Organizations exempt under most categories of Internal Revenue Code (IRC) §501 must meet two separate tests to retain exemption. The first test, called the organizational test, ensures that no one owns an exempt organization. No dividends are paid; shareholders exist only in certain membership organizations; and the circumstances under which funds can be returned to the members in the business league, social club, or other category are limited. When recognizing an organization’s exempt status, the Internal Revenue Service (IRS) applies this test to review the charter, bylaws, and other organizational documents.
The second test, though, is ongoing. Exempt organizations of all categories must continually operate “exclusively” for exempt purposes, whether that purpose is charitable, agricultural, or for the advancement of a line of business. An exempt organization (EO) must not devote itself to benefiting private individuals, although many EOs perform services, such as teaching or grant‐making, that benefit individuals. To describe the requirements of tax‐exempt status, IRC §501 uses the word inures to limit the activities of §§501(c)(3), (4), (6), (7), (9), (10), (13), and (19) organizations. The code provisions for all these categories require that “no part of the net earnings inure to the benefit of any private shareholder or individual.”
The IRS has denied exemption to organizations with a limited number of board members, particularly if those members are related. Also troublesome to the IRS is too close a relationship between the planned activities and a business or activity owned by the organization’s creators or board members. The examples and concepts presented in this chapter should be considered in view of the many private letter rulings that deny exemption because the IRS finds that private benefit or inurement will result when the applicant plans to educate, empower, and engage individuals in daily life skills,1 and one performing scientific research to help a founder transform his or her ideas into marketable patents, or conducting a program to train medical personnel.2
The last of the six definitions of inure found in Webster’s Deluxe Unabridged Dictionary, second edition, is the one applied for federal tax exemption purposes: “to serve to the use or benefit of, as a gift of land inures to the heirs of a grantee or it inures to their benefit.” The IRS 1981 Continuing Professional Education Text for EO agents3 comments that inurement is “likely to arise where the organization transfers financial resources to an individual solely by virtue of the individual’s relationship with the organization, and without regard to accomplishing exempt purpose, or more plainly stated, a private person cannot pocket the organization’s funds.” Whether private benefit is incidental to overall public benefit or interest turns on the nature and quantum of the activity and the manner by which the public benefit manifests. The 1983 text asserts that “the forms which inurement can take are limited only by the imagination of the insiders involved.”4 The 2001 text updated this important subject by applying the private benefit standards to fictitious charter schools and housing projects.5 The useful articles cited here were produced for training purposes in 1979–2004 and are available on the Internet.
Private benefit continues to be found, including, for example, benefits that accrue to parents of cheerleaders. The members of an organization volunteer their time to operate concession stands at school events to pay for tuition, books, and apparel for their children. The fact that the receipts were allocated to the members based on the number of events in which they participated indicated private inurement to the parents who were relieved of the burden of paying such expenses for their children.6 Similarly, private inurement was found when the parents who raised money for an amateur sports competition were excused from paying part or all of the cost of their child’s event entry fees because of the funds they raised for the organization. The IRS said those parents received net earnings from the entity and therefore received private inurement.7 A proposed §501(c)(4) entity to provide services to “fee‐paying entrepreneurs and businesses” to enhance their available capital investments operated to privately benefit its members and could not qualify for exemption.8
Private inurement potentially may be said to occur whenever a person receives funds or property from an exempt organization in return for which he or she gives insufficient consideration—in other words, pays less for something than it is worth or gives less than he or she receives. An organization that devotes too much of its funds to providing private inurement does not qualify for exemption.
To eliminate the possibility of private inurement in a privately funded charity, Congress in 1969 introduced the concept of self‐dealing.9 All financial transactions with insiders are absolutely prohibited for private foundations (PFs). The fact that the transaction actually benefits the PF (a bargain sale, for example) does not lift the ban. Neither will the facts that the transaction is at arm’s length and for fair market value rescue the transaction from self‐dealing sanctions (as these facts would for a public charity). A few limited exceptions permit reasonable compensation for personal services, expense reimbursements, and no‐interest loans and leases to the PF.10
To provide a tool to punish a public charity or civic league that paid excessive amounts to its insiders, Congress in 1996 added intermediate sanctions to the tax code.11 Until that time, the only penalty the IRS could impose on such an organization was revocation of its exempt status. Thus, as the word “intermediate” implies, sanctions that stop short of revocation can now be imposed when inurement occurs. This new regime for scrutiny of insider transactions did not replace the inurement standards, but rather can be thought of as a construct within which to evaluate the presence of inurement. The newest limit on benefits to insiders came with the Tax Cuts and Jobs Act of 2017, with a new $1 million limit on compensation for almost all exempt organizations (discussed at end of this chapter).
