Certain types of educational, religious and other tax-exempt, nonprofit organizations need to be careful that their leaders do not receive "excess benefits." This can occur when a person who is defined by law as an "insider" receives unwarranted compensation or a low-interest loan or pays the organization below-market rent. Insiders who receive such excess benefits (as well as organization managers who knowingly approve "excess benefits transactions") may be subject to intermediate sanctions: federal excise taxes that impose a personal liability.1 Moreover, the organizations themselves may be adversely affected if the excess benefits are revealed to donors and/or the public, which they often are.
What Are "Insiders"?
The law defines an insider (referred to as a "disqualified person") as any person who was "in a position to exercise substantial influence over the affairs of the organization" during the past five years. Insiders include key executives and voting members of the board.2 In addition, certain related parties may be considered insiders, including family members and businesses in which an insider (or group of insiders) has more than a 35 percent interest. A company may be an insider even if it is not controlled by an insider. For example, a management company may be an insider with respect to a client organization if it has ultimate responsibility for supervising the management of the organization and its day-to-day operations.
What Are "Intermediate Sanctions"?
Intermediate sanctions consist of a first-tier excise tax equal to 25 percent of the excess benefit. The insider is personally liable for this tax and must repay the excess benefit to the organization. Failure to "correct" the transaction by the end of the year in which the first-tier tax is imposed may result in a second-tier excise tax equal to 200 percent of the excess benefit.
Individuals who are "organization managers" — including board members — may be subject to an excise tax equal to 10 percent of the excess benefit for participating in an excess benefit transaction. (See the sidebar, "Board Members as Organization Managers.") Thus, even if an individual or a related party did not derive an excess benefit, he or she may be subject to the tax — which is limited to $20,000 per transaction — as an organization manager.3 Moreover, the IRS may also impose a penalty equal to 100 percent of the excise tax if the insider or organization manager had previously been liable for paying the excise tax or if the IRS determines that their involvement with an excess benefits transaction was "willful and flagrant."
What Is an "Excess Benefit"?
An excess benefit is any kind of transaction in which an insider receives an economic benefit from an exempt organization that exceeds the fair market value of what the organization receives in return. The law also covers transactions in which the economic benefit is provided to the insider indirectly (i.e., through an entity controlled by the organization or through an intermediary). (See the sidebar "Examples of Excess Benefits.")
Insiders may be receiving excess benefits if they:
- Collect compensation from the organization that exceeds the fair value of the services rendered,
- Buy property from the organization at less than fair value or sell property to the organization at greater than fair value,
- Lease property from the organization at less than fair value or lease property to the organization at greater than fair value,
- Borrow money from the organization on less than fair value terms or lend money to the organization on greater than fair value terms, and/or
- Engage in one of the above transactions with an entity controlled by the organization.
(For a list of economic benefits that will be disregarded when considering whether an insider has received an excess benefit, see the sidebar "Exempt Benefits.")
Impact on the Organization
Excess benefits can have a negative impact on the organization as well as the insider. Although the excise taxes are personal liabilities, exempt organizations are required to disclose transactions subject to intermediate sanctions on Internal Revenue Service (IRS) Form 990.4 Disclosure includes the names of the people involved, a detailed description of the transactions that led to the intermediate sanctions, whether the excess benefit transaction was corrected and the amount of excise taxes paid.
Because Forms 990 are publicly available, they are often reviewed by the press, regulators, donors and others. As a result, the imposition of a penalty can have a significant adverse impact on an organization's ability to raise funds.
Although this rarely happens, the IRS also has the option of revoking the organization's tax-exempt status if it engages in an excess benefits transaction. The IRS generally considers a number of factors in making its determination, and tends to look favorably on organizations that discover and correct the transaction before it comes to the attention of the IRS.
Protection for Insiders
Organizations can reduce the risk presented by intermediate sanctions through a series of well-designed policies and procedures. Existing policies — such as those governing conflicts of interest — may offer some protection.
