Nonprofits must carefully structure employee compensation to ensure compliance with IRS guidelines and avoid excessive salaries that could jeopardize their 501(c)(3) tax-exempt status. While the IRS does not set a fixed salary cap, it does evaluate whether compensation is reasonable based on industry norms and organizational finances. So, how does the IRS define reasonable salaries, and is there an acceptable percentage of payroll relative to revenue?
IRS Guidelines for Reasonable Compensation
The IRS evaluates nonprofit salaries using a "reasonable compensation" standard, which means employee pay must be:
Comparable to Similar Organizations – Salaries should align with what employees in similar-sized nonprofits earn for similar roles.
Justified by Job Responsibilities – Compensation should reflect the experience, duties, and qualifications of the employee.
Set Through an Independent Process – Salaries should be approved by an independent board or compensation committee, not determined solely by the individual being paid.
To ensure compliance, nonprofits should use compensation studies, salary surveys, and Form 990 data from similar organizations to justify pay levels.
Is There an Acceptable Payroll Percentage of Gross Revenue?
There is no strict IRS rule on what portion of a nonprofit’s revenue should go toward payroll. However, industry benchmarks suggest:
Nonprofit payroll expenses typically range from 30% to 60% of total expenses, depending on the organization’s mission, size, and operational model.
Program-heavy organizations (e.g., grantmaking nonprofits) may allocate less to payroll, while service-based nonprofits (e.g., social services) may allocate more.
If payroll exceeds 70% of total revenue, the IRS or donors may question whether too much funding is going to salaries rather than the nonprofit’s mission.
Maintaining a balanced ratio between payroll and programmatic expenses is crucial to demonstrating good financial stewardship to donors, grantors, and regulators.
How Does the IRS Determine If a Salary Is Excessive?
The IRS uses a "facts and circumstances" test to evaluate whether a salary is excessive. Key factors include:
Comparable Market Data – Does the salary align with compensation at similar-sized nonprofits in the same sector?
Board Oversight & Approval – Was the salary approved by independent directors without conflicts of interest?
Financial Impact on the Nonprofit – Does the salary leave enough funding for program expenses and mission-related activities?
Compensation Breakdown – Does the total pay include unreasonable perks, bonuses, or excessive benefits?
If the IRS determines that compensation is excessive, the nonprofit could face "intermediate sanctions," including:
Hefty financial penalties for the individual receiving the excessive salary and for board members who approved it.
Revocation of 501(c)(3) status in extreme cases of financial mismanagement.
Best Practices for Setting Nonprofit Salaries
To avoid IRS scrutiny and ensure financial accountability, nonprofits should:
Use Compensation Benchmarks – Reference Form 990 data, salary surveys, or compensation studies for comparable roles.
Establish a Formal Salary Review Process – Have an independent board or compensation committee approve salaries.
Maintain a Balanced Budget – Keep payroll within a reasonable range compared to program and administrative expenses.
Document Salary Decisions – Maintain detailed records of how compensation was determined in case of an IRS audit.
Final Thoughts
While nonprofits have flexibility in setting salaries, the IRS requires that compensation be reasonable, justifiable, and mission-aligned. Keeping payroll in check ensures compliance, financial sustainability, and donor confidence. If you need guidance on structuring nonprofit salaries, InstantNonprofit is here to help!