Ohio Nonprofit Executive Compensation Compliance and Other Arms-Length Transactions in 501(c)(3) Organizations

Executive Summary: Mitigating Risk via the Rebuttable Presumption Safe Harbor

For scaling 501(c)(3) tax-exempt organizations, transitioning to compensated leadership or entering into contracts with board members creates significant legal exposure under federal tax laws and state nonprofit regulations. To avoid IRS sanctions —which impose personal excise taxes on executives and board members—nonprofits must strictly follow 3 key steps to create a  rebuttable presumption safe harbor. This requires advance approval by an independent board, reliance on robust comparability data, and concurrent written documentation. Proactively structuring executive compensation and insider deals safeguards the organization’s tax-exempt status, public reputation, and funding sources.

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Early in the life of a tax-exempt entity, the organization heavily relies on volunteer labor and founder contributions. Decision-making tends to be very informal (for better or worse). And Financial arrangements are straightforward. And legal exposure is relatively low. However, as the organization secures grant funding, expands program revenue, and achieves operational maturity, it must transition to professional leadership.

For growing nonprofits, I typically see one of two scenarios that require careful legal planning:

1. Compensating the Founder or Executive Director: Transitioning a founding director or volunteer leader into a paid Executive Director or Chief Executive Officer role who is paid a salary and maybe even incentivized with bonuses.
2. Insider Business Contracts: Leasing office facilities, purchasing specialized technology, or contracting for professional services (e.g., accounting, legal, marketing) from a current board member, officer, or business entity owned by a board member’s family.

Early-Stage Nonprofit	Sustainable 501(c)(3) Charity
All-volunteer leadership	Paid Executive Leadership (ED/CEO)
Informal oversight and board discussions	Formal Board Governance and Committees
Founder contributions Working board and volunteer services	Formal compensation policiesArm’s-Length Vendor & Insider Contracts
990 postcard filings mean little scrutiny	More complex 990 filings expose the organization and its directors and officers to greater liability

While compensating leadership and engaging professional service providers are common strategies for achieving sustainability, doing so as a tax-exempt organization introduces legal considerations that do not exist in the for-profit world. In a taxable business, owners have broad discretion to set salaries or engage in self-dealing transactions, subject only to any agreements with their business partners and investors. In contrast, 501(c)(3) public charities hold assets in public trust and must be operated exclusively for their tax-exempt purposes. 

Failing to properly structure executive pay and insider agreements can result in IRS excise taxes, damage to the organization’s reputation (especially when these transactions are exposed via IRS Form 990 disclosures), director liability under Ohio law, and potential revocation of tax-exempt status.

The Technical Legal Masterclass (The “How”)

Private Inurement vs. Private Benefit & Board Fiduciary Duties

To structure compensation and insider transactions legally, leaders must understand the concepts of private inurement, private benefit and their fiduciary duties to their organizations. 

1. The Absolute Prohibition Against Private Inurement

Under Internal Revenue Code (IRC) § 501(c)(3), an organization is no longer being operated exclusively for exempt purposes if any part of its net earnings inures to the benefit of private shareholders or individuals. “Private shareholders or individuals”—commonly called insiders—are those in a position to exert substantial influence over the organization. Think founders, voting board members, top executives, or treasurers. 

The basic rule is simple: a nonprofit’s income can’t be used to improperly or unjustly benefit anyone with a personal or private interest in the organization. Remember, because tax-exempt orgs must operate exclusively for charitable purposes, even a tiny amount of private inurement can be fatal to tax-exempt status. While revocation is still on the table for egregious cases, federal law primarily handles these situations today through IRC § 4958 Intermediate Sanctions (excise taxes and penalties).

2. The Private Benefit Doctrine

While private inurement focuses specifically on insiders, the Private Benefit Doctrine casts a wider net to cover benefits received by non-insiders (like regular vendors, contractors, or non-executive employees). An organization fails to operate exclusively for its exempt purposes if it serves a private interest rather than a public one, or if it has a non-charitable purpose that is substantial in nature. Nonprofits can provide financial or economic benefits only if that benefit is purely incidental—both quantitatively and qualitatively—to further the organization’s exempt purpose. If a substantial part of an activity is designed to benefit private interests or commercial operations, it sets off major legal alarm bells.

