Do you consider yourself overpaid? What about the other officers in your organization? Probably nobody would answer these questions affirmatively.
However, on January 10 of this year, the International Revenue Service issued new regulations that interpret section 4958 of the Internal Revenue Code. This section, referred to as "Intermediate Sanctions," allows the IRS to impose excise taxes of up to 200 percent and other sanctions on you personally if you are a party to an "excess benefit transaction."
Prior to 1996, the IRS was limited in its actions if it found an insider improperly benefited from dealing with a nonprofit organization. The IRS could revoke the organization's tax exemption, or it could pursue criminal actions against the insiders. Both of these actions were difficult to implement. Consequently, the action was only used in extreme cases.
Both the IRS and the nonprofit community felt additional remedies were needed. Following some highly publicized situations, in 1996 Congress enacted Section 4958. The section applies to "disqualified persons" who deal with "applicable tax-exempt organizations" in an "excess benefit transaction."
The provisions apply to transactions occurring on or after September 14, 1995. In 1998, the IRS proposed regulations, and held hearings in 1999. In January 2001, they issued temporary regulations interpreting this section. They will apply until January 9, 2004, unless they are finalized prior to that date.
Are you covered?
Section 4958 may affect you if you work for an applicable tax-exempt organization. These include organizations exempt under Section 501(c)(3) or (c)(4) at the time the transaction occurs or at any time within the five-year period prior to the transaction.
Private foundations are not included, as separate self-dealing restrictions that are more restrictive than these apply to them. State organizations, such as colleges and universities, are also excluded, even if the IRS has determined they qualify under Section 501(c)(3).
Even if you work for a covered organization, Section 4958 will only affect you if you are a disqualified person (DP). You are a DP if you are (or were at any time during the five years prior to the transaction) "in a position to exercise substantial influence over the affairs of the organization." Once you meet this definition, members of your family, and any organization in which you and your family collectively own more than 35 percent, also become DPs.
Several categories of persons are DPs under the regulations. These include your organization's chief executive officer, chief financial officer and members of your governing body. Titles don't matter. The regulations look to the power held by the individual. If you do not hold one of these positions, the facts and circumstances of your position will determine whether or not you are a DP.
Among the facts and circumstances that indicate you have substantial influence are:
1. You founded your organization, or are a substantial contributor;
2. Your compensation is based on revenues from activities you control;
3. You have or share authority to control a substantial portion of your organization's capital expenditures, assets, income or expenses;
4. You manage a significant discrete segment or activity of your organization;
5. You control an entity that is a DP.
None of these facts is decisive, but they do indicate some ability to control the organization. The regulations contain numerous examples to illustrate the determination of control.
Under the regulations, certain persons are deemed not to have substantial influence. You will not be a DP if you receive economic benefits from your organization of less than $85,000. The IRS will adjust this limit to reflect changes in the cost of living.
You should note that it includes all economic benefits received from your organization, not just salary. Also, if you serve in one of the capacities that is a DP by definition (CEO, CFO, board), your compensation doesn't matter.
Another Section 501(c)(3) organization will not be a DP, nor will another Section 501(c)(4) organization in the case of a Section 501(c)(4) organization. If a Section 501(c)(5) or (6) organization controls a related Section 501(c)(3) or (c)(4) organization, it can be a DP, as can a (c)(4)that controls a (c)(3).
Some facts and circumstances indicate that you do not have substantial influence. If you have taken a bona fide vow of poverty as part of a religious organization, you are an independent contractor who is paid for advice, or if your direct supervisor is not a DP, you will likely not be a DP.
What's an excess benefit transaction?
You are a party to an excess benefit transaction (EBT) if you are a DP and your organization provides an economic benefit to you directly or indirectly, and the value of what you receive exceeds the fair market value of what you provide to the organization.
Your compensation can be an EBT if it exceeds the value of the services you render to your organization. In making this determination, your compensation will include all economic benefits provided by your organization. This includes current and deferred compensation as well as all benefits, whether or not you pay tax on them.
The value of your services is "the amount that would ordinarily be paid for like services by like enterprises under like circumstances;" i.e., reasonable compensation. The determination of this amount is factually based, and is done by comparing your compensation to that paid person's in similar positions by similar organizations.
In non-salary transactions, such as a purchase or sale of property, it is easier to measure fair market value, as you can obtain a qualified appraisal. Again, if the consideration paid by your organization exceeds the value received, there will be an EBT.
