While it is not uncommon for nonprofits to engage in business transactions with insiders, i.e., doing business with an entity related to a board member or officer of the nonprofit organization, it is important that the nonprofit engage in due diligence and strict corporate governance to ensure that such related party transaction will run afoul of IRS rules.
The Intermediate Sanctions rules set forth in Section 4958 of the Internal Revenue Code impose penalties in the event that the 501(c)(3) organization enters into a transaction with a so-called disqualified person that is considered an excess benefit transactions. An excess benefit transaction has three parts: (1) a tax-exempt organization is involved; (2) an economic benefit is provided by the organization, directly or indirectly to a disqualified person; and (3) the value of the economic benefit provided by the organization exceeds the value of the benefit received by the organization from the disqualified person. All three requirements must be met to trigger a violation.
Disqualified Person. A disqualified person is a person who is in a position to exercise substantial influence over the affairs of the organization during the five year period prior to the date of the transaction, regardless of whether they actually exercise such influence. In the event a person is deemed to be a disqualified person, any family member (not just immediate family), and entities in which such disqualified person owns at least 35% will also be deemed disqualified persons. Persons having substantial influence are voting members of the board of directors, the president, CEO, CFO, and any other person who has responsibility for implementing decisions in the organization. In the event a transaction does not involve a disqualified person, the analysis is complete. However, if there is a transaction between the organization and a disqualified person, the next step is to determine if it is an excess benefit transaction.
Excess Benefit Transaction. An excess benefit is defined as the amount by which the value of the economic benefit provided by the organization, either directly or indirectly, to or for the use of a disqualified person exceeds the value of the consideration (including the performance of services) received by the organization. For purposes of determining value received, fair market value of property and service is used.
Penalty for Violation. In the event a nonprofit participates in an excess benefit transaction with a disqualified person, the penalty is 25% of the excess benefit transaction, payable by the disqualified person (i.e., the insider). In the event that the transaction is not corrected, there is an additional 200% excise tax imposed on the disqualified person. In addition, there is an excise tax of 10% imposed on the organization manager (which may include board members) who knowingly participated in the excess benefits transaction, which in the aggregate for all managers shall not exceed $10,000.
Rebuttable Presumption. For those nonprofit organizations that engage in transactions with insiders, it is very important that they take certain steps to establish a rebuttable presumption that the transaction is not an excess benefit transaction. A rebuttable presumption is established if three requirements are satisfied: (1) advance approval (the arrangement is approved in advance) by the governing body, i.e., the board of directors; (2) comparable data is used (that data says that the compensation is reasonable and not an excess benefit); and (3) contemporaneous documentation of these steps (there is adequate documentation recorded concurrently with the transaction). Failure to establish the rebuttable presumption will not necessarily result in a violation, but it will strengthen the organization’s position. The IRS may rebut the presumption if it develops sufficient evidence to the contrary, however.
For more information, please contact Jenifer Schembri at firstname.lastname@example.org. Jenifer is a principal in our Business & Corporate, Estate Planning, and Tax Law Groups.