Moreover, as long as certain procedures are followed, the regulations give non-profit organizations the benefit of the doubt and consider their compensation arrangements and property transactions to be reasonable, unless it can be proven that they are excess benefits transactions. This is called "rebuttable presumption."5
For insiders to qualify for this protection, the following conditions must be met:
- The compensation arrangement or property transaction must be approved in advance by an independent board or authorized committee of the board,
- The board or committee must obtain and rely upon appropriate comparability data (e.g., compensation studies or third-party appraisals) in approving the arrangement or transaction, and
- The board or committee must document the basis for its approval in light of the comparability data, performance evaluations and similar information.
If an organization follows these procedures, intermediate sanctions excise taxes can be imposed only if the IRS develops sufficient contrary evidence to rebut the comparability data that the organization used. As a practical matter, the IRS would be unlikely to invest the considerable extra effort it would require to impose the taxes.
While organizations may indemnify board members against the intermediate sanctions excise taxes, the cost of doing so generally must be included in the board member's compensation for purposes of determining whether the compensation is reasonable. If the indemnification amount, when added to other payments to the board member, results in payment of more than reasonable compensation for the board member's services to the organization, the indemnification payment itself would constitute an excess benefit. Thus, the board member could be subject to an excise tax on the indemnification and be required to restore the payment to the organization.
To further protect themselves and their insiders, organizations should implement processes to identify insiders, to provide a means for those insiders to disclose related parties, to track transactions with insiders, to permit insiders to benefit from the "rebuttable presumption" process and to ensure correct tax reporting for transactions that are potentially subject to the excise tax.
Organizations with a large number of potential "insiders" (including related parties) subject to the excise tax should consider implementing an intermediate sanctions risk management program, which should include an educational component. Board members and other organizational insiders need to be reminded periodically of the mechanics of the law and how they can reduce their exposure.
Receiving excess benefits can subject insiders and certain other individuals at non-profit corporations and associations to a steep excise tax. Steps can be taken, however, to minimize the risk and protect both the insiders and the organization itself.
About the authors:
Myrna Hellerman is a senior vice president in the Chicago office of Sibson Consulting. She advises management and boards in the design and implementation of innovative, effective and sustainable people and reward strategies that lead to improved business results. She can be reached at 312.456.7914 or firstname.lastname@example.org.
David Insler is a senior vice president in the Los Angeles office and West Regional Leader. He can be reached at 310.231.1743 or email@example.com.
1 Intermediate sanctions can be imposed on two types of organizations: Section 501(c)(3) organizations (religious, educational, charitable, scientific, literary, testing for public safety, to foster national or international amateur sports competition or prevention of cruelty to children or animals) and §501(c)(4) organizations (civic leagues, social welfare organizations and local associations of employees). The law does not apply to §501(c)(3) private foundations, which are subject to a separate regime. Generally, private foundations are charitable organizations controlled and funded by a relatively small group of individuals or corporations. Additionally, the law generally does not apply to governmental entities or affiliates of governmental entities. The Taxpayer Bill of Rights 2 (1996) added intermediate sanctions to the Internal Revenue Code at §4958. Final regulations were issued in January 2002.
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2 The regulations classify people as insiders per se, those who are not considered to be insiders and those who may or may not be insiders depending on whether the "facts and circumstances" show they have substantial influence over the organization's affairs. Per se insiders include voting board members; the president, chief executive officer or chief operating officer; and the treasurer or chief financial officer.
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3 This excise tax can be abated if it is established that the transaction was due to reasonable cause and not to willful neglect and the excess benefit is corrected in a timely manner.
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4 Form 990, "Return of Organization Exempt From Income Tax," is submitted by tax-exempt organizations and non-profit organizations to provide the IRS with annual financial information.
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5 The regulations provide a "rebuttable presumption," which is an assumption made by a court that is taken to be true unless someone comes forward to contest it and prove otherwise. Detailed procedures for obtaining the rebuttable presumption of reasonableness are provided in the regulations.
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