The Rebuttable Presumption of Reasonableness procedures, described in Treasury Regulation Section 53.4958-6(a), were promulgated to help charities avoid overpaying certain individuals and entities (known as disqualified persons) that might be able to exercise influence on the charity’s decision-making. Among those included as disqualified persons (DQPs) are:

1. Directors (board members), trustees, presidents, CEOs, COOs, treasurers, CFOs, and other persons who were, at any time during the 5-year period ending on the date of such transaction, in a position to exercise substantial influence over the affairs of the organization (which typically include founders, substantial contributors over the past five years, and persons whose compensation is primarily based on revenues derived from a part of the organization that the person controls);
2. Family members of those individuals described in (1) above, including spouses, siblings, the spouses of siblings, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, and great grandchildren; and
3. 35-percent controlled entities, which are corporations in which individuals described above own more than 35% of the combined voting power, partnerships (including LLCs) in which individuals described above own more than 35% of the profits interest, and trusts and estates in which individuals described above own more than 35% of the beneficial interest; provided however, that entities exempt under 501(c)(3) and most entities exempt under 501(c)(4) are not disqualified persons.

While the Rebuttable Presumption of Reasonableness procedures were designed to apply only in cases in which an economic benefit is provided by a charity, directly or indirectly, to or for the use of a DQP, these procedures serve as a best practice to implement wherever significant payment is being made by the charity that might be considered excessive in relation to the goods, services, or rights being received in return. Even if the person or entity benefiting from the excessive payment is not a DQP, such payment may represent a prohibited private benefit and diversion of charitable assets. Accordingly, procedures that help assure that the payments are reasonable as to the charity, if carefully observed in good faith, will be protective to the charity and to the board. But practically speaking, following the Rebuttable Presumption of Reasonableness procedures may in some cases, particularly for smaller charities, be unduly burdensome and unnecessary where the payment made to a DQP is very obviously below fair market value.

Excess Benefit Transactions

Codified in section 4958 of the Internal Revenue Code (“IRC”), the excess benefit transaction rules impose penalty taxes on DQPs that receive excessive payments from a charity. These rules are meant to prevent the unjust enrichment of a DQP at the expense of the charity. If an excess benefit transaction has occurred, the IRS can levy taxes, commonly referred to as intermediate sanctions, on both the DQP who received the excess benefit and the organizational manager(s) (e.g., directors, officers) who knowingly approved the excess benefit transaction. This issue often comes up in the context of executive compensation.

If a DQP is found to have benefited from an excess benefit transaction, the DQP will need to return to the charity the portion of any payment considered excessive and pay to the IRS a first tier penalty tax (intermediate sanction) of 25% of the excessive amount and, if not timely corrected, a second tier penalty tax of 200% of the excess benefit. In some cases, the entire payment may be considered an excess benefit (e.g., where compensation to the DQP was not properly reported to the IRS), and the penalty can be extremely steep. For an example of such cases, see Automatic Excess Benefit Transactions (David Levitt, Adler & Colvin).

If the charity engaged in an excess benefit transaction, the organizational manager(s) (e.g., directors, officers) who knowingly approved the excess benefit transaction may also be subject to a penalty tax of 10% of the excess benefit. An organizational manager participates in a transaction knowingly only if the person –

• Has actual knowledge of sufficient facts so that, based solely upon those facts, such transaction would be an excess benefit transaction;
• Is aware that such a transaction under these circumstances may violate the provisions of Federal tax law governing excess benefit transactions; and
• Negligently fails to make reasonable attempts to ascertain whether the transaction is an excess benefit transaction, or the manager is in fact aware that it is such a transaction.

Generally, if the IRS penalizes a DQP under the excess benefit transaction rules, such individual bears the burden to prove that the transaction was reasonable. However, if the organization follows the Rebuttable Presumption of Reasonableness procedures described below, the burden of proof shifts to the IRS to show that the transaction resulted in an excessive payment to the DQP.

Three Steps to the Rebuttable Presumption of Reasonableness

The Rebuttable Presumption of Reasonableness procedures consist of three steps:

1. The compensation arrangements 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;
2. The authorized body obtained and relied upon appropriate comparability data prior to making its determination; and
3. The authorized body adequately documented the basis for its determination concurrently with making that determination.

