The National Office of IRS has just published a continuing professional education (CPE) article for its agents called, “Automatic” Excess Benefit Transactions Under IRC 4958”.1

In the article the IRS explains that where a so-called “disqualified person” receives compensation, if the compensation is not reasonable, there is an excess benefit transaction. An excess benefit transaction can subject the management of a nonprofit organization and the “disqualified person” to serious penalties. All economic benefits received for services (except specifically excluded items) are aggregated in order to determine if compensation is reasonable. However, where a disqualified person receives an economic benefit and there is not contemporaneous written substantiation that shows the organization’s intent to treat the payment as consideration for services, such payment will be considered an automatic excess benefit transaction unless the organization can establish that the payment was received in exchange for other consideration, e.g., a bona fide loan. The payment will be considered an automatic excess benefit regardless of its reasonableness or whether or not other compensation the disqualified person may have received is reasonable with or without counting the automatic excess benefit.

Because adverse tax consequences and publicity for 501(c)(3) and 501(c)(4) organizations could be severe if an excess benefit transaction is found to have occurred, nonprofit organizations should consider preemptive action. Compensation arrangements with respect to all key employees, particularly those who also serve as Board members and or officers of all large exempt organizations should be reviewed for compliance with IRS rules.

Intermediate Sanctions

Congress enacted intermediate Sanctions (IRC 4958) in 1996. The law provides that penalty taxes may be imposed upon “disqualified persons” who enter into “excess benefit transactions” with 501(c)(3) or 501(c)(4) organizations. Disqualified persons are officers, directors and key employees and those able to exercise substantial influence over the organization. Examples of an excess benefit include unreasonable compensation. A determination of whether compensation is reasonable is based on facts and circumstances.

If an organization’s independent governing body documents both the reasonableness of, and the fact of its approval of a compensation package based on comparable data that includes similarly situated individuals who work at nonprofit and for-profit entities, the organization can establish a rebuttable presumption that the compensation is reasonable.

On the other hand, where an organization pays personal expenses of an individual without documentation that all economic benefits were considered, the IRS now appears poised to automatically classify the portion of the compensation that was not disclosed to the Board as an excess benefit transaction. The undocumented benefit may be treated as an excess benefit regardless of whether total compensation is reasonable, hence called the “automatic” excess benefit.

The sorts of compensation which the IRS appears to be focused on is the payment of personal expenses that are not excluded from income under a specific provision of the Internal Revenue Code. For example, personal expenses include items such personal vacations, spousal travel, personal use of a car, and for meals and lodging and other economic benefits that do not meet statutory rules to be excluded from income.

Excess benefit transactions are subject to a 25% tax on the amount involved that exceeds fair market value and a 200% tax if the transaction is not corrected. Automatic excess benefits are subject to the 25% and 200% tax on the entire amount involved. In some cases the taxes may be abated if the disqualified person corrects the excess benefit transaction.

If intermediate sanctions taxes are imposed, Form 4720 Return of Certain Excise Taxes on Charities and Other Persons Under Chapters 41 and 42 of the Internal Revenue Code is required to be filed. If the return is not filed in a timely manner or payment is not made, significant penalties could apply.

Nonaccountable Reimbursement Plans

Certain economic benefits are disregarded when determining excess benefits and therefore, written documentation specifically indicating the benefit is received, as compensation for services is not required. For example, nontaxable fringe benefits and expense reimbursements paid pursuant to accountable plans are excluded. However, if expenses are reimbursed pursuant to a plan that is a “nonaccountable plan” the exclusion does not apply and such amounts are to be included in an individual’s W-2 income. If an organization does not substantiate that the payment is compensation, such payments will be considered automatic excess benefits.

Written Contemporaneous Substantiation

Tax exempt organizations can clearly indicate intent to provide an economic benefit as compensation for services if the organization provides written substantiation to that effect contemporaneous with the transfer of the economic benefit. An organization is treated as making contemporaneous substantiation if:

• The organization reports the benefit as compensation on an original Federal tax information return with respect to the payment (e.g., Form W-2 or Form 1099);
• The recipient disqualified person reports the benefit as income on the person’s original Federal tax return (e.g., Form 1040); or there is an approved written employment contract executed on or before the date of the transfer indicating the benefit is compensation;
• There is documentation by the organization’s authorized body approving the transfer as compensation for services on or before the date of transfer, or,
• There was other written evidence in existence before the due date of the applicable federal tax return indicating a reasonable belief by the organization that the benefit was a nontaxable benefit.

If a failure to report an economic benefit as compensation is due to reasonable cause and not willful neglect, the exempt organization is treated as having clearly indicated its intent to provide the economic benefit as compensation for services.

Relief by Filing Amended Returns

IRS regulations provide relief from the contemporaneous written documentation rule if an amended return is filed before the earlier date of when IRS has written documentation of a potential excess benefit transaction or has begun an audit of the organization or the individual. Therefore, in addition to coming up with protocols for future compensation decisions, we recommend that exempt organizations review the benefits and compensation arrangements being provided currently to key personnel to determine if remedial action is required or may be helpful.

Conclusion

The consequences can be severe if there is no written documentation of the intent to make an economic benefit consideration for services. However, if there is no contemporaneous documentation, filing amended returns can provide relief. If you would like to discuss any matter raised by this ALERT, please speak with either your contact at Arent Fox or one of the attorneys listed below.

1. “Automatic” Excess Benefit Transactions Under IRC 4958,” by Lawrence M. Brauer and Leonard J. Henzke, Jr., at www.irs.gov/pub/irs-tege/eotopiceo4.pdf