To ensure that it operates to benefit its exempt constituents, an exempt organization must monitor its financial relations with private shareholders or individuals. This broad group is somewhat narrowed by the regulations, which say it “refers to persons having a personal and private interest in the activities of the organization.”12 Although this language does not specifically say so, the “interest” commonly stems from control. The IRS also asserts that a nonprofit organization governed by related individuals is evidence of private inurement. To repeat, an EO must operate exclusively for exempt purposes rather than the benefit of private individuals.
IRS rulings usually find that insiders include:
The intermediate sanction rules are imposed on insiders called disqualified persons, defined as those in a position to exercise substantial influence over the affairs of the organization.14 Private foundation insiders are also called disqualified persons.15
Persons not on the preceding insider list—outsiders—can also receive unacceptable advantage or gain (often in the form of compensation), including employees, consultants, and exempt function beneficiaries. Examples include:
In deciding whether the significant fees paid to the fund‐raisers by the United Cancer Council (UCC) violated these rules, the courts struggled with this distinction between insiders and outsiders.19 Because the fundraiser did not control the UCC and the compensation arrangement was arrived at through arm’s‐length negotiations prior to any services being performed, private benefit was not found.20
Importantly, financial transactions involving insiders are not necessarily prohibited, but are constrained and subject to scrutiny. In each case, the same criteria are applied to evaluate the presence of disqualifying inurement to insiders and their family members. Form 990, Schedule L, beginning for 2008 returns, contains disclosures of any transactions with “interested parties.” Whether transactions result in inurement will be based on the facts of each case. The burden of proof is on the exempt organization.
Transactions between related for‐profit businesses are subject to reallocation among the parties if the IRS finds they were not conducted at arm’s length. The rules to test for fair pricing in intellectual property transactions use 12 factors.21 These income tax rules on reallocations can be instructive in evaluating possible inurement between an exempt organization and its related parties:
For inurement or private benefit to result, the organization’s net earnings must be paid in an impermissible fashion to one or more individuals. The meaning of net earnings is not the customary accounting definition—gross revenues less associated expenses.22 Instead, the term is very broadly construed to include assets an EO holds as permanent capital, restricted funds, and current or accumulated surpluses resulting from retained net profits. A prohibited distribution of net earnings or profits is not limited to an arrangement based on some sharing agreement, incentive, or ownership. It can take many forms, including but not limited to those discussed in the following sections of this chapter.
A financial transaction designed to avoid tax and lacking a genuine business purpose fails an economic substance test applied over the years by the IRS and courts to find that private benefit or inurement has occurred in a fashion that violates the operational test required by the tax code. A new prohibition, with penalty provisions, was enacted that asks if:
Reasonable compensation for personal services rendered can be paid to insiders in the form of salaries, directors’ fees, or other payment. The IRS position on compensation is expressed in its training literature:
The National Office has found that benefit to an exempt organization’s employees, so long as it constitutes no more than reasonable compensation for services rendered, is not necessarily incompatible or inconsistent with the accomplishment of the exempt purpose of the employer. Exempt organizations can establish and operate incentive plans that devote a portion of receipts to reasonable compensation of productive employees so long as the benefits derived from the plans generally accrue not only to the employees but also to the charitable employers through, for instance, increased productivity and cost stability, thus aiding rather than detracting from the accomplishment of exempt purpose.24
Payment of excessive compensation may can jeopardize exempt status.25 When compensation is found to be unreasonably high, the recipient may be treated as having received an excess benefit that must be returned and penalties paid by the recipient and those approving the payments.26
An evaluation of the reasonableness of compensation should also include an analysis of the EO’s need for the position. Questions asked to measure the reasonableness and answers that should be maintained include:
Comparative information is critical to test reasonableness of a salary. It is best to compare to exempt organizations in the same field of endeavor, for example, health care, academia, music, or child care. Data on Forms 990 is useful; copies must be provided upon request (a modest fee can be charged) by all EOs.34 Amounts paid to officers, directors, or key employees for compensation, employee benefit plans, or expense accounts are reported, along with their titles and average amounts of time devoted to the position each week. Form 990 Part VII, Schedule J, and Form 990‐EZ Part VI contain compensation information, including amounts paid to the top five employees receiving more than $100,000 a year. Additionally, the top five independent professional contractors paid more than $50,000 during the year are listed by name and amount.
When compensation is paid to directors, officers, or other controlling members of an organization, additional proof of the reasonableness of compensation is required. It is critical that local conflict‐of‐interest statutes be observed to prove that the payments do not violate fiduciary responsibility concepts. Persons who have significant control over an organization (whether or not they have a title) are treated as insiders for this purpose.35 Form 990 now asks whether the organization has a conflict policy and how it implements and monitors that policy. It is expected that the IRS will use that data, particularly from annual 990s, to choose organizations to scrutinize. Most organizations should adopt conflict‐of‐interest policies to evidence their good faith in securing independent and impartial approval for compensation payments. Such policies should require, at a minimum, that interested parties abstain from approving their own compensation. The IRS has emphasized the need for a sufficient number of what they call independent board members (uncompensated and unrelated to those who receive compensation) to achieve independent or disinterested approval for the compensation.36 A compensation committee comprising knowledgeable persons should be formed to gather data and make recommendations. Form 990 requires the inclusion of Schedule L to report relationships between the EO and key employees.
