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Head Compensation: The Law and the Process

Prior to the passage of the Intermediate Sanctions Act in 1996, the general population had no knowledge of IRS regulation of nonprofit executive compensation including that of heads of independent schools. 

In simplest terms, the Act was prompted by allegations about reported excessive executive compensation of a major high-profile charity. The Act stated that all nonprofits were required to form a compensation committee that meets annually to benchmark the compensation of the CEO. The nonprofit does not need to pay more or hire a compensation consultant, but the Act specifies that no disqualified person can sit on the compensation committee. That has come to mean not the CEO himself/herself nor any employee, vendor or relative of the CEO. 

The charge of the committee is to determine and use “safe harbors” benchmarks which have never been very clearly defined. Certainly, Harvard University would probably not be considered a credible benchmark for a small rural liberal arts college because they would not be considered peer institutions. However, a fair safe harbor benchmark might be what a CEO/head of school could earn at another comparable institution/school and might also be what a nonprofit/school might need to pay to a replacement. 

The Act seemed to prompt the development of the website, Guidestar.com (now called Candid), which provides up-to-date financial information as well as access to the IRS Form 990 forms that were previously unavailable in the public domain. Beginning in 1996, surfing those Forms has become a periodic pastime for reporters from several major national newspapers and some school parents and other constituents who question whether the performance of the leader of a school or nonprofit warrants the high compensation they are seeing on the 990.

There are some nonprofit international schools who must file the IRS Form 990 in the United States.

 

I. What to Know About the IRS Form 990

Because people disenchanted with a school head may be investigating the numbers, it is important to keep some things in mind.  To access the most accurate data from Guidestar, one needs to pay a hefty annual fee, and to analyze it requires background knowledge and experience. Recently a client school Head showed her Board a list of benchmarks that she felt were appropriate, but two of the rather large numbers were not a part of annual compensation. They were payouts from 457(f) non-qualified deferred compensation plans that had reached their vesting date. The contribution to those plans is reported annually, but the entire amount plus any accrued earnings is reported again when it is paid out in one lump sum that is fully taxable to the head.  Heads who are paid relatively less or perceive that they are being paid below market are the most likely ones to research the 990’s.

Also, the 990’s are often 24 or more months out of date. They do not include a large minority of US independent schools that are religiously affiliated and do not have to report publicly. A number still do report in our experience, but most do not. 

A few schools pay their heads through a foundation not the school.

A good bit of compensation may not be reported at all, if the IRS has not yet begun asking specific questions. For example, formerly the IRS did not ask specifically about school owned homes or about non-qualified deferred compensation plans. 

The amount of information and on the Form 990 variers greatly with the preparer, usually the CFO of the school or organization. Some report the bare minimum, and others provide some very helpful details in the notes. 

In our Firm’s experience, the data on the 990’s is still the best available because there is a legal requirement to report, and it is still more accurate than national, regional or state association data. The highest paid heads do not wish the details of their packages known for obvious reasons, and to the extent there are ways to keep that data out of the limelight or the press, schools will do that. When we look at associations’ data, we find some elements of high-end packages missing, and combined with the limitations of the 990 data noted above, boards may want to retain a compensation consultant who maintains a proprietary database.  Since 1983, Littleford & Associates has been doing this work and now for thousands of schools worldwide

 

II. The Board’s Appropriate Role

Boards want to be fair, responsible, and to know market replacement costs. Generally, our Firm is retained in one of these circumstances: when a school first hires a head, even if we are not the search firm; when the head’s contract is up for renewal; when the board wants to assess the package value mid-contract to be fair especially if it suspects that the head is “looking”; or when a long-term head is about to retire. 

We are always retained by boards not heads of independent and international schools or CEO’s of other nonprofits. We do not work for or advise heads because our credibility stems in part from not crossing that line. Heads, however, very often bring our Firm to the attention of boards, and they will also share with us confidentially the details of their compensation, not because they expect us to give them in return our benchmarks, but because they know that someday their board or a future board may retain us for this work. 

The other part of benchmarking head compensation is to know how well the head evaluation process is working. There should be some documentation about this process and a clear discussion about how and when an offer will be made to the head, i.e., by the board, by the compensation committee or by the entire board. We have not recently seen a situation in which the head’s package is discussed in detail at a full board meeting to allow board members to comment or make further suggestions. Most often a duly formed compensation committee of the board is empowered by the board to benchmark the head’s compensation. The committee either conveys the final offer or makes a summary recommendation of the head’s proposed new package. 

While some heads earn a great deal, many heads around the world earn modest compensation. The “eye-popping” numbers for some heads (and there are now dozens making well over one million a year) may seem unfathomable initially.  But then one reads or hears about the attacks on heads from all sides of the cultural, vaccination wars that are only the newest “wars” with which heads must contend. The tenure of school heads internationally averages about 3.5 years, in the US about 5.5 years, and a bit better in Canada at 7 years. However, those are still short tenures, and most heads do not leave of their own volition. 

 

III. What Littleford & Associates Provides

In addition to providing benchmarks that are among the most accurate available, after Mr. Littleford meets with the compensation committee of the board, and a compensation decision is reached, the Firm provides the Rebuttable Presumption of Reasonableness Checklist that the IRS requires. It also provides a safe harbors letter that defends the compensation decision. The board chair retains these in his/her files.