- 1. Applicability to Other Tax-Exempt Organizations.
Second, Section 501(c)(5) and 501(c)(6) organizations are subject to the same prohibition on private inurement as their 501(c)(3) and 501(c)(4) brethren (see Section I(B) above). Consequently, the guidelines imposed by the intermediate sanctions law as to who is a "disqualified person," what constitutes an "excess benefit transaction," and how to establish a "presumption of reasonableness" with respect to compensation arrangements and property sales or rentals, should be considered by Section 501(c)(5) and 501(c)(6) organizations in light of the statutory and regulatory prohibition on private inurement. Doing so should help ensure that compensation practices and property sales and rentals will withstand IRS scrutiny.
- 2. Overview.
An excess benefit transaction is any transaction in which a Section 501(c)(3) or 501(c)(4) organization provides an economic benefit to a "disqualified person" that has a greater value than what it receives from the person. This would include providing compensation to a person in excess of the value of the services rendered or selling or renting property to a person for less than the property's sale or rental value. The excess benefit equals the difference of the value of the benefit provided to the person over the value of the consideration received by the organization.
There are two types of excise taxes. The first is imposed on disqualified persons who receive an excess benefit. The tax is equal to 25% of the excess benefit. There is an additional tax equal to 200% of the benefit if it is not corrected before the date an IRS deficiency notice is mailed for the 25% tax or the date the 25% tax is assessed, whichever comes first. The second tax is imposed on "organizational managers" who knowingly, willfully and without reasonable cause participate in the excess benefit transaction. This tax is equal to 10% of the excess benefit, but no more than $20,000.
- 3. Disqualified Persons.
If an individual is a disqualified person, then certain related parties are also considered disqualified persons. These include spouses, brothers or sisters, spouses of brothers or sisters, direct ancestors, direct descendants and their spouses, and corporations, partnerships and trusts in which the disqualified person has more than a 35% interest.
- 4. Specifically Included.
- 5. Specifically Excluded.
- 6. Substantial Influence Test.
- the person founded the organization;
- the person is a substantial contributor;
- the person's compensation is based on revenues derived from activities of the organization;
- the person has authority to control or determine a significant portion of the organization's capital expenditures, operating budget, or compensation for employees; or
- the person has managerial authority or serves as a key adviser to a person with managerial authority.
- the person has taken a bona fide vow of poverty;
- the person is an independent contractor (e.g., an attorney) who would not benefit from a transaction aside from the receipt of professional fees; or
- the person is a donor who receives no more preferential treatment than other donors making comparable contributions as part of a solicitation intended to attract a substantial number of contributions.
- 7. Organization Managers.
An organization manager will be considered to have "participated" in an excess benefit transaction not only by affirmative steps, but also by silence or inaction when the manager is under a duty to speak or take action. However, a manager will not be considered to have participated in a transaction when he or she has opposed it in a manner consistent with the manager's responsibilities to the organization.
Organization managers can avoid the 10% penalty if they can show that they did not act willfully or knowingly. They can meet this requirement if, after disclosing all facts to an attorney, they receive a reasoned written legal opinion that a transaction does not provide an excess benefit. This will protect them even if a transaction is later determined to be an excess benefit transaction.
- 8. Economic Benefits.
For example, there is no problem with paying reasonable expenses for board members to attend board meetings (this does not include luxury travel or a spouse's trip). Also excluded are benefits provided to a disqualified person solely as a member of the organization if the same benefits are given to other members in exchange for a membership fee of $75 or less per year.
The payment of a premium for an insurance policy covering a potential excise tax liability is not an excess benefit transaction if the premium is treated as compensation to the disqualified person and his or her total compensation is reasonable.
- 9. Compensation.
For purposes of the excise tax, compensation includes, but is not limited to, salary, fees, bonuses, severance payments, and all forms of deferred compensation that are earned and vested, whether paid under a tax-qualified plan or not. If deferred compensation is paid in one year for services performed in two or more years, then that compensation will be allocated to the years in which the services are performed.
