Private Benefit Rules – Part III: Excess Benefit Transactions

The final private benefit rule discussed in this series is the excess benefit transaction rules, codified in section 4958 of the Internal Revenue Code (“IRC”), which are a similar but distinct set of rules from the private inurement doctrine discussed in Part II. Similar to the private inurement doctrine, the excess benefit transactions rules are concerned with a certain subset of individuals who stand in a particular relationship with the organization. However, the excess benefit transaction rules have nuanced differences in applicability, penalties, and available protections.

Applicability of the Excess Benefit Transaction Rules

The excess benefit transaction rules apply to any entity that has status as a 501(c)(3) public charity or 501(c)(4) organization (i.e., social welfare organizations) at any time during a five-year look back period from the date the excess benefit transaction occurred:

  •  An excess benefit transaction is defined as any transaction in which an economic benefit is provided by the organization directly or indirectly to or for the use of any disqualified person, and the value of the economic benefit provided exceeds the value of consideration (including the performance of services) received for providing the benefit. (Treas. Reg. 53-4958-4(a)(1)).
  • A disqualified person is a person in a position to exercise substantial influence over the affairs of the organization at any time during the five-year look back period from the date of the excess benefit transaction. (Treas. Reg. 53.4958-3(a)(1)).

The question of disqualification is factual inquiry that looks at actual powers and responsibilities as opposed to titles. Therefore, voting members of a governing body (e.g., directors) and those with the ultimate responsibility for implementing decisions of the governing body (e.g., President) or managing the finances of the organization (e.g., Chief Financial Officer) during the five year look back period would likely be considered disqualified irrespective of their titles in the organization and whether such influence was actually exercised. (See Treas. Reg. 53.4958-3(c)). Additionally some parties are automatically disqualified persons such as the family members of a disqualified person or an entity in which a disqualified person owns at least 35% control.

Additional facts and circumstances that tend to show substantial influence include (see Treas. Reg. 53.4959-3(e)(2)):

  • The person founded the organization;
  • The person’s compensation is primarily based on revenues derived from activities of the organization, or of a particular department or function of the organization that the person controls;
  • The person has or shares authority to control or determine a substantial portion of the organization’s capital expenditures, operating budget, or compensation for employees; or
  • The person manages a discrete segment or activity of the organization that represents a substantial portion of the activities, assets, income, or expenses of the organization, as compared to the organization as a whole.

Examples of Excess Benefit Transactions

Often the same situations that would trigger a private inurement issue also trigger a potential excess benefit transaction violation. Common situations include:

  • Loans to and from the Organization. Federal tax law does not prohibit a disqualified person from making loans to the public charity or social welfare organization and vice versa. However, such loans have the potential for abuse and are a common problem area with regard to excess benefit transactions. The IRS is commonly concerned about the legitimacy of the loan and terms of repayment. Circumstances that help to show an excess benefit transaction has not occurred include:
    • The organization makes a bona fide loan to a disqualified person with an interest rate at or above market value;
    • The disqualified person makes a loan to the organization with an interest rate below market value; and/or
    • The recipient’s intent to repay the amounts and transferor’s expectation of repayment and intent to enforce payment are supported by evidence.
  • Compensation for Past Services. Many nonprofit executives are paid below what a board might otherwise approve or desire to provide due to economic factors. Sometimes, a board will attempt to acknowledge the value of such services despite current limiting circumstances through arrangements such as an agreement at the outset to pay a higher amount at a later date for services to be rendered or an agreement at a later date to pay an additional amount in recognition of past services already rendered. The IRS will generally treat the deferred compensation as having been earned in equal amounts in each year unless there is sufficient evidence to show an alternative payment schedule. The common concern here is whether the total compensation, in consideration of the services rendered over such time period, is reasonable. Circumstances that help to show an excess benefit transaction has not occurred include:
    • The total compensation the person received was less than the value of the services the person performed for the organization during the prior years;
    • The board followed the Rebuttable Presumption of Reasonableness for each year in question (see below); and/or
    • The board evaluated and concurrently documented its consideration of the annual aggregate compensation including the deferred compensation in comparison to the fair market value of such services for each year in question.

Penalties for Excess Benefit Transactions

If an excess benefit transaction has occurred, the IRS can levy taxes, commonly referred to as intermediate sanctions, on both the disqualified person who received the excess benefit and the organizational manager(s) who knowingly approved the excess benefit transaction. Pursuant to IRC section 4958, the IRS is authorized to impose the following penalties:

  • 25% excise tax of the excess benefit on the disqualified person who received the excess benefit; and an additional 200% excise tax of the excess benefit if the violation is not corrected within the taxable period.
  • 10% excise tax of the excess benefit on the organizational manager [e.g., a director or board member] who knowingly participated in the transaction (maximum of up to $20,000).

Historically, the intermediate sanctions have been used as an alternative penalty to revocation under the private inurement doctrine because the penalty of revocation is so severe. However, the IRS can impose both the intermediate sanctions under the excess benefit transaction rules and revoke exempt-status under the private inurement doctrine for the same unlawful transaction.

Protections Against Excess Benefit Transactions

Compensation is probably the most problem-ridden area for exempt organizations with respect to excess benefit transactions. Luckily, the regulations provide for a process to create a presumption that payments under a compensation arrangement are reasonable (i.e., the Rebuttable Presumption of Reasonableness). Generally, if the IRS penalizes a disqualified person under the excess benefit transaction rules, such individual bears the burden to prove that the compensation arrangement was reasonable. However, if an organization follows the Rebuttable Presumption of Reasonableness procedures, the burden of proof shifts to the IRS to show the compensation arrangement was excessive. Therefore, while this presumption is rebuttable by the IRS, in practice, this creates an obstacle that the IRS is not likely to deal with unless a clear or egregious violation has occurred.