A key issue in determining whether an EBT has occurred is when the transaction is measured. With a property transaction, this is straightforward - it is done at the time of the transaction. Compensation transactions are more difficult to measure.
The time of measurement of compensation under the regulations depends on whether the amount is a fixed payment or not. A fixed payment is one specified in a contract or made pursuant to a fixed formula in a contract. Thus, a specific amount of salary and benefits is a fixed payment. If the second year's compensation is determined by increasing the first year's by the cost of living, that is a fixed formula.
If, however, the contract provides for a bonus determined at the end of the year by the board of directors, the bonus portion is not fixed. Fixed payments are measured for reasonableness at the time the contract is entered into, even if it runs for several years. Non-fixed payments are measured when they are paid, taking into account any fixed payments.
Thus, the bonus will be measured by including it with the other parts of compensation to determine whether the total is reasonable. Only the bonus could be an excess benefit transaction if the fixed portion was reasonable when the contract was signed.
Regardless of when compensation is measured, if you fail to substantially perform your obligations under the contract, your compensation could become an EBT.
In addition, your organization must establish that it intended the payments to you to represent compensation for your services. Otherwise, your services will not constitute consideration for the payments, and the entire amount will be an EBT You can establish this intent by reporting the payments as compensation on Form W-2 or 1099, including it on Form 990 or by showing other written contemporaneous evidence of intent such as an employment contract.
Suppose your present employment contract is your first one with your organization. When you negotiated it, you had no connection with the organization, although you became a DP once you began employment. The regulations provide that no fixed payment in an initial contract can be an EBT. Variable payments can, however. If your initial contract is renewed, extended or changed after you have become a DP, all of the compensation is subject to testing.
If a DP engages in an EBT, the IRS can assess an initial excise tax of 25 percent of the excess benefit. The DP must correct the transaction, however. Correction means repaying the excess to your organization, plus reasonable interest. If you fail to correct in a timely manner, you may be subject to a 200 percent penalty. The penalties are sizable, as the intent is to prevent EBTs from occurring in the first place.
In addition to the tax on the DP an "organization manager" who knowingly approved the EBT will owe a 10 percent penalty, limited to a total of $10,000 on all managers involved in the transaction. The IRS must show the managers knew the transaction was an EBT to assess this penalty. If the managers relied on professional advice in approving the transaction, their participation will not be knowing, and there will be no penalty.
How to protect yourself
The regulations provide that an organization can create a rebuttable presumption that a given transaction was not an EBT. Your organization can benefit from this presumption if it meets three conditions:
1. An authorized body, none of whose members have a conflict of interest with respect to it, approves the transaction in advance;
2. The authorized body relied on appropriate comparability data prior to making its determination;
3. It adequately documented the basis for its decision.
To meet the first condition, the authorized body must be your board or a committee appointed by it. In general, there will not be a conflict of interest as long as none of the members benefit from the transaction, reports to the DP who benefits, or receives compensation subject to approval by the DP who benefits.
The appropriate data must be sufficient to enable the body to determine that the compensation or other payment is reasonable. It can be a survey by an independent consultant, or data from a national survey with sufficient data to make the determination. A special rule allows organizations with gross receipts of less than $1 million to rely on compensation data paid by three comparable organizations in the same or similar communities for similar services.
The documentation must show the terms and date of the transaction, who decided to do it, and what data they relied on. It must also show the role played, if any, by anyone who did have a conflict of interest with respect to the transaction.
If the payments under the transaction are fixed, the presumption attaches when the transaction is entered into. If they are non-fixed, the authorized body must make the determination when the payment is made. If the presumption attaches, the IRS can only challenge the transaction by showing sufficient contrary evidence to rebut the documentation relied on by the authorized body.
This will be a difficult standard for the IRS to meet, so meeting the presumption is worthwhile. If you choose not to attempt to meet it, however, there will be no inference that the transaction is an EBT.
The new regulations are quite complex, and they contain many details and examples to illustrate the provisions. You and your organization will have to determine how they apply to you in your specific case. Failure to consider these provisions can result in major financial headaches in the fixture.
Harvey Berger is a partner and national director of not-for-profit tax services in Alexandria, Va., for the accounting and management consulting firm Grant Thornton LLP.
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|Publication:||The Non-profit Times|
|Date:||Mar 1, 2001|
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