A Quick Guide for NonProfit Directors – How to Read Your Form 990.
The IRS Form 990 is the tax return filed by not-for-profit organizations, and also a significant document for the disclosure of information concerning the policies and practices of the organization. Far too often, non-profit Boards do not take the opportunity to review this document — not surprising, as it can get to be a very long document when all the schedules are included, and, frankly, much of it is somewhat arcane and the typical Board member would not know whether it was accurate. However, Board members, particularly the Human Resources or Personnel Committee, should pay a great deal of attention to the information pertaining to the compensation of its CEO and employees. In our experience, parts of the Form 990s are frequently completed by people outside the organization who really don’t know how you do things, often filled out incorrectly, and text answers often appear to be “copied and pasted” generic language intended to be a minimal disclosure, but not really an accurate disclosure.
Let’s start with the first page (we’ll be talking about the 2010 version of the Form, the last one with significant revisions). Line 15 provides you with information on the total cost of salaries, other compensation, and employee benefits for the last two years. Divide that by the total expenses (line 18) and you’ll get a percentage. For most non-profits, this will be a pretty big number. Federally Qualified Health Centers (FQHCs) will likely be between 65 and 75%. Trade associations and professional societies may have percentages of 80% or more.
Whenever you are dealing with compensation issues, you want to make sure that you only have “disinterested” directors on the job; go to Part VI, Item 2, and see if you have anyone who might be “interested” because of a family or business relationship.
Here is a big one – Part VI, Item 15, asks if you have been correctly following the procedures for properly making decisions on executive compensation, that is, have you been setting up the “rebuttable presumption of reasonableness.” The question reads “Did the process for determining compensation of the following persons include a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision?” As I type this, I am looking at an organization that answered “yes,” when in fact, they did not. If you answered yes, there should be a thorough explanation in Schedule O of exactly what that process was. Beware, accounting firms or software programs may have “stock” language that they insert here that may or may not be anywhere near what you actually do. I have talked to a number of Board members who say that they have not been a part of any of the discussions described in their Form 990.
Part VII is the disclosure of the compensation paid to certain employees (as well as Board members). At a minimum, the five highest paid employees must be listed, provided they earned at least $100,000 in total compensation (“highly compensated employees”). Key employees must be listed, regardless of how much compensation they have earned. Key employees include, by definition, at least the CEO and the top financial officer. If you list an accountant as your CFO, even if he or she only earns $25,000, that person much be listed in Part VII. When looking at these disclosures, make sure the numbers make sense to you. Part VII lists total W-2 income, reportable compensation from related organizations (W-2 or 1099) as well as the estimated amount of other compensation. If anyone reported in the schedule on Part VII earned income of more than $150,000, or receive income from another organization for services related to your organization, you much also file Schedule J, which includes a great deal more disclosure.
Most FQHCs will also be required to file Schedule J, where the most significant disclosures are found. This is the Schedule that every Board member should be familiar with. This is the kind of information that donors or grant-makes will be interested in. Questions 1a and 2, for example, asks about “perqs” that might be provided to executives, such as first class travel. These are the kind of things that might be legitimate, but represent payments that aren’t always “necessary’ — if they’re made, there should be a Board policy concerning them (Item 1(b) confirms whether this is true). Merces’ first concern is always the check boxes on question 3. The “big 6” questions relating to how the compensation of the CEO is established come next. These boxes aren’t there for window dressing — these are the first clues as to whether your governance process is adequate and defensible. These include: 1) maintaining a Compensation Committee; 2) using an Independent Compensation Consultant; 3) consulting the Form 990s of other organizations; 4) a written employment contract; 5) use of a compensation survey or study; and 6) approval by the Board or Compensation Committee. The more of these you have, the better. In our view, items 1, 2, 5 and 6 are essentials to a “best practice” program.
There are some other interesting tidbits on the first page of Schedule J. Question 4 tells you whether anyone received a severance payment or a change in control payment, and if anyone participates in a supplemental nonqualified retirement plan or an equity based compensation plan. Merces believes that these questions, particularly 4(b) on a supplemental non-qualified retirement plan, are often answered incorrectly. There are many types of retirement funding options that would fit in this definition, and we believe that many nonprofits are not reporting the formal and informal arrangements they have, simply because they don’t recognize them as being this type of plan. Questions 5 and 6 are particularly touchy for 501(c)(3) organizations. Employees are not supposed to be paid directly based on the revenues or net earnings of the organization. Checking yes here is not a good thing. Of course, you should check the box if you did, but you shouldn’t be doing it. Be very careful, as an organization, when you have any incentive plan that distributes net earnings. I recently spoke to a CEO whose incentive compensation plan required that there be “net earnings” for the incentive to be paid. My feeling was that this requirement (which is not atypical) could fit the definition of compensation contingent on net earnings, and therefore might be a red flag.
The table in Part II of Schedule J provides much more detail on compensation. Unlike the disclosures in Part VII, which only deal with total W-2 earnings, Schedule J breaks the W-2 down into base salary, bonus/incentive, and “other” compensation, and also discloses retirement contribution and nontaxable benefits. This is a very good “total direct compensation” figure for comparison purposes, providing you’re always comparing to the same numbers. What Board members should be looking for here is a couple of simple things:
- Does the base compensation (particularly for the CEO) look like the number you approved? You should be able to find the approval of the base compensation in the minutes of your Board meeting.
- If there is incentive compensation, does it look right for the plan that you have in place? If there is incentive compensation, it should be pursuant to a Board-approved incentive plan, and the plan should have identifiable goals and objectives, and should not have significant discretion. I’m looking at a Form 990 that became highly problematic for the Board of the organization, and I see clearly a very large number in the bonus column, most of which had nothing to do with the bonus plan. It is footnoted, but not correctly.
- If you have items in “other reportable compensation,” you might want to ask what that is. Car allowances, club dues, some insurance products and the like may be reported here. If the number is big, you might want to ask what it includes
- Retirement and deferred compensation can be a large cost, but you should also be aware that it might not be additional cost to the organization. If an executive voluntarily defers compensation into a retirement plan, it may be money that otherwise would have appeared in the “base compensation” line. It may also include the executive’s contribution to a 401(k)/403(b) plan, the company’s match, and the purchase of life insurance.
There are a number of items that are either improperly or inadvertently put in the wrong place, and some where there might be a question. For example, when paid time off is “cashed out,” some organizations put it in base compensation (which actually inflates that figure), and others put it in “other reportable compensation” (which is probably more accurate).
The ultimate big question, of course, is when should a number concern you. Merces collects information on the range of reported compensation for all of the separate items reported in Schedule J for the CEO, COO, CFO, CMO and CDO. The analyses include the critical variable — the size of the organization. If you’re concerned about your numbers, contact us and we’ll help you put them in perspective.
Last, but certainly not least, are the footnotes and “supplemental information” disclosed in Part III. This is important. You should be describing in detail any variation from the expected answers in Schedule J, and also how you govern your compensation program. Depending on how your organization answered these questions, you may find the responses in Schedule O. Wherever you find them, make sure that these text answers accurately describe the process that you have in place. If you don’t remember doing the things that are described, remember that you are being held accountable for them as if you were.
For more information on best practice executive compensation governance processes, contact the author at email@example.com.