1. Authorized Independent Body Free of Conflicts

The authorized body charged with approving the transaction may be made up of the full board of directors or a smaller authorized board committee, so long as all members of the body do not have a conflict of interest with respect to the transaction. The regulations identify five conditions that must be satisfied in order to establish the requisite absence of a conflict of interest. Generally, the members of the authorized body should not consist of:

• A DQP or anyone related to the DQP who is, or will, participate in, or economically benefit from, the transaction or arrangement (hereafter, referred to as “Person X”);
• A person in an employment relationship subject to the direction or control of Person X;
• A person who receives compensation or other payments subject to approval by Person X;
• A person who has a material financial interest affected by the transaction or arrangement; or
• Any person who receives or will receive from a DQP approval of a transaction benefiting such person in turn for such person’s approval of the transaction providing economic benefits to the DQP (i.e., a “you-scratch-my-back, I’ll-scratch-yours-type reciprocal transaction).

The authorized body may invite the DQP to come to a meeting and answer questions with respect to the transaction or arrangement, so long as that person recuses themselves from the meeting and is not present during debate and voting of the transaction or arrangement.

2. Appropriate Comparability Data

The requirement for reviewing comparability data helps the authorized body determine what economic benefit (payment) is fair and reasonable as to the charity, particularly when what would constitute such amount under similar circumstances is not well-known. It may also be thought of as an extension of a director’s duty of care, which includes reasonable inquiry. One way to show that a transaction or arrangement is fair and reasonable to the charity, does not provide an excess benefit to any private individuals or companies, and overall is in the best interest of the charity, is to look at other similar transactions or arrangements for comparison. We’ve previously written a post on appropriate comparability data for compensation arrangements. Note that, for transactions involving property, the regulations provide that appropriate comparability data may include “current independent appraisals of the value of all property to be transferred; and offers received as part of an open and competitive bidding process.” See Treas. Reg. § 53.4958-6(c)(2)(i).

Generally, the regulations do not specify the types of information or number of comparables that must be reviewed in order to benefit from the presumption; instead they state that the authorized body must use its judgement, given the knowledge and expertise of the body’s members, to determine whether the information gathered is sufficient to satisfy the standard set in the regulations (i.e., that “the compensation arrangement in its entirety is reasonable or the property transfer is at fair market value”). Thus, it will be a matter of facts and circumstances in determining whether sufficient and/or appropriate and current data was obtained and reviewed by the authorized body when making its decision. One exception to this general rule is for charities with annual gross receipts of less than $1 million (based on an average of its gross receipts during the three prior taxable years). For those small charities, there is a special rule that provides that consideration of three comparables of similarly situated organizations and positions will be appropriate.

Comparability data must be gathered and presented to the authorized body in advance of, or at, the meeting at which the arrangement or transaction is being considered. As a best practice, the data should be in writing and sent to the members of the body prior to the meeting so that each member has time for review and analysis.

3. Concurrent Documentation of Basis for Determination

To satisfy the third requirement of the rebuttable presumption, that the authorized body adequately documented the basis for its determination concurrently when making it, the regulations require that the documentation includes the following:

• the terms of the transaction and the date it was approved;
• the members of the authorized body who were present when the transaction was debated and those who voted on it;
• the comparability data obtained and relied on by the authorized body and how the data was obtained; and
• any actions taken by a member of the authorized body who had a conflict of interest with respect to the transaction (e.g., abstention).

Such documentation belongs in the minutes of the authorized body’s meeting or a written consent. The records must be prepared before the authorized body’s next meeting or 60 days after the body’s final actions are taken, whichever is later. Records must be reviewed and approved by the authorized body as reasonable, accurate, and complete within a reasonable time period.

If an organization satisfies the rebuttable presumption of reasonableness requirements, the IRS may rebut the presumption, “only if it develops sufficient contrary evidence to rebut the probative value of the comparability data relied upon by the authorized body.” Treas. Reg. § 53.4958-6(c)(3)(ii).

Ensuring that your organization’s conflict of interest policy conforms to these standards, as well as any other potential standards governing self-dealing transactions under state law, is one way to mitigate providing excess benefits to insiders in the future.