Create a step-by-step plan that values the current volunteer while making clear that volunteer service does not create a presumption of later employment.
Channing Hillway (email@example.com) provides the following action plan for this situation:
It is time for you to have a meeting of the Board where the Executive Director is not included. That will, of course, be legal as you will be discussing personnel matters. Prepare a document outlining a three-year plan on one page. It should be called the Personnel Planning Document, or some such. The Board should understand that it is not a binding document, in that it will not be a plan they will be obliged to honor without future change, but that it will state the Board's official position as of the current date. Include fundraising goals and other development goals. Indicate that an Executive Director will be hired -- tentative plan depending on various other elements falling into place -- sometime during the third year. Then add that the plan is seek a volunteer Executive Director for three years, to include volunteer work during the third year when the volunteer ED would participate in conducting a "nationwide" search for a paid ED. The volunteer would be welcome to apply for the position. Once that document is completed, the Board should draft a letter to your current, unpaid-wants-to-be-paid ED. The letter should refer to the Personnel Planning Document, copy included, and invite the current ED to serve as the volunteer ED for the first year, of the three years, with the possibility of renewal of her contract for a second year -- yes, even the volunteer ED should have a contract. Such documentation will be a very solid signal to the ED that she is wanted but that the terms of her participation in the organization will be highly specific and will not include a salary for at least two years and possibly longer. It will let her know that the Board is acting in a highly professional manner and that she is not indispensable. She may either continue with the organization, or not. The Board must realize that no one in any NPO is indispensable and that tax-exempt organizations take on a life of their own once they are formed -- and they do not even belong to their founders, but to the public for public benefit, as specified in the law. All Board members, in other words, are just passing through while the organization will continue until properly decommissioned in accordance with legal statute. I believe that by undergoing the policy process I have described that the Board will be able to communicate clearly and with no ambiguity to the ED that she must make a decision about whether to continue as a volunteer, or not. It she decides to leave, then the Board must live with that and do what is necessary until a volunteer can be found -- or do whatever is necessary if there must be an ED in place.
Note: I am not a lawyer. This is not legal advice. If you need legal advice about this matter (and you may) you should consult a local attorney with experience in employment law.