Compensation planning is obviously a multiple step process even though nonprofit organizations have a tendency to either combine some of the steps or skip a few steps. Last week we discussed creating the umbrella of reasonable compensation for an employee. This week we are expanding on this step by reviewing the reasons why determining reasonable compensation is important to organizations.
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.