The Rebuttable Presumption of Reasonableness [link to 8/10/19 post] consists of three steps:

  1. The compensation arrangement or the terms of the property transfer are approved in advance by an authorized body of the organization composed entirely of individuals who do not have a conflict of interest with respect to the compensation arrangement or property transfer (Treas. Reg. 53.4958-6(a)(1));
  2. The authorized body obtained and relied upon appropriate data as to the comparability data prior to making its determination (Treas. Reg. 53.4958-6(a)(2)); and
  3. The authorized body adequately documented the basis for its determination concurrently with making that determination (Treas. Reg. 53.4958-6(a)(3)).

Although the Rebuttal Presumption of Reasonableness is prescribed with respect to compensation arrangements, it generally lays out a process that organizations are encouraged to follow in approving any transaction with a disqualified person or other individual with a possible conflict of interest.

Certain filing organizations should also remember that the annual information return with the IRS (i.e., Form 990 and Form 990-EZ), which is a publicly available document and signed under penalty of perjury, requires organizations to disclose whether an excess benefit transaction has occurred or the organization became aware that an excess benefit transaction has occurred in a prior year (see e.g., Form 990, Part VI, Question 89b). Organizations are well advised to understand the consequences of this rule both in terms of intermediate sanctions and the loss of good will and public trust that results from organizations that allow such violations to occur under their leaders’ oversight.

For more information on excess benefit transactions, please see the following Internal Revenue Service Exempt Organizations Unit internal documents:

The private inurement doctrine is another private benefit rule applicable to public charities. The doctrine comes directly from the language of section 501 of the Internal Revenue Code that only organizations “no part of the net earnings of which inures to the benefit of any private shareholder or individual” may be exempt under section 501(c)(3). A 501(c)(3) organization that violates the private inurement doctrine fails to be operated exclusively for one or more exempt purposes and is subject to revocation of its exempt status. (See Treas. Reg. Section 1.501(c)(3)-1(c)(2)).

There is no strict definition for “inure” but this is generally understood as providing unjust enrichment from the organization’s gross or net earnings to another party. (See People of God Community v. Commissioner, 75 T.C. 127 (1980)). Unlike the private benefit doctrine discussed in Part I, the restriction on inurement is absolute (i.e., the doctrine does not allow for incidental private inurement). Additionally, the private inurement doctrine is narrower in reach than the private benefit doctrine, which can apply to any person. “Private shareholder or individual” is defined in the Treasury Regulations as “persons having a personal and private interest in the activities of the organization.” (See Treas. Reg. Section 1.501(a)-1(c)). In other words, the private inurement doctrine generally applies to persons, commonly referred to as “insiders,” who are in a position to influence or control use of the organization’s assets for personal gain such as founders, directors, or officers.

It is important for public charities to understand the private inurement doctrine does not bar the organization from entering into transactions with insiders.  The private inurement doctrine does however bar the organization from providing a disproportionate share of benefits to an insider regardless of whether the inurement conferred is $1 or $1,000.

Private inurement violations may be found in situations involving:

  • A compensation arrangement with an insider where there is no upper limit (see People of God Community);
  • A compensation arrangement that is based on factors extrinsic to performance at and benefit to the organization (see G.C.M. 39498);
  • Use of gross or net earnings to provide goods and services to insiders; or
  • Paying more than fair market value in exchange for goods or services provided by an insider.

Organizations should also be wary of the certain transactions that due to their complexity, unfamiliarity, or other circumstances, can be more difficult to analyze and may result in private inurement violations for unwary or uninformed organizations, such as:

  • Assignment of rights to intellectual property developed by insiders and funded, in whole or in part, with organizational assets;
  • Compensation arrangements with added considerations such as deferred compensation, bonuses, fringe benefits, or retirement or severance packages; or
  • Use of organizational assets to support, fund, or otherwise invest in an insider’s business.

Boards of directors should furthermore be cautious of poor governance practices that can exacerbate the likelihood of private inurement violations under their oversight, such as:

  • A failure to acquire sufficient information to allow for thorough board discussion and informed decisions prior to board approval;
  • A limited understanding about the fiduciary duties of care and loyalty;
  • The absence of a conflict of interest policy; and
  • A lack of knowledge about applicable state laws that may place additional restrictions or procedural requirements on
    transactions with insiders.

The private inurement doctrine is often overlooked because of its overlap with the private benefit doctrine which subsumes the private inurement doctrine. Additionally, the penalty of revocation has historically not been enforced except in egregious cases. However, regardless of whether an organization would face such a severe penalty at the hands of the IRS, the private inurement doctrine is a cornerstone principle that all public charities should understand.

*Please note 501(c)(3) private foundations are subject to self-dealing rules under Internal Revenue Code section 4941 which generally prohibits private foundations from engaging in transactions with certain disqualified persons.

For more information on the private inurement doctrine and private benefit issues, please read the IRS Exempt Organizations internal document “Overview of Inurement/Private Benefit Issues in IRC 501(c)(3).”

Part I of this series of posts discusses the private benefit doctrine and is available here.

Part II of this series discusses the private inurement doctrine and is available here.