Intermediate Sanctions on NPO Executive: Unreasonable Compensation Can Bring an Unexpected Tax Liability
Kuhn, Nancy Ortmeyer, Journal of Accountancy
A relatively recent tax on executives in the charitable sector is getting attention due to vigorous IRS enforcement and extensive new Treasury regulations issued in January 2001. This tax, sometimes referred to as an intermediate sanction (the ultimate being revocation of the NPO's exempt status), is imposed on executives whose compensation the IRS considers excessive. CPAs--and the NPO executives they advise--must plan carefully to avoid the tax. The law targets not only top executives but also their family members and family-controlled entities if any receive excess benefits.
Congress had passed IRC section 4958 as part of the Taxpayer Bill of Rights 2 and made it retroactive for transactions on or after September 14, 1995. The rules gave the IRS a tool to regulate the activities of exempt organizations--with or without revoking the organization's exempt status. CPAs should understand section 4958 and the new regulations to help guard against unexpected tax liability for NPO executives--the targeted taxpayers. (While NPOs themselves have no liability under section 4958, they are subject to other penalties.)
Section 4958 imposes an excise tax on excess benefits received by a "disqualified person"--anyone in a position to exercise substantial influence over a qualifying organization's affairs. IRC section 501(c)(3) or 501(c)(4) entities are considered "qualifying organizations." Section 4958 does not apply to individuals employed by private foundations; executives of such organizations are already subject to similar IRC section 4941 self-dealing penalties.
There is a five-year look-back period starting with the transaction date. This means the IRS can look back five years from the date the executive received the excess benefit and impose the tax if he or she was a disqualified person at any time during this period. The term disqualified person can apply to that person's immediate family as well as to family-controlled entities. (The law defines control as 35% of the total combined voting power.) Congress clearly did not want executives to divert benefits to family members by way of family-controlled businesses or trusts. Independent contractors, including advisers, do not fall within these rules since they presumably do not hold positions of influence in the organization.
A parallel five-year look-back rule applies in determining qualifying organizations. If an entity was a section 501(c)(3) or (c)(4) organization at any time within the five years before the transaction date, section 4958(e) considers it a qualifying organization.
An excess benefit is one a disqualified person receives that exceeds the value of the benefit the organization gets in return, including the value of services he or she performs. For example, the IRS would consider an executive with a salary and benefits greater than those of comparable executives performing comparable work at similar organizations to be in receipt of an excess benefit subject to the section 4958 excise tax.
The legislative history shows that when valuing compensation, NPOs and their executives can use either for-profit or nonprofit comparables. In a footnote to the committee report accompanying the 1996 legislation, the House of Representatives said that "an individual need not necessarily accept reduced compensation merely because he or she renders services to a tax-exempt, as opposed to a taxable, organization." The 2001 regulations also specify executives can use for-profit comparables.
THE BINDING CONTRACT EXCEPTION
A transitional rule in the 1996 legislation allows an executive to continue receiving excess benefits when there is a long-standing affiliation between a disqualified person and the organization. Congress included this exception for written contracts that were binding on September 13, 1995, and, at all times thereafter, up to and including the transaction date. …