The Internal Revenue Service provides a model conflict‐of‐interest policy in the Form 1023 instructions. Though the instructions to that form say the adoption of the policy is not necessarily required, it is highly recommended. Existing organizations that have such a policy in effect might find it prudent to compare it to the model. Organizations without a policy might find it easy to adopt the model.
Compensation that is measured by the results of activities—net profits, number of patients served, funds raised, and so on—is subject to enhanced scrutiny. The intermediate sanctions rules have a special section on transactions in which the amount of economic benefit is determined in whole or in part by the revenues of one or more activities of an organization.37 One court has said that “there is nothing insidious or evil about a commission‐based compensation system,” and decided that a 6 percent commission for procuring contributions was reasonable, despite the absence of a ceiling on the total commission that could be paid.38
In evaluating a “fixed percentage of income” formula, the IRS dissected one hospital’s policies and intentions in reviewing the compensation of a radiologist. He received a fixed percentage of the department’s gross revenues less bad debts. The IRS found this incentive compensation method to be acceptable because the physician had no control over compensation decisions, either managerial or from a governance position. He was simply an employee. It also noted that the negotiations over compensation were conducted at arm’s length.39 The factors to consider in evaluating incentive compensation include the following (note that not all factors need be present):
In the health‐care context, the IRS, in 1997, updated its guidance regarding incentive compensation packages used to recruit physicians. The IRS suggested 12 questions that should be asked to determine whether incentive payments to staff physicians who serve Medicare beneficiaries result in private inurement.42 The factors reflect the bullet list at the beginning of this section, as applied to a health‐care context that embodies the community benefit standards and other issues unique to the practice of medicine.43
A couple of pre‐intermediate sanction cases illustrate the concept. Uncapped compensation equal to a percentage of the tithes and offerings received by People of God Community was found to be excessive and to allow private inurement to its founder and could not continue to qualify for tax exemption.44 Commissions of up to 20 percent paid to fund‐raisers by the World Family Corporation were found to be reasonable in light of all of the circumstances.45 Stock options or employee stock purchase plans can be made available for employees of for‐profit corporations. A nonprofit corporation may wish to offer shares of its for‐profit subsidiary to key employees of the subsidiary as incentive compensation. Encouragement of personnel by issuing a minority interest was found acceptable for an exempt organization.46 The president of a newly created for‐profit subsidiary received 4 percent of the shares as a part of his compensation. The plan was found to be consistent with the charity’s purpose of providing the employee an incentive to maximize commercial exploitation of the charity’s technology transferred to the subsidiary.
An exempt organization should have a good reason to provide housing or meals, or allowances for these purposes, to its officers, directors, or employees. Using the four basic criteria outlined in §20.1(b), amounts incurred for meals and other travel expenses while conducting the organization’s business can be paid. Questions to ask to ensure that the four criteria are met include:
Documentation is essential to prove both the amount and the nature of each expense, as well as its connection to organization affairs. A diary could be kept of meetings, persons entertained, and the project to which discussions related. Due to the self‐dealing rules, scrutiny can be expected, but a private foundation can reimburse its disqualified persons for “reasonable expenses” incurred in conducting the foundation’s affairs.49 Daily expenses in excess of the federal per‐diem reimbursement rate would require explanation.
An exempt organization can buy, lease, or sell property to or from an insider in certain circumstances. The appropriateness of any such transaction depends partly on whether the property is devoted to exempt functions, such as administrative offices, or an investment to produce income. The standards for reasonable compensation discussed previously may also be applicable to sales of property. The intermediate sanctions apply to property transactions.50 When a property transaction takes place between an insider and an exempt organization, the following tests must be satisfied:
Although a PF is absolutely prohibited from buying, selling, or leasing anything to or from its disqualified persons for any price—even one dollar—a rent‐free lease to the PF is allowed if it serves the organization’s charitable mission. A PF can pay its proportion of occupancy costs, but careful documentation is needed for such “sharing arrangements.”59 The Caracci case can be studied to learn the depth of adequate and accurate documentation needed to evidence reasonableness of the amounts paid.60 Significant excess benefits were asserted by the IRS and partly sustained by the court in a transfer of assets from three tax‐exempt home‐health‐care agencies to for‐profit corporations. The valuation placed on nursing home assets was found inadequate by the IRS, which assessed millions of dollars of sanctions plus penalties against members of the Caracci family. The IRS also proposed, but the court did not approve, revocation of exemption for the three home‐health agencies the family had managed since the 1970s before transferring the assets to for‐profit corporations.