3. Ohio Nonprofit Corporations Law & Director Fiduciary Duties

Under Ohio Revised Code (R.C.) 1702.30, directors of an Ohio non-profit corporation owe fiduciary duties of loyalty and care. 

• The duty of care requires a director to act in good faith, stay fully informed, and exercise the competence, care, and due diligence that an ordinarily prudent person in a similar position would use under comparable circumstances. 
• The duty of loyalty mandates that a director act solely in the best interests of the organization at all times, avoiding self-dealing, conflicts of interest, or personal financial gain at the organization’s expense. 

R.C. 1702.301 specifically addresses directors who enter into contracts with their nonprofit organizations. A contract or transaction between a non-profit corporation and one or more of its directors or officers may be voidable unless:

• The material facts of the relationship and transaction are fully disclosed to the board or committee;
• The board or committee in good faith authorizes the transaction by the affirmative vote of a majority of disinterested directors; and
• The transaction is fair and reasonable to the corporation at the time it is authorized.

IRC § 4958 Intermediate Sanctions & Disqualified Persons

Under IRC § 4958, the IRS evaluates executive compensation and insider deals through the lens of excess benefit transactions. An excess benefit transaction occurs when a tax-exempt organization provides an economic benefit directly or indirectly to a Disqualified Person (DQP), and the value of the economic benefit provided exceeds the fair market value of the services or property received in exchange.

Defining a Disqualified Person (DQP)

Under Treas. Reg. § 53.4958-3, a disqualified person is any person who was in a position to exercise substantial influence over the affairs of the organization at any time during the 5-year period immediately preceding the date of the transaction in question. DQPs automatically include:

• Voting members of the board of directors or trustees.
• Presidents, Chief Executive Officers (CEOs), Chief Operating Officers (COOs).
• Treasurers and Chief Financial Officers (CFOs).
• Family members of the above individuals (spouses, siblings, ancestors, children, grandchildren, great-grandchildren, and their spouses).
• Entities (corporations, partnerships, trusts) in which the individuals above own more than a 35% voting or beneficial interest.

The Penalty Structure Under IRC § 4958

Intermediate sanctions directly penalize the individuals involved:

1. Initial Tax on the Disqualified Person (25%): The recipient of the excess benefit must pay an immediate, non-deductible excise tax equal to 25% of the excess benefit amount.
2. Correction & Secondary Tax (200%): The DQP must also make full correction by repaying the excess benefit plus interest back to the organization. If the DQP fails to fully correct the excess benefit within the tax determination period, an additional 200% excise tax is levied on the excess amount.
3. Tax on Organization Managers (10%): Any board member or corporate officer who knowingly, willfully, and without reasonable cause approves an excess benefit transaction is personally subject to a 10% excise tax (capped at $20,000 per transaction).

Establishing the 3-Step Rebuttable Presumption Safe Harbor

Organizations may establish a rebuttable presumption that the compensation paid to an insider is reasonable under Treasury Regulation § 53.4958-6. Doing so shields officers and directors from excise tax liability under IRC § 4958. Once this presumption is successfully met, the burden shifts to the IRS to demonstrate that the transaction or compensation package is unreasonable.

Step 1: Advanced Approval by an Independent Body

The compensation arrangement or insider transaction must be approved in advance by the disinterested members of an authorized body of the organization—such as a dedicated Compensation Committee or the full Board of Directors.

• Independence Requirement: Members who participate in the vote on the transaction cannot have a financial interest in the transaction, cannot be in an employment relationship subject to the direction of the disqualified person, and cannot receive compensation approved by the DQP. (In other words, no tit-for-tat voting arrangements.)
• Conflict Protocol: Any board member with a potential conflict must disclose all material facts, refrain from participating in discussions, and physically recuse themselves from the room during voting.

Step 2: Reliance on Appropriate Comparability Data

Prior to making its determination, the independent body must obtain and review reliable, objective market comparability data.

