The Internal Revenue Code imposes an excise tax of up to 225% on certain “disqualified persons,” usually directors and officers, who benefit from a so-called excess benefit transaction with a tax-exempt organization. A disqualified person receives an excess benefit where he or she receives a benefit from an organization that is greater in value than what the person gives in return, as may occur when an officer receives a salary that is greater than what is reasonable for the services performed or when a director purchases property from an organization at a price below fair market value. Other officers or directors may be subject to an excise tax of 10% of the excess benefit if they knowingly participate in an excess benefit transaction, such as by voting to approve the transaction or remaining silent with regard to the transaction.
Excess benefit transaction excise taxes are based on a percentage of the excess benefit itself and are imposed on the disqualified person personally, rather than on the organization. However, the organization itself must follow certain rules to preserve its tax-exempt status, and an excess benefit transaction may compromise that status. The Internal Revenue Service (“IRS”) views excess benefit transactions and loss of tax-exempt status as two separate issues, and it analyzes each issue independently. However, the same set of facts may be relevant to making each determination. In other words, even if an organization participates in an excess benefit transaction, it will not necessarily lose its tax-exempt status.
When an organization is involved in an excess benefit transaction, the IRS will consider several factors, including the following, in determining whether to continue recognizing the organization’s tax-exempt status:
- The size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after the excess benefit transactions occurred. (An exempt purpose is one which gives rise to tax-exempt status, including religious, charitable, scientific, and educational.);
- The size and scope of the excess benefit transactions in relation to the size and scope of the organization’s regular and ongoing activities that further exempt purposes;
- Whether the organization has been involved in multiple excess benefit transactions with one or more persons;
- Whether the organization has implemented safeguards that are reasonably calculated to prevent excess benefit transactions; AND
- Whether the excess benefit transactions have been corrected or the organization has made good faith efforts to seek correction from the disqualified person(s) who benefited from the excess benefit transactions.
The IRS may weigh some factors more heavily than others, depending upon the particular situation. The last two factors will weigh more heavily in favor of continued exemption where the organization discovers the excess benefit transactions and takes action before the IRS discovers the transactions. The last factor, by itself, will not be a sufficient basis for continued recognition of tax-exempt status where the IRS discovers the transaction first.
Tax-exempt organizations should take special care in preventing excess benefit transactions, including setting certain organizational policies, properly reviewing proposed transactions, and establishing appropriate compensation structures. (See “Establishing a Presumption that Compensation is not an Excess Benefit Subject to Excise Taxes,” Katie A. Ahern, July 2009, Available at: www.haslaw.com under Attorney Ahern.) If you would like more information about excess benefit transactions and taxexempt status, including establishing organizational policies, please contact Katie Ahern, or any other member of our Non-Profit Practice Group.