An exempt organization should very carefully consider the consequences before lending money to or borrowing from an insider. One court has commented that the very fact that an exempt organization was a source of credit for an insider represented inurement.61 Loans are subject to the same criteria as leases and sales of property, and many of the same questions apply. Additionally, one should ask the following questions:
A private foundation is prohibited from borrowing money from or lending money to a disqualified person. A gift of indebted property to a PF is prohibited unless the debt was placed on the property 10 years before the gift.65 Essentially, the PF’s taking over responsibility for the debt is treated as compensation or a loan to the donor.
Contributing a business to a nonprofit organization with purely gratuitous motivation does not necessarily result in private inurement or benefit to the donor, but such transactions are closely scrutinized. If such a transfer occurs for tax avoidance purposes, as when the donor retains the right to occupy the property and essentially continues to operate the business for his or her own purposes, the level of private interest prevents tax‐exempt status for the new nonprofit organization.66
When the conversion is basically a sale to the exempt organization, the purchase must be examined for unreasonable price and terms favorable to the seller.67 In a sale of a proprietary school to a newly created educational organization, the consideration paid for goodwill was found to be excessive.68 Payments for intangible earning capacity are not, however, prohibited per se. When an exempt organization intends to operate a facility and will clearly benefit from the goodwill that has been established, the intangible assets contribute to the new organization’s exempt functions and can be paid for. The IRS has ruled that the “capitalization of excess earnings” formula is an acceptable manner by which to value such an intangible asset.69
The health‐care industry during the 1990s provided countless examples of the purchase of a nonprofit provider by a for‐profit company and vice versa. Whether private inurement occurs is a significant question in such situations, to be judged by standards developed by the IRS particularly for the industry.70 For an excellent discussion of the other circumstances in which a for‐profit might convert itself to a nonprofit and the tax consequences to shareholders, refer to the transcript of the May 1995 meeting of the American Bar Association Exempt Organization Committee.71
The transfer of substantially all of the assets of a taxable corporation to a tax‐exempt organization is essentially treated as a taxable sale of the transferred assets at their fair market value under the so‐called General Utilities Doctrine.72 Thus, the conversion of a taxable entity to a tax‐exempt one is treated as a transaction in which gain may be recognized.
Converting a Nonexempt Nonprofit into an Exempt Nonprofit. For a variety of reasons, an entity organized as a nonprofit may not seek approval for tax‐exempt status, or it may lose its exempt status. Converting such a nonprofit into a tax‐exempt entity may require several steps. The charter or other organizing documents might have to be revised to include constraints required for the particular category of exemption.73 If the nonexempt entity has relationships with persons who control it, such entanglements may have to be undone. The second issue is whether the future operations would qualify under the desired category of exemption. Third, the proposed exempt would have to prove that no private inurement resulted from the conversion. If, for example, the entity has incurred debt, the assets should be sufficient to retire the debt. Terms of debt owed to persons controlling the organization must be reasonable as to rate of interest and repayment terms. The IRS might require that the debt be retired prior to the conversion. Other business relationships, such as space rental and management service contracts, must also be scrutinized.74
When services are rendered to board members and their related parties, terms must evidence that the organization does not operate to unfairly benefit those persons. Instead, an EO must benefit a sufficiently large number of persons that don’t control it, often referred to as the “public,” rather than insiders.
Another issue is when is service revenue classified as unrelated business income?75 As a general proposition, these questions are of most concern to §501(c)(3) organizations, but all exempt organizations must serve some exempt constituency—be it the poor, the pipefitters, or the social set—in a group sense, not on an individual level. For (c)(3) organizations, the basic question is whether the charitable class is sufficiently broad that the individuals are served as a means of achieving the public purpose. The distinction is best made through examples, although the logic is not necessarily clear.76
Certain types of services provide public benefit, even though they are furnished to individuals, because they serve a societal purpose that is considered to be charitable. Examples include:
Some services produce more than incidental private benefit to individual recipients and, therefore, cause the activity to be considered nonexempt. Examples of such services include:
Member benefit is an especially confusing aspect of this issue. In the §§501(c)(3) and (c)(4) context, a membership composed of contributors can be given preferential treatment in certain circumstances. For example, reduced or free admission, discounts in bookstores, attendance at conferences or receptions, and other benefits directly connected with the exempt organization’s mission are permitted when their value is small in relation to the charges.85 However, services construed to benefit individuals on a personal level unrelated to the exempt activities, such as group insurance plans, are troublesome.
Because (c)(5), (c)(6), and (c)(7) organizations are formed to benefit members, they have wider latitude in providing services. Nevertheless, services still must be directed toward the objectives of the exempt organization. Labor unions also provide a wide range of work‐related services, including day care, job training, and placement services germane to their members’ gainful employment. A union might incur nonexempt function income and potential unrelated business income tax from its sale of housing, food, or medical products.
