Most of us engage with non-profits in our community because we are committed to their mission, and as a result of this passion, often times those related to us also become engaged in supporting our chosen organizations. In addition, these organizations are often organized and controlled by a small group of dedicated employees and volunteers. As a consequence, it is important for the Board of Directors to understand the IRS’s Intermediate Sanction rules that apply to transactions, including employment contracts, between the non-profit organization and “disqualified persons.”
Section 4958 of the Internal Revenue Code, referred to as the Intermediate Sanction rules can impose an excise tax on certain transactions between a non-profit organization and a disqualified person if the result of the transaction is that the value of the economic benefit provided by the non-profit organization exceeds the value received from the disqualified person. These transactions can take many forms, including employment agreements, loans, joint ventures, leases, or service contracts.
The first step is to identify transactions with disqualified persons. A disqualified person is someone in a position to exercise substantial influence over the affairs of the non-profit organization at any time during the five-year period prior to the date of the transaction, regardless of whether the disqualified person actually exercises such influence. Examples of those that are considered to have substantial influence that will trigger the application of these rules include:
(a) voting members of the board of directors; (b) the president, chief executive officer and/or chief operating officer, and any person, regardless of title, who has the ultimate responsibility for implementing the decisions of the board of directors or for supervising the management, administration, or operations of the organization; (c) the treasurer or chief financial officer, and any person, regardless of title, who has the ultimate responsibility for managing the finances of the organization; and (d) persons with a material financial interest in a provider-sponsored organization.
In the event a person is determined to be a disqualified person, any family member and 35% controlled entities will also be deemed disqualified persons, which includes spouses, children, brothers, sisters, their spouses, ancestors and grandchildren.
In the event a non-profit organization is engaging in a transaction with a disqualified person, i.e., negotiating and approving an employment contract with their president, or leasing real property from a board member, the Treasury Regulations provide steps to follow that will create a rebuttable presumption that the transaction is reasonable and not subject to these sanction rules. These steps include the following: (1) Advance Approval. The terms of the arrangement are approved in advance by the authorized body of the non-profit organization, such as the board of directors or executive committee, composed entirely of individuals who do not have a conflict of interest. (2) Comparable Data is Used. The authorized body obtained and relied upon appropriate data as to comparability prior to making its determination. The data must provide information that is sufficient to determine if the compensation is reasonable or if it is fair market value. (3) Contemporaneous Documentation. The authorized body adequately documented the basis for its determination concurrently with making that determination.
In order to satisfy this requirement, the written or electronic records must include:
(a) the terms of the transaction that was approved and the date it was approved;
(b) the members of the authorized body who were present during the debate on the transaction that was approved and those who voted on it;
(c) the comparability data obtained and relied upon by the authorized body and how the data was obtained; and
(d) any actions taken with respect to members of the authorized body who had a conflict of interest.
In order to be concurrent, records should be prepared before the later of the next meeting or 50 days after the final actions are approved.
Taking the steps to achieve the presumption is important because in the event the Intermediate Sanction rules are triggered, the penalty is an excise tax of 25% of the transaction, payable by the disqualified person. 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 (and possibly the Board of Directors) who knowingly participated in the transaction, which in the aggregate for all managers shall not exceed $10,000.
