Simply put, excess benefit transactions occur when a 501(c)(3) that is not a private foundation or a 501(c)(4) overpays an insider or enriches an insider. These transactions can include a nonprofit overpaying for goods or services as well as fraud and embezzlement. If an economic transaction occurs with in insider, and the nonprofit does not receive fair value in return for its payment, there may be an excess benefit transaction.
Before 1996, the only option the IRS had when faced with a tax-exempt organization that had violated the private inurement rules was to do nothing or to revoke the organization’s tax-exempt status, a penalty that often punished the organization’s beneficiaries more than the insiders who benefited from the inurement. To cure this problem, Code Section 4958 was added to the Internal Revenue Code in 1996 to provide the IRS with an “intermediate” tool between the extremes of either ignoring the problem or revoking the nonprofit’s tax-exempt status.
Intermediate Sanctions. The excess benefit transaction rules establish excise taxes as intermediate sanctions where 501(c)(3) public charities or 501(c)(4)s engage in an “excess benefit transaction” with disqualified persons such as officers, directors, key employees or others in a position to exercise substantial influence. These excise taxes are payable by the insiders who benefit from the excess benefit transaction and by the organization’s officers, directors and other influential people who knowingly participate in these transactions.
These rules have sharp teeth. To illustrate, assume insider A contracts with charity B for services. The IRS determines that the services contract provides unreasonable compensation to A based on surveys of what similar organizations in the same geographic area pay for comparable services. Further assume the contract is for $200,000 a year and the going rate for similar services is determined to be $100,000. In that case, the IRS would deem an excess benefit of $100,000. A would be responsible for paying back the $100,000 excess benefit. In addition, the IRS would assess a penalty equal to 25% of the excess benefit, or $25,000 against A. If the full $125,000 were not paid by the earlier of the date the tax is assessed or the date the deficiency notice is mailed, an additional penalty equal to 200% of the unpaid portion of the excess benefit, or in this example another $200,000, would be due for a total of $325,000 penalty on a $100,000 excess benefit. Interest would also apply.
In addition, there is a penalty tax equal to 10% of the excess benefit on the organization managers who “knowingly” approve of the transaction. The failure to make reasonable attempts to ascertain whether a transaction was an excess benefit transaction is evidence that the transaction was entered into knowingly. Liability for the manager level tax is joint and several and is capped at $20,000 per transaction.
Revocation of Exemption. The IRS has retained the long-standing option to revoke an nonprofit’s tax-exempt status when it engages excess benefit transactions. Although the IRS will consider all relevant facts and circumstances in determining whether to revoke the tax-exempt status of an organization that engages in an excess benefit transaction, the following factors play an important role in the decision:
- The size and scope of the organization’s activities that advance exempt purposes both before and after the excess benefit transaction took place;
- The size of the excess benefit transaction compared to the organization’s exempt activities;
- Whether the organization has participated in “multiple” excess benefit transactions (defined as either (i) repeated instances of the same or substantially similar excess benefit transactions, or (ii) more than one excess benefit transaction, regardless whether they are the same type of transaction or the same persons are involved);
- Whether the organization has implemented safeguards that are reasonably calculated to prevent future excess benefit transactions; and
- Whether the organization has corrected or made a good-faith effort to seek correction from the disqualified person who benefited from the transaction.
The IRS will consider all these factors in combination with each other, but will weigh more heavily in favor of continuing to recognize exemption where the organization discovers the excess benefit transaction and takes action before the IRS discovers the excess benefit transaction. Additionally, the regulations note that correction after the IRS discovers the excess benefit transaction, by itself, is never a sufficient basis for continuing to recognize exemption.
Avoiding Excess Benefit Transactions. To avoid excess benefit transactions, tax-exempt organizations should be proactive in implementing adequate safeguards to prevent excess benefit transactions, and in correcting such transactions when they are discovered. To this end, nonprofits should consider the following actions.
- Implement the Rebuttable Presumption Safeharbor Procedure. All nonprofits subject to these rules should follow the “rebuttable presumption” procedure when approving transactions with disqualified persons. The rebuttable presumption procedure requires the nonprofit to: (i) have the transaction approved in advance by an authorized body composed of individuals who do not have a conflict of interest; (ii) ensure that the authorized body obtains and relies upon appropriate comparability data; and (iii) ensure that the decision is appropriately documented. When properly performed, this procedure gives nonprofit the benefit of a presumption that the compensation is fair and reasonable.
- Avoid Conflicts of Interest. The nonprofit should have a written policy concerning conflicts of interest that includes procedures for reviewing all contracts and financial transactions with disqualified persons.
- Expense Reimbursements. To avoid “automatic” excess benefit transactions, the nonprofit should ensure that expense reimbursements and similar payments are made under an “accountable” plan, in which the disqualified person must account for expenses and return excess reimbursements. Another alternative would be to treat such reimbursements as compensation by reporting payments on IRS Forms W-2 or 1099. In either event, the School should enter into a Travel and Expense Reimbursement Policy that follows one of these two approaches and limits reimbursements to those that are reasonable and necessary to conduct the nonprofit’s legitimate business.
Nonprofits that operate with the highest fiduciary standards to prevent excess benefit transactions and proactively self-report and correct violations as they are required to do by law will likely be permitted to retain their tax-exempt status and may avoid penalties on the directors, officers and managers if excess benefit transactions occur.