Business leagues run afoul of the inurement test more often than unions, and a clearer distinction is possible. Such a league must carry out programs that benefit an industry or locality, and, while incidental individual benefit can result, the overriding purpose must be to serve the industry. For example, the American Institute of Certified Public Accountants can perform peer reviews and administer qualifying tests that maintain the standards of its profession, but running an executive search department to secure job placement for individual members would be an unrelated business. Many examples of individual benefits can be found in Revenue Rulings:86
Private inurement occurs when an exempt organization’s assets are placed at unreasonable risk of loss in comparison to the assets of private investors joining it in a venture. Of equal importance is whether the exempt organization receives a share of ownership equivalent to the non‐EO investors. There is also the burden of proving that the transaction serves the exempt purposes of the EO.
The IRS has repeatedly refused to allow §501(c)(3) organizations to be general partners in any venture, to prevent them from taking on an obligation to further the private financial interests of any for‐profit partners. Only when the venture is buying exempt function property (not investment property), such as a school building or opera production, has the IRS allowed an exempt organization to be a general partner. The Plumstead Theatre Society90 won a decision that yielded the following characteristics of an acceptable limited investor venture:
The medical community in the past was fraught with controversy about private inurement. There were hundreds of private letter rulings seeking approval of hospital reorganizations involving sales of nonprofit hospitals, purchases of medical practices, for‐profit subsidiaries, and other rearrangements of health‐care entities. The standards for joint ventures are outlined in Chapter 22, and the rules applicable to hospitals can be found in Chapter 4. Private foundations are not only constrained when entering into joint ownership with their disqualified persons, but also face the possibility that a joint venture could be classified as a jeopardizing investment or an excess business holding.91
To enforce the existing rule that no private individual unfairly reap benefit from a §501(c)(3) or (4) organization, penalties called intermediate sanctions can be imposed.92 Unlike the sanctions on self‐dealing applicable to private foundations,93 the only recourse available to the IRS before 1996 to punish a public charity paying excessive salaries to its key employees was to revoke its exemption. IRC §4958 imposes a nondeductible excise tax on disqualified persons who receive excess benefits and the managers who approve of the transaction(s).94 A new and separate penalty imposed on compensation in excess of $1million may also apply. No penalty is assessable against the organization itself.
These sanctions aid in enforcing the requirement that both IRC §501(c)(3) and (c)(4) organizations must operate exclusively to benefit the exempt class they are formed to serve—the poor, culture seekers, or the sick, for example. Exemption revocation was considered an ineffective sanction because it deprived the public of needed services and did not recover the excessive benefits paid. Excessive salaries may be a relatively minor part of the expenditures of an organization that serves its charitable constituents and should thereby be entitled to retain exempt status. Despite the private inurement, an organization may operate substantially for, and devote most of its assets to, the charitable purposes.95 IRC §4958 serves to complement, not to alter, the requirements for tax‐exempt status. Both revocation and penalties can be invoked in a circumstance in which the level of excess benefits reflects a question of whether the organization as a whole functions as a charity.96 In approving of these new penalties, Congress said, “[I]n practice, revocation of tax‐exempt status, with or without the imposition of excise taxes, would only occur when the organization no longer operates as a charitable organization.”97 Indeed, in the first case considering these penalties,98 the IRS proposed, but the court did not agree, that exempt status should be revoked. The nursing homes that were sold in a transaction the court found yielded excess benefits had indeed operated—prior to the single transaction in question—for exempt purposes. IRC §4958 requires that the excessive compensation or benefits be repaid and imposes a 25 percent initial, or first‐tier, penalty tax (the intermediate sanction) on the disqualified person who receives excess benefits from a §501(c)(3) (other than a private foundation) or §501(c)(4) organization in a transaction that occurred on or after September 14, 1995.99
The statute is brief, but the regulations are thorough. Regulations on most of these significant sanctions were finalized on January 23, 2002, six years after enactment and after several versions and many public comments. Happily, a proposal that the sanctions could be imposed on a newly hired executive, referred to as a first bite rule, was not retained. The final regulations also narrowed the definition of disqualified persons. Originally, a person who could exercise authority over a discrete department or division, rather than the whole organization, was treated as a disqualified person. Also eliminated as a factor indicating substantial influence was the fact that the person serves as a key advisor to a disqualified person. The definition of excess benefits paid indirectly to a disqualified person was expanded by the regulations to include amounts paid through an intermediary in addition to a controlled subsidiary. Economic benefit is indirect when (1) the organization provides the funds to the intermediary that are paid over, under an oral or written agreement, or (2) the intermediary lacks a significant business purpose or exempt purpose of its own for engaging in the transfer.100
The sanctions are imposed on disqualified persons who receive and those who approve of excess benefits. The definition of those treated as disqualified persons is broader than the definition of the same term under the private foundation rules. The term is generally used to mean a person “in a position to exercise substantial influence over the affairs of the organization,” whether that person is an exempt organization manager, officer, director, or trustee.101 Facts and circumstances tending to show that a person manages a substantial portion of the activities, assets, income, or expenses or the organization as a whole are to be considered. Those who are members of Groups A through C, discussed in the following subsections, at any time during the five‐year period ending with the transaction are considered disqualified persons; persons described in Groups D and E are not.
