One of the most important decisions a board determines is what constitutes reasonable compensation. The rules for this determination are robust and so are the taxes imposed for violations of the Internal Revenue Code and the corresponding Treasury Regulations. In this 2-Part series, we examine the taxes imposed for unreasonable compensation and explain the steps for determining reasonable compensation. In this Part 1, we introduce the persons potentially subject to the taxes and the taxes themselves.
Whose compensation is possibly subject to I.R.C. § 4958 taxes?
In 1996, Congress enacted I.R.C. § 4958, the intermediate sanction on excess benefit transactions. An excess benefit transaction occurs when a disqualified person receives improper personal gain from the exempt organization.[1] A disqualified person is any person who was in a position to exercise substantial influence over the affairs of the tax-exempt organization at any time during the five-year period ending on the date of the excess benefit transaction.[2] Disqualified persons also include family members of other disqualified persons, including spouses and children.[3] Importantly, to be a disqualified person, it is not necessary that the person actually exercise substantial influence, only that the person be in a position to exercise substantial influence.[4] The Treasury Regulations define persons deemed to have substantial influence (e.g., presidents, CEO, treasurer, and CFO) as well as persons who are deemed not to have substantial influence.[5] When it is not clear whether someone is a disqualified person based on the influence, or lack of influence, the person has over the organization, a facts and circumstances test applies.[6]
While excess benefit transactions may arise in various situations, the issue most often arises when nonprofits pay unreasonable compensation to disqualified persons. Hence, the focus of this article.
Our organization paid unreasonable compensation to a disqualified person, now what?
The I.R.C. provides three types of tax to be imposed as intermediate sanctions when an excess benefit transaction occurs. Two of the taxes apply to disqualified persons who receive a benefit because of the excess benefit transaction. The third tax can apply to an organization manager.
Tax on disqualified person
The disqualified person who receives unreasonable compensation is liable for an initial tax and potentially liable for an additional tax. The initial tax equals 25% of the value of the excess benefit.[7] The term excess benefit is defined as the amount by which the value of the compensation received exceeds the value of the services provided to the organization by the disqualified person in return.[8] This initial 25% tax is automatically due if an excess benefit transaction occurs. Further, the excessive compensation must be corrected, which is defined further below, in the taxable period if the disqualified person does not want to pay an additional tax. The taxable period begins on the date on which the excess benefit transaction occurs and ends on the earlier of: (i) the date of mailing of a notice of deficiency under I.R.C. § 6212 regarding the 25% tax, or (ii) the date when the 25% tax is assessed.[9] If the initial 25% tax is imposed and the disqualified person does not correct the excessive compensation within the taxable period, then an additional tax is imposed on the disqualified person equal to 200% of the excessive compensation received.[10] The financial burden of these two taxes plus the repayment of the excessive compensation can reach 325% of the excessive compensation. Stated alternatively, even if the disqualified person pays the 200% tax to the IRS, they are still required to return the entire excess benefit to the nonprofit organization.
Tax on organization manager
If a tax is imposed against a disqualified person under I.R.C. § 4958, then any organization manager who knowingly participated in the excess benefit transaction is subject to a tax equal to 10% of the value of the excess benefit, unless that participation “is not willful and is due to reasonable cause.”[11] An organization manager is defined as “any officer, director, or trustee” of the non-profit organization, or “any individual having powers or responsibilities similar to those of officers, directors, or trustees of the organization . . . .”[12] An organization manager participates in a transaction knowingly only if the person:
- Has actual knowledge of sufficient facts so that, based solely on those facts, the transaction would be an excess benefit transaction;
- Is aware that the transaction may violate Federal tax law governing excess benefit transactions; and
- Negligently fails to make reasonable attempts to ascertain whether the transaction is an excess benefit transaction, or the manager is aware that it is an excess benefit transaction.[13]
If more than one manager participates in the transaction, all are jointly and severally liable.[14]
If an organization manager relies on reasoned written opinion of an appropriate professional and the opinion reflects elements of the transaction within the professional’s expertise, then the organization’s manager is not considered knowing.[15] A written opinion is reasoned even though it reaches a conclusion that is later determined to be incorrect.[16] However, if the written opinion only recites facts and express a conclusion, then it is not reasoned.[17] An appropriate professional includes legal counsel, certified public accountants, accounting firms, and independent valuation experts.[18]
How to correct an excess benefit transaction
An excess benefit transaction imposed against a disqualified person is corrected by (1) undoing the excess benefit, and (2) attempting to place the non-profit in a financial position not worse than if the non-profit would be if the disqualified person were dealing under the highest fiduciary.[19] The Treasury Regulations describe certain acceptable forms of correction (e.g., cash and return of specific property). The correction amount equals the sum of excess benefit and interest on the excess benefit.[20] Again, correction must occur during the taxable period.
This doesn’t end here . . .
In this Part 1, we’ve defined excess benefit transactions, explored the taxes imposed when excess benefit transactions occur, and explained how to correct excess benefit transactions. While that’s quite a bit of information, many of you are likely wondering how to determine reasonable compensation, and thus avoid everything stated above. For that discussion, you’ll need to read Part 2 of this series. So stay tuned for the next post, Part 2!
Freeman Law aggressively represents clients in tax litigation at both the state and federal levels. When the stakes are high, clients rely on our experience, knowledge, and talent to help them navigate all levels of the tax dispute lifecycle—from audits and examinations to the courtroom and all levels of appeals. Schedule a consultation or call (214) 984-3000 to discuss your tax needs.
[1] I.R.C. § 4958(c)(1); see also Treas. Reg. § 53.4958–4(a)(1).
[2] Treas. Reg. § 53.4958–3(a)(1). The five-year period is often referred to as the lookback period.
[3] Id. § 53.4958–3(b)(1). Special rules, not discussed here, apply to corporations and partnerships in which disqualified persons have an interest as well as donor advised funds and supporting organizations.
[4] See id. § 53.4958–3(a)(1).
[5] See id. § 53.4958–3(c), (d).
[6] See id. § 53.4958–3(e). The Treasury Regulations include facts and circumstances tending to show substantial influence as well as facts and circumstances tending to show no substantial influence.
[7] I.R.C. § 4958(a)(1).
[8] Treas. Reg. § 53.4958–1.
[9] I.R.C. § 4958(f)(5); Treas. Reg. § 53.4958–1(c)(2).
[10] I.R.C. § 4958(b).
[11] Id. § 4958(a)(2).
[12] Treas. Reg. § 53.4958–1(d)(2).
[13] Id. § 53.4958–1(d)(4).
[14] Id. § 53.4958–1(d)(8).
[15] Id. § 53.4958–1(d)(4)(d)(iii).
[16] Id. § 53.4958–1(d)(4)(d)(iii).
[17] Id. § 53.4958–1(d)(4)(d)(iii).
[18] Id. § 53.4958–1(d)(4)(d)(iii).
[19] Id. § 53.4958–7(a).
[20] I.R.C. § 4958(f)(6); Treas. Reg. § 53.4958–7(c).
