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What You Need To Know: Understanding And Avoiding Excess Benefit Transactions

Intermediate sanctions legislation was passed in 1996; however, in recent years, the Internal Revenue Service (IRS) has renewed its focus on enforcement of the private inurement rule as it relates to relevant not-for-profit (NFP) organizations: 501(c)(3), 501(c)(4), and 501(c)(29) organizations that are tax-exempt under section 501(a).

Specifically, the IRS is looking for whether tax-exempt organizations are overcompensating individuals who might be able to influence activities within those organizations. 

Consequences of noncompliance begin with intermediate sanctions on any disqualified person who partakes in an excess benefit transaction and can ultimately lead to the revocation of an organization’s exempt status in some circumstances.

NFP organizations must be aware of the IRS’s authority to impose such financial penalties and take action to ensure their activities are within set regulations.

The intermediate sanctions section of the Internal Revenue Code (IRC), Section 4958, defines a disqualified person as an individual or an entity who, within five years prior to the date of the transaction, was in a position to exercise substantial influence over the affairs of an exempt organization.

Only payments made to disqualified persons are subject to the excess benefit rules; therefore, it is important for NFPs to understand the full definition so they may avoid providing excess benefits to these persons. There are three broad classes:

  • Any person in a position to exercise substantial influence (voting members, implementing decisions, supervision of management, or responsibility for managing finances) over the affairs of the NFP organization;
  • The family members of such persons, including spouses, children, grandchildren, or their respective spouses;
  • Any entity in which the above two classes of persons hold more than a 35% interest.

IRC Section 4958 defines an excess benefit transaction as any transaction in which the value of the economic benefit provided by the tax-exempt organization to a disqualified person exceeds the fair market value of the consideration received by the organization in return.

Determining Excess Benefit Transactions

Excess benefits are often assumed to revolve strictly around compensation (i.e. salaries). However, the definition of excess benefit transactions encompasses many financial transactions other than executive compensation. Payments can be in the form of cash, providing services, transfers of property, or any other benefit that has economic value to the disqualified person. An excess benefit transaction can also occur when a disqualified person embezzles from the exempt organization. Excess benefit transactions are considered to have occurred on the date the disqualified person receives the benefit. If a series of transactions stems from one contractual arrangement, the benefit is considered to occur on the last day of the person’s tax year.

To determine whether an excess benefit transaction has occurred, an organization must consider all benefits exchanged, for all entities it controls. Reasonable compensation is the standard that is used to determine if excess benefits have occurred. To determine the reasonableness of compensation, all items of compensation provided by an organization in exchange for the performance of services are taken into account for consideration (such as all forms of compensation, payment of insurance premiums, and nontaxable fringe benefits). Certain economic benefits are disregarded, such as payment of reasonable expenses for board members to attend meetings, or payment for memberships for volunteers of the organization if they are normally $75 or less.

Steps to Avoid Excess Benefit Transactions

Given the complexities of excess benefit transactions as noted above, and the stiff penalties in place, there are several steps an organization should consider to mitigate its risk:

  • The board of directors should review all benefit decisions carefully with the regulations as noted above in mind, specifically considering all benefits for a disqualified person;
  • In determining the value of an economic benefit, an organization should consider other similar arrangements for comparability (similar services or property, similar geographic location, and within the same industry);
  • The organization should consider obtaining professional guidance when reviewing any potential excess benefit transactions (i.e. attorneys or certified public accountants);
  • The organization should attempt to qualify for the “safe harbor” rules (documenting its reasoning behind benefit payments or transfers of property through compensation agreements);
  • The organization should carefully document the reasoning behind benefit transactions, including records of any comparability data used and maintain detailed minutes of any decisions approved by the board;
  • The organization should be mindful to accurately present all information on its tax forms to avoid any automatic excess benefit transactions.
  • The organization should include excess benefit transactions as a consideration during its annual risk assessment review overall.

The above information is intended to provide a basic understanding of the issues surrounding excess benefit transactions. If you have questions or would like to talk about your organization, please give us a call.

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