Group A. Persons in control of the organization are treated as disqualified because they have voting powers and responsibilities of the sort included in the following list:
Ex‐officio, advisory, emeritus, or other organizational officials not entitled to vote are not necessarily treated as disqualified persons unless they are members of Group B. The absence of a title, or the actual title, for a person in a position of control is not determinative, if the person has or shares responsibility for managing the organization’s finances.
Group B. A person not listed in Group A may still be treated as a disqualified person based on the facts and circumstances of his or her relationship to the organization. The following facts tend to indicate that a person has substantial influence:
Group C. A person is a disqualified person with respect to a transaction if the person is a member of the family of the person with substantial influence. Members of the family and related businesses are defined for this purpose as the following “statutory categories of disqualified persons”:
Group D. Persons deemed not to have substantial influence include the following:
Governmental units and their affiliates are not subject to the intermediate sanctions, nor are they required to file the annual information return, Form 990. For clarity, the final regulations tie the definition of those governmental entities excluded from the sanctions to the existing procedures that govern return filing exclusion.104 The excess benefits tax does not apply to a foreign organization that receives substantially all of its support from sources outside the United States.
Group E. Facts tending to indicate that a person does not have control over an organization include the following:
A separate penalty equal to 10 percent of the excess benefits can be imposed on the managers who willingly participated in approving of the transactions. The managers are jointly and severally liable up to a maximum penalty of $10,000. A manager is any officer, director, or trustee of an organization and those individuals who have and exercise power and responsibility similar to those of officers, directors, or trustees. A person is considered a manager if105
Many disqualified persons are also managers. The distinction rests in the first bullet point in the preceding list that allows a person to be a manager for reason of his or her title, even if the person does not have a vote.
A person lacking control of the organization may be subject to sanction if he or she participates in approving the excess benefit transaction. Any person with authority merely to recommend administrative or policy decisions, but not to implement them without approval of a superior, is not an officer. A person serving on a committee of the governing body of the organization that invokes the rebuttable presumption of reasonableness based on the committee’s action is treated as a manager for purposes of the 10 percent tax, regardless of whether the person is an officer, director, or trustee.
A manager is subject to sanction if he or she willingly participates in the approval of a transaction, knowing that an excess benefit transaction would result. The regulations refer to the definitions of these terms in the rules pertaining to private foundation managers.106 A manager knows if he or she negligently fails to make reasonable attempts to ascertain whether the transaction will result in excess benefits. A manager is excused from the penalty if he or she, after full disclosure of the facts, relies on the advice of outside or in‐house counsel expressed in a reasoned written legal opinion that the transaction is not an excess benefit transaction. For this purpose, appropriate professionals on whose written opinion a manager can rely are limited to:
A manager may be deemed willing if he or she had reason to know because of actual knowledge of facts that indicate an impermissible act would occur. Willfulness must be voluntary, conscious, and intentional. Penalties can be forgiven if the participation was due to reasonable cause, particularly if the person exercised fiduciary responsibility on behalf of the organization with ordinary business care and prudence in relying on appropriate data described in §§20.10(e) and (f).107
Mirroring efforts in the business community to implement governance policies mandated by the Sarbanes–Oxley Act, EOs should establish audit and compensation committees and otherwise adopt practices designed to enhance the depth of financial oversight. When this process brings more persons into the circle of decision makers, concerns arise about the meaning of the term manager. The role of a compensation committee and its relationship to an organization’s board has evolved. “While responsibility for executive compensation analysis may properly be delegated to an appropriately constituted board committee, organizational and legal tension often arises concerning the full board’s ‘need to know.’”108 Involving the full board in the decision‐making process may create an expanded group of “participating and knowing” officials who would share the joint liability for excise tax on excess benefits. Form 990, Part VI, asks a series of governance questions and requests an explanation of how the compensation approval system functions. Significant details of compensation for those paid more than $150,000 are presented on Form 990, Schedule J, and Schedule L discloses any transactions with disqualified persons, with some detail enhancing the ability of the public and the IRS to scrutinize potential excess benefit transactions.
