THE RAMIFICATIONS OF EXCESS BENEFITS.
First published by Ellis Carter, nonprofit lawyer with Caritas Law Group, P.C
An excess benefit* occurs when a 501(c)(3) that is not a private foundation or a 501(c)(4) overpays or enriches an insider. This may be in the form of below-market interest on loans, above-market compensation packages, influence on purchasing goods and services, or other transactions that severely benefit another.
​ When there is an excess benefit transaction, the person receiving the benefit will be subjected to penalties. Consequently, board members who knowingly approve the transaction or fail to object may be subjected to penalties. Most importantly, the EO may lose its tax-exempt status. Since the violation of this provision is subject to “intermediate sanctions,” excess benefit transactions must be disclosed to the public which may negatively impact the EO’s image and therefore the EO’s public goodwill and fundraising prospects. Learn more about excess benefit transactions and how to avoid them in this in-depth article.
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Intermediate Sanctions
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​The excess benefit transaction rules establish excise taxes as intermediate sanctions where 501(c)(3) public charities or 501(c)(4)s engage in an excess benefit transaction with disqualified persons such as officers, directors, key employees, or others in a position to exercise substantial influence.
These excise taxes are payable by the insiders** who benefit from the excess benefit transaction and by the organization’s officers, directors, and other influential people who knowingly participate in these transactions.
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These rules have sharp teeth. To illustrate, assume insider A contracts with charity B for services. The IRS determines that the services contract provides unreasonable compensation to A based on surveys of what similar organizations in the same geographic area pay for comparable services.
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Further, assume the contract is for $200,000 a year and the going rate for similar services is determined to be $100,000. In that case, the IRS would deem an excess benefit of $100,000. A would be responsible for paying back the $100,000 excess benefit.
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In addition, the IRS would assess a penalty equal to 25% of the excess benefit, or $25,000 against A. If the full $125,000 were not paid by the earlier of the date the tax is assessed or the date the deficiency notice is mailed, an additional penalty equal to 200% of the unpaid portion of the excess benefit, or in this example another $200,000, would be due for a total of $325,000 penalty on a $100,000 excess benefit. Interest would also apply.
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In addition, there is a penalty tax equal to 10% of the excess benefit on the organization managers who knowingly approve of the transaction. The failure to make reasonable attempts to ascertain whether a transaction was an excess benefit transaction is evidence that the transaction was entered knowingly. Liability for the manager level tax is joint and several and is capped at $20,000 per transaction.
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Revocation of Exemption
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The IRS has retained the long-standing option to revoke a nonprofit’s tax-exempt status when it engages in excess benefit transactions. Although the IRS will consider all relevant facts and circumstances in determining whether to revoke the tax-exempt status of an organization that engages in an excess benefit transaction, the following factors play an important role in the decision:
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The size and scope of the organization’s activities that advance exempt purposes both before and after the excess benefit transaction took place;
The size of the excess benefit transaction compared to the organization’s exempt activities;
Whether the organization has participated in “multiple” excess benefit transactions (defined as either (i) repeated instances of the same or substantially similar excess benefit transactions, or (ii) more than one excess benefit transaction, regardless of whether they are the same type of transaction or the same persons are involved);
Whether the organization has implemented safeguards that are reasonably calculated to prevent future excess benefit transactions; and
Whether the organization has corrected or made a good-faith effort to seek correction from the disqualified person who benefited from the transaction.
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The IRS will consider all these factors in combination with each other but will weigh more heavily in favor of continuing to recognize exemption where the organization discovers the excess benefit transaction and takes action before the IRS discovers the violation. Additionally, the regulations note that correction after the IRS discovers the violation, by itself, is never a sufficient basis for continuing to recognize exemption.
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Avoiding Excess Benefit Transactions
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To avoid excess benefit transactions, tax-exempt organizations should be proactive in implementing adequate safeguards to prevent excess benefit transactions, and in correcting such transactions when they are discovered. To this end, nonprofits should consider the following actions:
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Implement the Rebuttable Presumption Safeharbor Procedure
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All nonprofits subject to these rules should follow the “rebuttable presumption” procedure when approving transactions with disqualified persons.
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The rebuttable presumption procedure requires the nonprofit to:
(i) have the transaction approved in advance by an authorized body composed of individuals who do not have a conflict of interest;
(ii) ensure that the authorized body obtains and relies upon appropriate comparability data; and
(iii) ensure that the decision is appropriately documented.
When properly performed, this procedure gives nonprofits the benefit of a presumption that the compensation is fair and reasonable.
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Avoid Conflicts of Interest
​The nonprofit should have a written policy concerning conflicts of interest that includes procedures for reviewing all contracts and financial transactions with disqualified persons.
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Expense Reimbursements
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To avoid “automatic” excess benefit transactions, the nonprofit should ensure that expense reimbursements and similar payments are made under an “accountable” plan, in which the disqualified person must account for expenses and return excess reimbursements. Another alternative would be to treat such reimbursements as compensation by reporting payments on IRS Forms W-2 or 1099.
Nonprofits that operate with the highest fiduciary standards to prevent excess benefit transactions and proactively self-report and correct violations as they are required to do by law will likely be permitted to retain their tax-exempt status and may avoid penalties on the directors, officers, and managers if excess benefit transactions occur.
*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:
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​• 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
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** 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.T
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NONPROFIT OVERSIGHT
Governing and monitoring the regulations of trust.
Despite the increase in fraudulent activity reported in nonprofit organizations, many United States nonprofits still operate in an ethical and accountable manner. However, nonprofits are not immune to damage caused by unscrupulous and fraudulent solicitors, financial improprieties, and executives and/or board members who place personal gain above the organization’s mission. Because nonprofits are held to such high standards and depend on the public's trust, many safeguards have been initiated to defend against fraud and corruption:
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Boards – All nonprofits are governed by a board of directors or trustees consisting of a group of volunteers that is legally responsible for making sure the organization remains true to its mission, safeguards its assets, and operates in the public interest. But, as this office has seen firsthand, not all boards or directors are ethical. Conflict of Interest cases are the highest reported complaints filed by insiders. Some boards have even elected to "unofficially" remove that stipulation from its policy while continuing to claim compliance with government officials. ​
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Private Watchdog Groups – Private groups made up of everyday citizens, usually, those with a vested interest, monitor the behavior and performance of nonprofits in their local community. With the right attitude and fortitude, these Groups are extremely effective. ​
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State Charity Regulators – The Attorney General’s office maintains a list of registered charitable solicitors and investigates complaints of fraud and abuse. The AG is the first and best place to report any misappropriation or misconduct of a nonprofit. ​
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Internal Revenue Service – The Tax Exempt/Government Entities Division is charged with ensuring that nonprofits are complying with the requirements for eligibility for tax-exempt status. As a result of the thousands of audit investigations, a handful have their tax-exempt status revoked; others pay fines and taxes.​
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Donors & Members – Some of the most powerful safeguards of nonprofit integrity are individual donors and members. By withholding their financial support, donors can strongly encourage nonprofits to reappraise their operations.​
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Media – Many nonprofit leaders may feel misunderstood or even maligned by negative media coverage, however, this media watchdog role has resulted in increased awareness and accountability throughout the sector. Often it is the fear of being caught and the public exposure that deters a would-be fraudster. Hiding the crime only leads to more crime. Showing those who have been caught and the humiliation and punishment associated is the best way to deter others from following that same path. Harsher penalties now mean fewer crimes in the future.