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Intermediate Sanctions

The Internal Revenue Service (IRS) is charged with under the Internal Revenue Code 4958 to impose intermediate sanctions, or excise taxes, against 501(c)(3) and 501(c)(4) organization managers and other disqualified individuals who conduct "excess benefit transactions." These rules penalize nonprofit insiders without punishing the nonprofit itself. Under the sanctions, offenders are required to return assets to the nonprofit. The sanctions are considered "intermediate" because they penalize the individuals involved without taking away an organization’s tax-exempt status.

The excise taxes do not substitute for a nonprofit potentially losing its tax-exempt status. If a nonprofit is not operated exclusively for tax-exempt purposes, then the IRS still retains the power to take away its tax exemption. The intermediate sanctions allow the IRS to punish nonprofit insiders without taking away the essential tax-exempt status of the nonprofit.

The goal of these rules is to deter inappropriate transactions. Intermediate sanctioning is certainly better than revocation of exempt status, which punishes the entire organization and those it serves for the abuse of power by individuals. Nonprofits who pay substantial salaries and benefits to top executives or enter into significant contracts for the supply of goods or services should be particularly alert to intermediate sanctions rules.

Excess benefits defined

An excess benefit transaction is any transaction in which the organization provides an economic benefit to a disqualified person that has a greater value than what it receives from the person. This includes the payment of: excessive compensation, certain revenue-sharing arrangements, sales, leases, loans, or royalty arrangements with disqualified persons in which the terms of the transaction unduly favor the disqualified person.

Reasonable compensation is reasonable only if the amount paid "would ordinarily be paid for like services by like enterprises under like circumstances." When determining if compensation amount is reasonable, all economic benefits made to the employee are considered, including bonuses and severance payments, insurance reimbursements, etc.

Summary of key terms

  1. An excess benefit transaction occurs when an organization provides an economic benefit directly or indirectly to, or for use by any disqualified person, if the value of the benefit provided is greater than the value of consideration, which includes the performance of services.

  2. An excess benefit transaction includes any transaction in which the amount of economic benefit provided to or for use by a "disqualified person" is determined in whole or in part by the organization’s revenues and which results in any private inurement.

Who is a disqualified person?

A disqualified person is someone who, at any time during the five-year period ending on the date of the transaction in question ("the lookback period") was "in a position to exercise substantial influence over the affairs of the [nonprofit] organization." Disqualified persons also include any family member of a disqualified person, as well as any entity in which one or more disqualified persons together own, directly or indirectly, more than a 35% interest. Individuals who are deemed to have "substantial influence" over the affairs of an organization have the power to affect major decisions of the organization and include:

  • Voting members on the governing board

  • The president, chief executive officer, chief operating officer, treasurer or chief financial officer

  • Any person, "regardless of title, if that individual has or shares ultimate responsibility for implementing the decisions of the governing body or supervising the management, administration or operation of the applicable organization"

  • People with "material financial interest in a provider-sponsored organization"

  • The founder of the organization

  • Substantial contributors

Some examples of individuals who might not be viewed as exercising a substantial influence are:

  • An independent contractor, such as an attorney, accountant, or investment manager acting in that capacity

  • An employee who receives benefits from a charity that are less than what a highly compensated employee earns--currently $100,000 in 2007, indexed for inflation (provided he or she isn’t a disqualified person or a substantial contributor)

  • A person who receives preferential treatment such as that offered to any other donor making a comparable contribution as a part of a solicitation intended to attract a substantial number of contributions

Summary of key terms

  1. A "disqualified person" is:

    1. any person who within the last 5 years was in a position to exercise substantial influence over the affairs of the organization;

    2. a family member of an individual described in the preceding clause; and

    3. a corporation, partnership, trust, or estate in which 35% of the organization is owned or controlled by persons described in this paragraph.

  2. An "organization manager" is any officer, director, or trustee of the organization, or any individual having powers or responsibilities similar to those described in the preceding clause.

Examples of
who might exercise
substantial influence

Examples of who might not
be seen as exercising
a substantial influence

  • Voting member on the governing board

  • President, CEOs or COOs, treasurers or CFOs

  • Any person "regardless of title, if that individual has or shares ultimate responsibility for implementing the decisions of the governing body or supervising the management, administration or operation of the applicable organization"

  • People with "material financial interest in a provider-sponsored organization"

  • Founder of the organization

  • Substantial contributor

  • An Independent contractor, such as an attorney, accountant or investment manager acting in that capacity

  • An employee who received benefits from a charity that are less than what a highly compensated employee earns (provided he or she is not a disqualified person or a substantial contributor)

  • A person who receives preferential treatment such as that is offered to any other donor making a comparable contribution as a part of a solicitation intended to attract a substantial number of contributions

What are the tax penalties?