An excess benefit transaction is one in which the economic benefit the disqualified person receives, directly or indirectly, exceeds the value of the consideration (work performed or price paid) he or she gives back to the organization, also called a non‐fair‐market value transaction.109 The excess benefit is the difference between the fair market value, or the reasonable or customary amount, and the higher amount actually paid. FMV is defined as the amount a willing buyer would pay a willing seller in the marketplace in which the item is normally sold, with neither the buyer nor the seller being under any compulsion to buy or sell.110 An agreement based on the revenues of an organization’s activities must be judged by existing private inurement standards.111
The FMV of property sold, leased by, or purchased from the EO is determined following well‐established standards previously discussed.112 Valuations should be sought from qualified and reputable appraisers when the property in question, raw land or an operating business, is difficult to value. The Caracci case illustrated the significance of a complete appraisal.113
Excess Benefit Transactions. These will cause sanctions to be imposed unless reasonableness is evidenced by certain rebuttal presumptions.114 Three specific types of excess benefit transactions are called out:
Excess benefit transactions can be direct or indirect.115 A payment of the type previously listed made by the organization’s controlled subsidiary to a person who is an insider of the organization can make that person subject to sanctions.
The following types of payments are disregarded for this purpose:
An initial contract exception applies. The sanctions do not apply to any fixed payment made to a person pursuant to a binding, written contract with a nondisqualified person in regard to the organization immediately prior to the time it is executed. Fixed means a specified amount of money or a specific formula for calculating compensation for services rendered or property transferred. The formula is considered fixed even if it changes upon the occurrence of some contingency or condition, such as a percentage of the revenue generated or the rate of inflation. The compensation will be considered fixed so long as no person exercises discretion over the formula for the fluctuating amount. For the compensation agreement to be treated as fixed, the contract cannot change. A new contract occurs when there is a material change to it, including a renewal or a more‐than‐incidental change to any amount payable under the contract.
Intermediate sanctions can also be imposed on persons receiving payments from a supporting organization, and tax‐exempt status could be questioned, if a supporting organization (SO) pays in excess of reasonable compensation for services or in excess of fair market value for goods.116
A “taxable distribution” occurs when a donor‐advised fund (DAF) makes a payment to any natural person.117 The penalty is equal to 20 percent of the payment and is imposed on the DAF’s sponsoring organization and 5 percent on the fund manager agreeing to the distribution. A penalty similar in concept to the intermediate sanctions can also be imposed when a DAF makes a distribution that results in more than incidental benefit to a fund donor, or any person appointed or designated by such donor, that has, or reasonably expects to have, advisory privileges with respect to the distribution or investment of amounts held in such fund or account by reason of the donor’s status as a donor.118 The penalty for this violation is a tax of 125 percent of such benefit payable by the person receiving the benefit. A 10 percent tax is imposed on a fund manager who agrees to the making of the distribution.119
In determining when an excess benefit transaction has occurred, one must consider whether the combination of all compensation paid to an individual is unreasonable. The IRS website has extensive information pertaining to definition of and reporting of compensation paid by an exempt organization to persons who perform services for it.120 Form 990, Part VII, List of Officers, Directors, and Trustees, reports the names and addresses, positions and time devoted, compensation, employee benefit and deferred compensation plan contributions, and expense account and other allowances paid to each individual officer, director, trustee, or key employee. For the rebuttable presumption to apply, it is important that all forms of compensation—taxable and nontaxable—be reported on Form 990. Premiums for liability insurance coverage for penalties imposed by these rules must be treated as compensation, albeit a nontaxable fringe benefit, to avoid classification as excess benefits themselves.121 Omission of fringe benefits, such as spousal travel, use of company aircraft, and loans, is also common in exams conducted by the IRS and result, in the opinion of the IRS, in “automatic excess benefits.”122
The IRS also cautions that consultants preparing compensation reports must be independent of the executive in question.
Revenue‐Sharing Arrangements. Compensation arrangements based on sharing revenues or profits were addressed separately in proposed regulations that are reserved but not finalized.123 Whether excess benefit occurs when incentive compensation is paid is not necessarily based on the reasonableness of the amount paid. Instead, a proportional standard may apply. If, at any point, the arrangement allows a disqualified person to receive additional compensation without providing proportional benefits that contribute to the organization’s accomplishment of its exempt purpose, an excess benefit will occur. The intention is to ensure that a fair share of the profits goes to the exempt organization. An incentive arrangement that pays a percentage of the increase in the value of the organization’s portfolio may be okay. Though the manager controls profits (or losses) when choosing the investments, the fruits of his or her choices are shared by the organization. An increase in the manager’s income also yields an increase for the organization and does not constitute an excess benefit.
In a revenue‐sharing transaction, the compensation is determined in whole or in part by the revenues from one or more of the organization’s activities. Due to the withdrawal of proposed regulations, readers should be cautious in gathering all of the facts and circumstances that might prove the sharing resulted in reasonable compensation and the EO received a proportional benefit.