• What Constitutes Total Compensation: The analysis must cover total annual compensation, including base salary, performance bonuses, deferred compensation, contributions to retirement plans, health and life insurance premiums, housing allowances, personal vehicle use, severance packages, and non-cash perquisites.
• Acceptable Data Sources: Executive salary surveys by independent firms, IRS Form 990 filings of functionally comparable organizations (similar budget, geographic region, employee head-count, and mission), formal job offers from competing entities, or certified opinions from independent compensation consultants.
• Small Charity Exception: For organizations with annual gross receipts under $1,000,000, reviewing comparability data from three similar organizations in the same or similar communities regarding similar positions satisfies this requirement.

Step 3: Adequate and Concurrent Written Documentation

The approving body must document its decision in writing concurrently with the determination.

• Timing: Records must be prepared before the next board meeting or within 60 days of the determination, whichever is later, and formally approved as accurate by the board within a reasonable time.
• Required Record Contents: The record should include:
  • The exact terms of the approved compensation package or transaction and the approval date.
  • The members present during the discussion and a record of the vote.
  • The specific comparability data obtained, relied upon, and how it was sourced.
  • Documentation of any conflicts of interest disclosed and recusal actions taken.
  • The explicit legal basis for the board’s decision if it approved a compensation amount higher or lower than the range of comparable data.

Incentive Compensation and Bonuses

Sometimes, my nonprofit clients ask about implementing incentive compensation or performance bonus programs to attract or retain executive talent. Pursuant to IRS guidance, bonus plans are fully permissible under tax law, provided they contain specific structural safeguards:

1. Mission-Driven Purpose: The plan must further the organization’s charitable mission (e.g., improving quality of service, operational efficiency, or cost containment) rather than serving as a mechanism to distribute net earnings.
2. Objective Performance Metrics: Incentive targets must be tied to objective, measurable organizational goals linked to exempt purposes. Bonuses must never be tied to a percentage of revenues or net earnings.
3. Pre-Established Cap: The arrangement must include a fixed ceiling or dollar cap on maximum potential earnings to ensure that total combined compensation remains reasonable.
4. Independent Board Oversight: The bonus plan must be established, monitored, and calculated by disintered directors.

Strategic Risks (The "So What?")

Many non-profit boards and founders treat executive compensation agreements and conflict-of-interest policies as administrative paperwork. Viewing these measures through an accounting lens rather than a legal lens creates significant operational and financial liabilities.

The Invisible Liabilities of Unstructured Insider Transactions

1. Personal Financial Liability for Directors and Executives
   
   When the IRS identifies an un-substantiated salary or insider lease as an excess benefit transaction, the financial consequences fall on the individuals, not the nonprofit organization. Insiders face personal, non-deductible tax assessments equal to 25% to 225% of the excess amount, while board members who approved the arrangement face personal liability under the 10% manager tax.
2. Public Exposure and Donor Flight
   
   Tax-exempt 501(c)(3) organizations are required to file IRS Form 990 annually, which is publicly accessible. Form 990 requires explicit disclosures regarding compensation approval processes, insider business dealings, and excess benefit transactions. Institutional grantmakers, high-net-worth individual donors, and government funding agencies routinely review these 990 disclosures prior to awarding funds. An improper compensation structure or reported conflict of interest can halt donor contributions and kill major grant applications.
3. Corporate Veil Piercing and Breach of Fiduciary Duty Claims
   
   Under Ohio law, failing to follow conflict of interest protocols strips board members of their standard business judgment protections. Insider transactions executed without disinterested board approval expose directors to derivative lawsuits, breach of fiduciary duty actions, and personal liability.

Framing Compliance with Board Fiduciary Duties as an Investment

Implementing a robust compliance framework—including formal Compensation Policies, Conflict of Interest Policies, market comparability studies, and compliant employment offer letters—is an investment in protecting the nonprofit’s assets and funding sources. Proactive legal compliance protects the organization's tax exempt status, shields individual directors from personal liability, protects executives and insiders from excise taxes, and signals operational sustainability to major funders.

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About the Author

Maritza "Shay" Nelson, Esq. is the Founder and Managing Attorney of MSN Law Office. They advise business owners, social enterprises, and tax-exempt 501(c)(3) organizations across Ohio on nonprofit & social enterprise governance, executive compensation structuring, regulatory compliance, contracts and employment law issues. Learn more about Shay's strategic approach.