result:
• Transactions may not be flagged early
• Documentation may be incomplete
• Disclosures may be inconsistent
The issue is often not the transaction itself—but the lack of clear procedures and oversight.

📊 A Practical Approach
Organizations can reduce risk by implementing structured processes:
• Maintain and update conflict of interest disclosures annually
• Identify potential related parties before entering into transactions
• Obtain independent approval from disinterested board members
• Document how terms were determined (e.g., comparability data)
• Ensure accurate reporting on Form 990
Coordination between governance, finance, and leadership is key.

📌 Final Thought
Related party transactions are not inherently problematic—but they are highly visible and closely reviewed.
Proper structuring, documentation, and disclosure can help ensure that these transactions withstand scrutiny and support the organization’s compliance.

We’ll continue this series with a closer look at:
• Governance and internal controls
• Filing and compliance risks

IRS Audit Triggers for Nonprofits (Part 3): Compensation & Private Benefit Risks

One of the most closely reviewed areas in nonprofit audits is compensation and private benefit.
Tax-exempt organizations are required to operate for a public purpose—not private interests. When compensation or financial arrangements appear excessive or improperly structured, it can raise significant concerns.
Understanding how the IRS evaluates these areas is critical for reducing risk.

📊 What the IRS Is Looking For
The IRS focuses on whether an organization’s earnings are being used to benefit insiders, including:
• Officers
• Directors
• Key employees
• Related parties
This is commonly referred to as private inurement or private benefit.
⚠️ Even unintentional issues can trigger scrutiny.
🔹 Common Audit Triggers
Excessive Compensation
The IRS reviews whether compensation paid to insiders is reasonable based on the services provided.
This includes:
• Salary and bonuses
• Deferred compensation
• Fringe benefits
Compensation that appears above market without proper support may be considered an excess benefit transaction.
Lack of Documentation
Even reasonable compensation can raise concerns if there is no documented approval process.
Best practices include:
• Independent board or committee review
• Use of comparable market data
• Written documentation of decisions
⚠️ Without documentation, it is difficult to demonstrate that compensation is reasonable.

Payments to Related Parties
Transactions involving insiders or their affiliated entities are closely reviewed.
Examples include:
• Consulting arrangements
• Contracts with board members’ businesses
• Lease agreements
⚠️ These transactions must be at arm’s length and properly disclosed.

Revenue Sharing or Benefit Arrangements
Arrangements where insiders receive a share of revenue or benefits tied to organizational activities can raise concerns.
The IRS evaluates whether these arrangements provide private benefit beyond what is permissible.

Unreported Benefits
Compensation is not limited to salary.
It may also include:
• Housing allowances
• Expense reimbursements
• Use of organizational assets
• Other fringe benefits
⚠️ Failure to report these benefits properly can lead to compliance issues.

📌 The Most Common Issue: Process vs. Outcome
Many organizations focus on whether compensation is reasonable, but the IRS also evaluates how decisions are made.
A strong process includes:
• Independent review
• Use of comparability data
• Documentation of decisions
This is often referred to as establishing a “rebuttable presumption of reasonableness.”

📊 Why This Matters
Issues related to compensation and private benefit can have serious consequences, including:
• Intermediate sanctions (excise taxes)
• Required correction of transactions
• Increased scrutiny from the IRS
• Reputational risk
These areas are not only technical—they are also highly visible to stakeholders.

📊 A Practical Approach
Organizations can reduce risk by:
• Establishing formal compensation review processes
• Documenting board and committee decisions
• Using independent data to support compensation
• Reviewing related-party transactions regularly
• Ensuring full and accurate disclosure on Form 990
Coordination between leadership, governance, and finance is key.

📌 Final Thought
Compensation and private benefit issues are among the most common areas of IRS scrutiny for nonprofits.
Even well-intentioned arrangements can create risk if they are not properly structured and documented.
A proactive, well-documented approach helps ensure compliance and reinforces trust in the organization’s operations.

We’ll continue this series with a closer look at:
• Related party transactions and disclosures
• Governance practices that reduce audit risk