Two types of excise taxes apply to intermediate sanctions. The first taxes 25% of the excess benefit to the disqualified persons who receive an excess benefit. Failure to correct the excess benefit in a timely manner will result in a 200% excise tax. The second taxes 10% of the excess benefit to organization managers who knowingly and willfully participated in the excess benefit transaction.

The regulations presume in favor of the nonprofit that a transaction is not an excess benefit if the three following requirements are met:

  1. The compensation arrangement of the terms of transfer must be approved by the organization’s governing body or by a committee of the governing body comprised entirely of individuals who do not have a conflict of interest with respect to the transaction.

  2. The governing body or its committee obtained and relied upon appropriate data as to comparability, before making its decision.

  3. The governing body or its committee adequately documented the basis for its determination at the time it was made.

Summary of tax penalties

  • 25% of excess benefit is taxed against the disqualified person involved.

  • 10% of the excess benefit is taxed against any organization manager who was knowingly involved.

  • 200% of the excess benefit is taxed against the disqualified person if correction is not made by the end of the taxable year.

Intermediate Sanctions Safe Harbors

Disinterested Board Review

A member of a governing body or its committee will be treated as not having a conflict of interest if he or she:

Appropriate Data

Compensation is deemed reasonable if it is approved by a charity’s governing body or committee:

Adequate Documentation

Corporate board or committee minutes must provide the following documentation on which to have a determination of reasonableness:

  • is not the disqualified person benefiting from the transaction or a person related to the disqualified person;

  • is not an employee under the direction of the disqualified person;

  • does not receive compensation or other payments under the approval of the disqualified person;

  • has no material financial interest affected by the transaction; and will not receive any economic benefit from another transaction in which the disqualified person must grant approval.

  • of persons unrelated to — and not controlled by — the disqualified person;

  • that relied on appropriate comparability data independent compensation surveys compiled by independent firms; appropriate comparability data; actual written offers from similar nonprofits competing for the services of the disqualified person; and independent appraisals of the value of the property; and

  • that adequately document the basis for its determination.

  • the terms of the transaction or arrangement that was approved and the date it was approved;

  • board or committee members present during the debate on the transaction or arrangement approved and those who voted in favor it;

  • the comparability data obtained and relied upon by the board or committee and how the data was obtained; and

  • the action taken with respect to consideration of the transaction or arrangements by anyone who was otherwise a member of the corporate board or committee, but who had a conflict of interest with respect to the transaction or arrangement.

Correcting an excess benefit

A disqualified person correct an excess benefit transaction by reversing the excess benefit to the extent possible, and by taking any additional measures necessary to place the organization in a financial position as good as if the disqualified person were dealing under the highest fiduciary standards.

A disqualified person corrects an excess benefit transaction by making a payment in cash or cash equivalents equal to the correction amount to the applicable tax-exempt organization. The correction amount equals the excess benefit plus the interest on the excess benefit. The interest rate may be no lower than the applicable Federal rate. There is an anti-abuse rule to prevent the disqualified person from effectively transferring property other than cash or cash equivalents.

With the agreement of the applicable tax-exempt organization, a disqualified person may make a payment by returning the specific property previously transferred in the excess benefit transaction. The return of property is considered a payment of cash (or cash equivalent) equal to the lesser of the fair market value of the property on the date the:

  • property is returned to the organization, or

  • excess benefit transaction occurred.

If the payment resulting from the return of property is less than the correction amount, the disqualified person must make an additional cash payment to the organization equal to the difference.

If the payment resulting from the return of the property exceeds to correction amount, the organization may make a cash payment to the disqualified person equal to the difference.

"Correction" means:

  • reversing the excess benefit to the extent possible; and

  • taking any additional measures necessary to place the organization in a financial position that is not worse than it would be if the disqualified person were dealing under the highest fiduciary standards.

 

 
 

This text is provided with the understanding that ECFA is not rendering legal, accounting, or other professional advice or service. Professional advice on specific issues should be sought from an accountant, lawyer, or other professional.

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