Excess Benefit Transactions for Nonprofit Organizations
As stated in our discussion of inurement, the prohibition on private inurement is absolute. In theory, even one dollar of private inurement could result in loss of tax exemption. Because of the harshness of the penalty, private inurement was infrequently invoked. This effectively meant that most inurement was not penalized.
To address this enforcement deficiency, Congress enacted sanctions on “excess benefit transactions” under Code § 4958 in 1996. These rules parallel and overlap the private inurement rules and have become the primary focus on enforcement efforts. Code § 4958 imposes “intermediate sanctions” (i.e., a sanction that is less penal than full loss of exemption) for insubstantial inurement.
How to Determine if There Has Been an Excess Benefit Transaction
Unlike the vague tests for inurement and private benefit, testing for excess benefit is fairly straightforward. The test requires three definitional inquiries: (1) is this 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 all three questions is “yes,” then there has been an impermissible excess benefit.
Applicable Tax-Exempt Organizations
The first question is whether the organization is an “applicable tax-exempt organization.” Applicable tax-exempt organization include only 501(c)(3) and (c)(4) organizations or organizations that were 501(c)(3) or (c)(4) organizations at any time within the five preceding years. For example, 501(c)(6) organizations are not subject to Code § 4958.
The second question in excess benefit analysis is whether there is a “disqualified person.” Disqualified persons include:
- 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);
- A family member of an individual in the preceding category; or
- An entity in which individuals described in the preceding categories own more than a 35 percent interest.1
Those who perform the functions of voting members of the governing body, presidents, chief executive officers, chief operating officers, chief financial officers, and treasurers are all disqualified persons, regardless of title. And certain persons are deemed not to be disqualified persons. These “deemed non-disqualified persons” include 501(c)(3) and (c)(4) organizations and employees receiving economic benefits of less than a specific amount.
Excess Benefit Transaction
An “excess benefit transaction” is a transaction in which an economic benefit is provided by an applicable tax-exempt organization to or for the benefit of any disqualified person, if the value of the economic benefit provided by the exempt organization exceeds the value of the consideration (including performance of services) received for providing the benefit. Reasonable compensation paid to employees of the non-profit organization is not considered an excess benefit.
Excess benefit transactions include more than just benefit provided to a disqualified person. Also includes are benefit is provided to a non-disqualified person for the use of a disqualified person. This could occur, for example, when benefit is provided to an organization in which a disqualified person has a financial interest.
Penalties for Excess Benefit Transactions
Unlike the remedies for inurement and private benefit, which penalize the tax-exempt organization alone, intermediate sanction regime penalizes the disqualified person involved in the transaction. Organizational managers who participate in the transaction could also be liable.
Penalties on the Disqualified Person
A disqualified person is subject to an excise tax (called the “initial tax”) equal to 25 percent of the excess benefit. An additional tax in the amount of 200 percent of the excess benefit involved is imposed on the disqualified person if the initial tax was imposed and there was no correction within the taxable period. The “taxable period” is the period beginning on the date of the transaction and ending on the earliest date of either the date of mailing of a notice of deficiency as to the initial tax or the date on which the initial tax is assessed.
To correct an excess benefit, the disqualified person must undo the excess benefit transaction to the extent possible and take all necessary steps to place the organization in no worse position than if the disqualified person had dealt property. This usually requires the disqualified person to make a payment in cash or cash equivalents (other than promissory notes) and/or return the property transferred in the excess benefit transaction to the applicable tax-exempt organization.
Penalties on Other Organizational Managers
If the tax is imposed on a disqualified person and no correction occurred during the taxable period, an organizational manager that participated in the transaction, knowing that it was an excess benefit transaction, is subject to an excess tax equal to 10 percent of the excess benefit, up to a maximum amount of $20,000 per transaction. The tax on the organization manager is not imposed, however, if participation in the transaction was not willful and was due to reasonable cause.