Wednesday, February 29, 2012
The World of Excess Benefit Transactions and Intermediate Sanctions
Nonprofit organizations as a general rule are prohibited from participating in transactions that are deemed to be excess benefit transactions. These are transactions that involve disqualified persons and the provision of benefits in excess of what the organization receives in return for the benefit. In the mode of compensation, an organization is not allowed to pay more compensation than is reasonable for the services provided by the employee. Any compensation paid above reasonable compensation or above the "umbrella" to a disqualified person is considered to be an excess benefit transaction.
Disqualified persons are generally officers, directors, trustees and key employees of an organization. In addition, the term also includes the family members of any of these individuals. I often tell my classes that this group is generally the movers, shakers & decision makers of the organization and their families.
It is important that this group of people be identified in order that the organization can properly handle any transaction related to a member of this group. Compensation is one of those areas that requires special attention for this group.
Excess Benefit Transactions & Intermediate Sanctions
As described above, payment of unreasonable compensation creates an excess benefit transaction for a disqualified person. Excess benefit transactions are subject to a set of penalties called intermediate sanctions. These sanctions are assessed to the recipient of the excess benefit and to anyone who agreed to the transaction giving rise to the excess benefit.
If an excess benefit occurs, the following are the consequences:
1. The benefit is required to be repaid to the organization; and
2. The disqualified person is required to pay a penalty or tax to the IRS of 25% of the amount of the benefit.
If the IRS discovers the transaction and it is not corrected before they discover the transaction, additional penalties may be assessed to the disqualified person equaling 200% of the benefit.
If someone else within the organization agrees to the transaction giving rise to the excess benefit transaction, they can be assessed a penalty of 10%. This includes such persons as other officers, directors, and trustees.
Excess Benefit Transactions & Inurement of Benefit
Nonprofit organizations are prohibited from entering into transactions that create inurement of benefit to control parties, i.e., disqualified persons. The Internal Revenue Code indicates that the mere existence of inurement of benefit is grounds for revocation of the organization's exempt status. Virtually all excess benefit transactions create inurement of benefit. Therefore, if an excess benefit transaction occurs, the IRS has grounds to revoke the tax exempt status of the organization. Normally the IRS will utilize the above described sanctions to punish the guilty insider and not revoke unless the activity is egregious. However, the law allows the IRS to both revoke the tax exempt status of the organization as well as assess the penalties described above to the disqualified person.
Defining the "umbrella" of reasonable compensation is critical to avoiding the creation of excess benefit transactions and the related consequences of such transactions as well as being vital to protecting the tax exempt status of the organization.
Wednesday, February 22, 2012
One of my mentors who is a teacher and pastor once taught me that people retain concepts that are associated with pictures. I try to incorporate this philosophy into my technical training since technical topics tend to be "uninteresting" and sometimes downright boring. Keeping in line with this teaching technique, I created the idea of the compensation umbrella. The compensation umbrella is the amount of reasonable compensation that may be paid to an employee. In other words, it is the maximum amount that may be paid to an employee. It does not have to be paid, but it is the measuring stick used to determine the maximum that can be paid.
Defining the umbrella or the amount of reasonable compensation that may be paid should be accomplished using outside data compiled from an independent source.
These include salary surveys from organizations such as the National Association of Church Business Administrators and using independent compensation experts. These are people specifically trained in the arena of compensation and human resources and have practiced in this area for many years. (The IRS and some states' attorney general offices have declared that this does not include certified public accountants or attorneys unless compensation and human resources is their area of specific practice. In addition to a lack of qualifications, most attorneys and CPAs are not independent to the person whose compensation is being evaluated.) Additionally, smaller organizations, i.e., less than $1,000,000 in revenue may accumulate information from like size and like minded organizations.
After gaining data from outside sources, the data should be reviewed through the lens of the operations of the organization. To this end, the organization would want to consider the following factors:
- The employee/minister's qualifications
- The nature and scope of the employment arrangement
- The size and complexity of the organization
- The prevailing economic conditions of the area
- The organization's overall salary philosophy
- The financial condition of the church
The above steps only create the umbrella of reasonable compensation. The organization is not bound to pay this amount. However, if it pays more than this amount then the employee and the decision makers may be subject to penalties and the organization's exempt status could be jeopardized. This subject will be discussed in next week's post.
Tuesday, February 14, 2012
One of the most common areas that I speak on across the country is regarding the area of compensation. As a general rule, it seems that nonprofit organizations struggle with the intricacies of the rules regarding the payment of compensation and even the definition of what is compensation. Therefore, I have decided to start a multiple part blog series on this subject as a means of offering some much needed guidance. I plan to post once a week. I don't know how many weeks it will take, so join in for the next few weeks to brush up on your knowledge in this area and maybe learn a few new things along the way.
Compensation & the Overriding Philosophy of Tax Law
Perhaps the first stumbling block or hurdle to overcome in this area is to finally acknowledge how vast an array of information this topic covers. I generally find that the normal person does not realize one of the foundational truths of the U.S. tax code. This truth is based on two premises:
- Everything that benefits an employee is a form of compensation and
- Everything is taxable until the Internal Revenue Code says its not.
In general, it seems that the natural human response or thought process goes something like this:
- Compensation is what is reported on my paycheck stub and
- Nothing is taxable until somebody proves to me it is (or with my clients, until Elaine tells me it is.)
Needless to say, it is necessary for an organization to first come to a realization that compensation has a more far reaching definition than may have previously been considered and that taxation should be the assumed consequence of any benefit until otherwise proven. This is critical because there are very specific rules that apply to nonprofits, including religious organizations and churches. A deviation from these rules can be costly to the organization and the employee.
With this as the basis for the series, we will start to work through a 10 Step process for defining and dealing with compensation within a nonprofit organization. Next week - Step #1 - Who Gets to Decide on Compensation.