Compensation also includes all benefits, whether or not included in income for tax purposes, such as medical, dental, life insurance, and disability benefits, and both taxable and nontaxable fringe benefits (other than job-related fringe benefits and fringe benefits of inconsequential value).
An economic benefit will not be treated as reasonable compensation unless the organization clearly indicates its intention to treat it as compensation at the time it is provided. For example, if the organization fails to include compensation or other payments to disqualified persons on a Form W-2 (for employees) or Form 1099 (for board members and other non-employees) and does not treat the payments as compensation on its Form 990, then the payments will be considered an excess benefit.
Revenue-sharing arrangements. A special rule applies to arrangements that compensate a disqualified person in proportion to revenue generated by the organization. Such compensation may be considered an excess benefit even if it does not exceed the fair market value of the services provided. This can happen if, at any point, the arrangement permits a person to receive additional compensation without providing proportional benefits to the organization. Whether such compensation is an excess benefit will depend on the facts of the individual case, taking into account such factors as the relationship between the size of the benefit provided and the quality and quantity of the services provided, as well as the ability of the party receiving the compensation to control the activities generating the revenues.
- 10. Avoiding the 200% Tax.
An excess benefit can be corrected if the disqualified person repays the organization an amount equal to the excess benefit, plus an interest element for the period the excess benefit was outstanding. A correction may also be accomplished, in some situations, by returning property to the organization and taking any additional steps necessary to make the organization whole.
- 11. Presumption of Reasonableness.
To qualify for this presumption, three requirements must be met:
- (i) The compensation arrangement or property sale or rental must be approved by the organization's governing body or a committee of the governing body composed entirely of individuals who do not have a conflict of interest with respect to the transaction;
- (ii) The governing body or its committee must have obtained and relied upon appropriate data as to comparability prior to making its decision; and
- (iii) The governing body or its committee must have adequately documented the basis for its decision at the time it was made.
- a. Conflict of Interest. A member of a governing body or its committee will be treated as not having a conflict of interest if he or she:
- Is not the disqualified person benefiting from the transaction or a person related to the disqualified person;
- Is not an employee subject to the control or direction of the disqualified person;
- Does not receive compensation or other payments subject to approval of the disqualified person;
- Has no financial interest affected by the transaction; and
- Will not receive any economic benefit from another transaction in which the disqualified person must grant approval.
- b. Appropriate Data. This includes such things as compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for similar positions; independent compensation surveys compiled by independent firms; actual written offers from similar organizations competing for the services of the disqualified person; and independent appraisals of the value of the property. There is a special relief provision for organizations with annual gross receipts of less than $1 million. An organization will be automatically treated as satisfying the data requirement if it has data on compensation paid by five comparable organizations in similar communities for similar services.
- c. Adequate Documentation. To meet this requirement, the governing body or its committee must have written or electronic records showing the terms of the transaction and the date it was approved; the members of the governing body or committee who were present during debate on the transaction and the names of those who voted on it; the comparability data obtained; and what was done about the members who had a conflict of interest. For a decision to be documented concurrently, records must be prepared by the next meeting of the governing body or committee occurring after the final action is taken. Records must be reviewed and approved by the governing body or committee as reasonable, accurate and complete within a reasonable time period thereafter.
Organizations should note that if a committee member is not on the governing board and the presumption is utilized, then the committee member becomes an "organization manager" for purposes of the 10% penalty. In other words, committee members are treated like members of the governing body if the presumption is rebutted by the IRS.
A person will not be treated as a member of the governing body or its committee if he or she meets with other members only to answer questions and is not present during debate and voting on the transaction.
Finally, organizations subject to the intermediate sanctions law should note that this presumption of reasonableness is only a presumption. The IRS can rebut the presumption if there is additional information showing that the compensation was not reasonable or that the property transfer was not at fair market value. However, satisfying these three requirements should go a long way toward helping organizations avoid further IRS scrutiny in this area.
- 12. Conclusion.