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Tax-Exempt Organizations: Excess Benefit Transactions vs. Private Inurement
In the past several years, tax-exempt organizations (hereinafter "Organizations") have faced greater scrutiny and attention from the IRS. As a result, Organizations must adhere to stricter compliance and administrative requirements to maintain their tax-exempt status.
Within the tax-exempt realm, the concept of excess benefit transactions is often confused with the concept of private inurement, and, as frequently, it is often not afforded the proper level of attention by Organizations.
Private inurement is embodied within section 501(c)(3) of the Internal Revenue Code of 1986, as amended (the "Code"). Section 501(c)(3) of the Code provides that no part of a tax-exempt organization's net earnings may inure to the benefit of a private shareholder or individual, which in practice means that an Organization's income or assets may not unduly benefit a person or company that is closely related to the Organization. While rarely applied, the prohibition against private inurement has consistently been interpreted as an absolute prohibition, meaning that even a single dollar of private inurement can cause an Organization to lose its tax-exempt status.
The excess benefit transaction rules are a creature of the prohibition against private inurement. To combat the void created by the harshness of the prohibition against private inurement, which led to the doctrine rarely being invoked, Congress enacted legislation under section 4958 of the Code that created sanctions for excess benefit transactions. The legislative intent of the sanctions was to provide the IRS with a penal enforcement mechanism to promote compliance with the rules and to deter such excess benefit transactions. Excess benefit transactions bring adverse consequences to not only the Organization but to the participating individuals as well.
A disqualified person who receives the excess benefit is subject to excise taxes ranging from 25percent of the excess benefit all the way up to 200 percent of the excess benefit received, depending upon when and if the excess benefit transaction is corrected.
If the excise tax is imposed on a disqualified person and the excess benefit transaction was not corrected within a prescribed period, any Organization managers that participated in the excess benefit transaction, with knowledge that the transaction constituted an excess benefit transaction, are also subject to an excise tax of 10 percent of the excess benefit, up to a maximum amount of $20,000 per transaction.
Excess benefit transactions are evaluated under a three part definitional test:
1. Is the organization an applicable tax-exempt organization;
2. Is the person involved a disqualified person; and
3. Is the transaction an excess benefit transaction?
If the answer to any of the three questions is no, then there has not been an excess benefit transaction. If the answer to all three questions is yes, then there has been an excess benefit transaction.
By definition, an "applicable tax-exempt organization" includes only 501(c)(3) and 501(c)(4) organizations and organizations that were 501(c)(3) or 501(c)(4) organizations at any time within the five preceding years.
A "disqualified person" is defined to include:
1. Any person who was, at any time during the five-year period ending on the date of the transaction involved, in a position to exercise substantial influence over the affairs of the organization (whether such influence is formal or informal);
2. A family member of an individual in the preceding category; and
3. An entity in which individuals described in the preceding categories own more than a 35 percent interest.
An "excess benefit transaction" is defined to mean all transactions in which an Organization bestows an economic benefit upon or for the benefit of a disqualified person. Provided, however, the value of the economic benefit bestowed by the Organization exceeds the value of the consideration (including performance of services) received for providing the benefit.
While it is perfectly acceptable for Organizations to pay "disqualified persons" reasonable compensation for services provided, the biggest problems that Organizations face with regard to excess benefit transactions, especially when facing an IRS audit, are 1) determining the value of the economic benefit bestowed upon a disqualified person, 2) determining the value of services provided by disqualified persons, and 3) substantiating such determination. These problems arise because it is not practical for Organizations to have valuation of services studies or compensation studies performed contemporaneously with each transaction with a disqualified person. Additionally, many Organizations do not have adequate policies and procedures in place for documenting such justification for the value of the economic benefit bestowed upon a disqualified person at the time of the transaction - which places the burden of proof heavily on the Organization to prove such bestowment is reasonable during an IRS audit.
As the end of the tax year approaches for calendar year Organizations, and the mid-point of the tax year approaches for fiscal year Organizations (assuming a June 30 year end), this is an ideal time for Organizations to evaluate their current transactions with disqualified persons and to review their policies and procedures, so that the Organizations and its key individuals may avoid the negative consequences of excess benefit transactions.
This article is intended as a summary of state and federal law and does not constitute legal advice.
Pursuant to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, nothing contained in this communication was intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. No one, without our express prior written permission, may use or refer to any tax advice in this communication in promoting, marketing, or recommending a partnership or other entity, investment plan or arrangement to any other party.