Recently, several states have enacted or proposed laws prohibiting, limiting or otherwise regulating the compensation of nonprofit board members and nonprofit executives. In some cases, this is in reaction to provocative reports of high pay for board members and top executives at high-profile nonprofits. In other cases, it's part of states' efforts to cut costs.

Federally, compensation at nonprofits is limited by the reasonableness standard, with excessive compensation resulting in a violation of the prohibition on private inurement. In addition, compensation paid to disqualified persons of private foundations results in an excise tax unless the compensation is for personal services necessary to the private foundation.

Reasonableness is a question of fact, and in recent years the Internal Revenue Service (IRS) has encouraged charities to focus on their process for setting compensation as a means to ensure reasonable results. Although it is not a legal requirement, the IRS suggests charities determine the compensation for executives, key employees and other highly compensated persons after a review and approval by independent people of comparability data and contemporaneous substantiation of the deliberation and decision.

On the state side, there has been an increase in regulatory activity. New York's Gov. Andrew Cuomo issued an executive order in May limiting compensation supported by state funds to $199,000. The proposed regulations implementing the executive order -- scheduled to go into effect in January 2013 -- are complex and not well-tied to the federal standards already in place. Any charities in New York receiving funds from state agencies should carefully evaluate their compensation structure in light of these impending changes.

In New Jersey, starting in July 2010, those charities providing services under state contracts from the departments of Human Services and Children and Families have been limited in the use of contract funds. These new limitations include a $141,000 cap on salaries funded by state grants.

In Massachusetts, which does not currently impose any limits on the compensation paid by a charity to its board of directors or executives, several pieces of legislation were introduced in 2011 to limit or prohibit compensation of board members. This flurry of activity was the result of an investigation launched by the Office of the Attorney General into executive and director compensation at Massachusetts' four major charitable health insurers. The legislation remains in committee, and its champions, such as Sen. Mark Montigny and Attorney General Martha Coakley, remain committed to addressing the issue.

In light of the regulatory efforts in these states as well as in others outside the Day Pitney LLP footprint, all nonprofits are encouraged to review their state's rules and their internal processes for making compensation decisions for executives and board members.