Managers and disqualified persons can be excused from the sanctions if a rebuttable presumption of reasonableness can be shown—though it may not be prudent. To prove this presumption exists, the compensation arrangement or property transaction must be approved by a board of directors, trustees, or compensation committee to which the following apply:124
The rebuttable presumption cannot apply to payments to disqualified persons that are not reported by the organization and the individual as compensation. It is extremely important for an organization to maintain contemporaneous documentation of process in this regard. The fact that payments are unreported suggests an intention to make excess benefits even if the unreported payments, when combined with reported amounts, result in reasonable compensation.125
Correction of a transaction occurs when the person repays the excess benefits or otherwise financially restores the organization. The transaction must be corrected or undone to the extent possible126 by taking whatever steps are needed to place the organization in a financial position no worse than what would have existed had the person dealt with it under the highest fiduciary standards. Restoration must be made in cash or cash equivalents, not a promissory note. The organization may choose to accept a return of property that was involved, subject to restitution of any decline in value of the property, or it may not. If the property is worth less than its value at the time of original transfer, the difference is to be repaid to the organization. Interest is be paid at a rate that equals or exceeds the applicable federal rate, compounded annually, for the period between the month of the transaction and return of the cash or property.
Correction does not require that the contractual agreement under which payments were made be terminated if the terms are amended to eliminate the excess benefit element. Unless the excess is corrected, a second‐tier tax is imposed on the insider, as described in the following subsection.
If the organization does not exist when repayment is due, the restitution must be made to another organization exempt under the (c)(3) or (c)(4) category of the terminated organization.127
An excise tax equal to 25 percent of the excess benefit is imposed on the disqualified person.128 The managers who willfully participated in the excess benefit transaction, knowing that it was such a transaction, unless their action was due to reasonable cause, are liable for a tax equal to 10 percent of the excess benefit, subject to a maximum of $10,000. Managers are jointly and severally liable for the tax. A manager who receives excessive benefits may be liable for both taxes and return of excess benefits. The penalty is not imposed if the reasonableness is evidenced by the rebuttal presumptions.129
The person(s) subject to the excise tax must file Form 4720 to report the transaction and calculate the tax due. Form 990, Schedule L, of the organization must disclose any excess benefit transactions and disclose if a correction has been made.
If the excess is not corrected by repayment to the organization, an additional second‐tier tax of 200 percent can be assessed against disqualified person(s) (not the managers). Note that no tax is imposed on the organization.
Any reimbursement of the penalty tax to the disqualified person by an organization is to be treated as another excess benefit transaction subject to tax unless the reimbursement is treated as additional compensation during the year it is paid, and the total compensation paid, including the reimbursement, is reasonable. The penalty for excess benefits will not be imposed if a prospective organization’s application for recognition of exemption under §501(c)(3) is denied because the IRS determines that excess benefit transactions have occurred or will occur. Sanctions do not apply to transactions with an organization that has failed to establish that it met the requirements for exemption under §501(c)(3).130
Abatement. The tax imposed on a disqualified person by the intermediate sanction rules can be abated if the overpayment(s) were not due to willful disregard for the law and the excessive amounts are repaid. The standards of IRC §§4961 and 4962 are made applicable by the regulations in allowing abatement.131 Losing exempt status to avoid the tax is not effective because the rules are made applicable to any organization that was exempt from tax at any time during the five‐year period ending on the date of the excess benefit transaction.132 The Wiley Nonprofit Series has a book dedicated exclusively to this important subject.133
Exempt Status. Final regulations issued in March 2008 explain by example, in a section called “Interaction with §4958,” the types of excess benefit transactions that can endanger an organization’s tax‐exempt status. The issue is this: When do excess benefit transactions become so egregious as to warrant revoking the organization’s tax‐exempt status? Regardless of whether a transaction is subject to excise taxes under §4958, the substantive requirements for tax exemption under §501(c)(3) still apply to an applicable tax‐exempt organization. In other words, if the primary purpose and operations of the organization are charitable, exemption can be maintained despite impermissible transactions. The regulations can be studied to understand the factors the IRS will consider in evaluating whether excess benefits should cause revocation of tax‐exempt status.134
21% tax on “excess tax‐exempt organization executive compensation” was added as IRC §4960 by the Tax Cuts and Jobs Act. The purpose was to make exempt organizations subject to parallel treatment regarding the similar tax now imposed by new §162(m), which says: “In the case of any publicly held corporation, no deduction shall be allowed under this chapter for applicable employee remuneration with respect to any covered employee to the extent that the amount of such remuneration for the taxable year with respect to such employee exceeds $1,000,000 and/or any separation or ‘parachute’ payments made to a highly compensated employee [defined by the IRS as greater than $125,000 for 2020] terminating employment that is equal to or greater than three times the average W‐2 earnings of that individual for the five years prior to the year of termination.”135
This new tax differs from IRC §4958, which imposes an excise tax on “unreasonable compensation” by prescribing a precise ceiling above which the tax will be due. It also differs by excluding physicians and veterinarians. The penalty is imposed when compensation by the tax‐exempt and its related exempt and for‐profit entities are combined without a reasonableness test. The new code does not grandfather existing contract and employment arrangements. Tax‐exempt organizations will be well advised to review compensation policies, employment contracts, and other aspects of compensation even if overall compensation is less than the combined $1 million threshold.136
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