The Internal Revenue Code imposes an excise tax on certain “disqualified persons” who receive an excess benefit from a tax-exempt organization. The initial penalty rate is 25%, but the disqualified person will also be subject to a 200% penalty tax if the excess benefit is not timely returned to the organization. A disqualified person is anyone who was in a position to exercise substantial influence over the organization during the preceding five years. In addition, if such a tax is imposed, any officer, director, trustee, or similar individual who knowingly participated will be personally subject to a tax equal to 10% of the excess benefit. Knowing participation may include voting to approve an excess benefit.
An excess benefit exists where the disqualified person receives a benefit from the tax-exempt organization that is greater in value than what the person gives in return. For example, if an officer of a taxexempt organization receives a salary that is greater than what is reasonable for the services he or she performed for the organization, an excise tax may be imposed on the officer based on the portion of his or her compensation that exceeds the fair market value of his or her services.
Fortunately, the Internal Revenue Service has provided guidance describing three main steps that, if taken by a tax-exempt organization, will generally establish a presumption that a compensation arrangement is reasonable.
COMMITTEE APPROVAL
First the compensation arrangement must be approved by the board of directors, or by a committee authorized by the board. However, no member of the group giving approval may have any conflict of interest with regard to the compensation arrangement. A conflict of interest exists where a committee member: (i) is a disqualified person participating in or benefiting from the compensation arrangement, (ii) is a family member of such a person, (iii) is employed or otherwise subject to the control of such a person, (iv) receives payments subject to such a person’s approval, (v) has a material financial interest affected by the transaction, or (vi) has approved a transaction benefiting such a disqualified person who in turn has or will approve a transaction benefiting the committee member.
COMPARABILITY
The board or committee must gather enough information so that, in combination with the knowledge and expertise of its members, it can decide whether the compensation arrangement is reasonable. Such information may include: (i) compensation levels paid by similar organizations, preferably of similar size and scope, both taxable and tax-exempt, for functionally comparable positions; (ii) the availability of similar services in the geographic area of the applicable tax-exempt organization; (iii) current compensation surveys compiled by independent firms; and (iv) actual written offers from similar institutions competing for the services of the disqualified person. If the organization has annual gross receipts of less than $1 million, the committee need only look to three comparable organizations in similar communities for similar services.
DOCUMENTATION
The board or committee must keep adequate records, including: (i) the terms of the compensation arrangement approved and the date it was approved, (ii) the names of the members of the committee present for the debate over the approved compensation arrangement, (iii) who voted for the arrangement, (iv) the comparability information obtained and relied on by the committee, (v) documentation of how such information was obtained, and (vi) documentation of any actions surrounding the decision-making process taken by a person who otherwise would be on the board or authorized committee but who was excluded for conflict of interest reasons. If the committee decides that reasonable compensation is higher or lower than the range of comparability data it obtained, records must be prepared, stating the basis for that decision, within sixty days or before its next meeting, whichever is later, and the records must be timely reviewed and approved by the committee as reasonable, accurate, and complete.
If these steps are taken, the organization will generally have established a presumption that the compensation arrangement is reasonable. However, the presumption may be rebutted if the Internal Revenue Service can provide information showing that the compensation was not reasonable.
Another defense for an officer or director who participated in the transaction is his or her reliance on the properly-reasoned, written advice of a professional advisor with applicable expertise, such as an attorney, a CPA, or certain independent valuation experts.
IRS DETERMINATION TO CONTINUE RECOGNIZING THE ORGANIZATION AS TAX-EXEMPT
Tax-exempt organizations should also be aware that the facts constituting an excess benefit transaction may also be taken into consideration by the IRS in deciding whether to continue allowing the entity to be tax-exempt. While the same facts may be examined by the IRS for both purposes, the issues of whether an excess benefit transaction exists and whether an organization will remain tax-exempt are two separate issues.
When an organization engages in an excess benefit transaction, the IRS will examine the surrounding facts and circumstances to determine whether to continue recognizing the organization’s taxexempt status. The IRS has stated that such facts and circumstances include:
- The size and scope of the organization’s regular and ongoing activities that further its exempt purposes before and after the excess benefit transactions occurred;
- 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 its 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 who benefited from the excess benefit transactions.
The last two factors will weigh more heavily in favor of a continued exemption if 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 exempt status.
In light of these potentially significant penalties, trustees, board members, and senior executives of a tax-exempt organization must take special care in the process used to set the compensation of individuals who might be considered disqualified persons, such as the chief executive and chief financial officers of the organization.