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Insiders can be subject to a steep excise tax; steps can be taken to minimize the risk
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") could be subject to "intermediate sanctions": federal excise taxes that impose a personal liability. Moreover, the organizations themselves might be affected adversely if the excess benefits are revealed to donors or the public, which they often are.
Nonprofit Organizations"Intermediate sanctions" can be imposed on two types of organizations: Section 501(c)(3) organizations (religious, educational, charitable, scientific, literary, amateur sports) and section 501(c)(4) organizations (civic leagues, social welfare organizations and local associations of employees). The law does not apply to section 501(c)(3) private foundations, which generally are charitable organizations controlled and funded by a relatively small group of individuals or corporations.
Who 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.
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.
Board Members as Organization ManagersIn addition to being insiders, board members are organization managers. In this capacity, they may be called on to approve transactions between the organization and other insiders. For example, board members are often responsible for approving compensation paid to senior officers of the organization. If those officers are themselves considered insiders (which is likely), and a board member approves compensation knowing that it is unreasonably high, the board member may be subject to the 10 percent excise tax on organization managers. In addition, the tax applies to other board-approved transactions that do not involve compensation, such as the purchase, sale or licensing of assets.
A board member potentially could be liable for the excise tax applicable to insiders and the excise tax applicable to organization managers if the board member participates in a transaction directly and participates as an organization manager. For example, if a board member purchases property from the organization for less than its fair market value and participates in the approval of the sale on behalf of the organization, he or she could be liable for both taxes.
The regulations contain a significant protection for organization managers by providing that their participation in a potential excess benefit transaction will not be considered "knowing" if they rely on a reasoned written opinion of an appropriate professional advising the organization to proceed with the transaction. In addition to legal counsel, an "appropriate professional" for this purpose includes a certified public accountant or an accounting firm with expertise regarding the relevant tax matters and a valuation expert who meets certain requirements.
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. This excise tax can be abated if it is established that the transaction was attributable to reasonable cause and not to willful neglect and the excess benefit is corrected in a timely manner.
Moreover, the IRS may 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. In addition, the law 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).
Insiders might 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.• Engage in one of the above transactions with an entity controlled by the organization.
• 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.
• Engage in one of the above transactions with an entity controlled by the organization.
Examples of Excess BenefitsThe following examples illustrate situations under which the intermediate sanctions excise taxes may be imposed:
President's compensation.A board member is on the committee that approves the compensation of the organization's new president. The board member knows that the fair-market value of the president's services does not exceed $150,000. Nevertheless, the board member votes to approve setting the president's compensation at $250,000. The board member may be subject to an excise tax of $10,000 (10 percent x $100,000 excess benefit) as an organization manager. In addition, the president would be subject to an excise tax of $25,000 (25 percent x $100,000 excess benefit) and would be required to repay the $100,000 excess benefit, plus interest, to the organization in order to avoid the imposition of an additional tax of $200,000 (200 percent x $100,000 excess benefit).
Legal services.A board member who is an attorney performs legal services for the organization. During the year, the attorney bills the organization $100,000 for legal services. It is later determined that the fair market value of those services was $50,000. The board member is subject to a first-tier excise tax of $12,500 (25 percent x $50,000 excess benefit) and must repay the $50,000 excess benefit, plus interest. Failure to repay the excess benefit may result in a second-tier excise tax equal to $100,000 (200 percent x $50,000 excess benefit).
Lease. A board member rents office space from the organization for $100,000 per year. It is later determined that fair rental value is $200,000 per year. The board member is subject to a first-tier tax of $25,000 (25 percent x $100,000 excess benefit), and must repay $100,000 plus interest to the organization. Failure to repay may result in a second-tier tax of $200,000 (200 percent x $100,000 excess benefit). If the board member participated in the board's decision to enter into the lease, the board member could be liable for an additional tax of $10,000 (10 percent x $100,000 excess benefit) as an organization manager.
Purchase from related party.A board member owns more than 35 percent of an office supply corporation. The corporation has a contract to supply all of the organization's paper needs. During the year the corporation charges the organization $100,000 for paper, but it is later determined that the fair market value of the paper is $50,000. Because the corporation is more than 35 percent owned by the board member, it is considered an insider. The corporation is subject to a first-tier excise tax of $12,500 (25 percent x $50,000 excess benefit) and must repay $50,000 plus interest to the organization. Failure to repay may result in a second-tier tax equal to $100,000 (200 percent x $50,000 excess benefit).
The regulations list certain types of economic benefits that will be disregarded when considering whether an insider has received an excess benefit, including most nontaxable fringe benefits and expense reimbursements paid in accordance with an accountable plan (such as paying reasonable expenses for members of an organization's governing body to attend meetings).
In addition, the regulations provide an "initial contract" exception. Under this exception, intermediate sanctions do not apply to a fixed payment for services or property made under a contract with a person who is not an insider with respect to the organization prior to entering into the contract. There must be a binding written contract and the payments under the contract must either be specified in the contract or determined by a nondiscretionary formula specified in the contract.
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 IRS Form 990, "Return of Organization Exempt From Income Tax," submitted by tax-exempt organizations and nonprofit organizations to provide the IRS with annual financial information.
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 available publicly, often they are reviewed by the news media, 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 happens rarely, the IRS 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—might offer some protection.
Moreover, as long as certain procedures are followed, the regulations give nonprofit 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," 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.
For insiders to qualify for this protection, all of 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 on appropriate comparability data (e.g., compensation studies or third-party appraisals) in approving the arrangement or transaction. • The board or committee must document the basis for its approval in light of the comparability data, performance evaluations and similar information.
• 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 on appropriate comparability data (e.g., compensation studies or third-party appraisals) in approving the arrangement or transaction.
• 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 consider implementing processes to:
• Identify insiders.• Provide a means for those insiders to disclose related parties.• Track transactions with insiders.• Permit insiders to benefit from the "rebuttable presumption" process.• Ensure correct tax reporting for transactions that are potentially subject to the excise tax.
• Identify insiders.
• Provide a means for those insiders to disclose related parties.
• Track transactions with insiders.
• Permit insiders to benefit from the "rebuttable presumption" process.
• 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.
Richard V. Smith is a senior vice president in the New York office of Sibson Consulting and Executive Compensation and Governance Practice leader. He has 25 years of experience in executive compensation and benefits consulting.
This article is adapted and reposted with permission from Sibson Consulting, a division of Segal.
© 2011 by The Segal Group Inc. All rights reserved.
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