Similar to inurement, nonprofits must also be careful to avoid excess benefit transactions (EBTs). Code § 4958 governs EBTs, and the regulation applies to organizations that are tax-exempt under 501(c)(3) or (c)(4), either currently or at any time in the 5 years preceding an EBT.
An EBT is a transaction in which your organization provides an economic benefit to a disqualified person, greater than the value of the consideration you receive. This may come in the form of paying someone above market rates, selling an asset below market value, purchasing it above market value, reimbursing personal expenses without properly treating it as taxable income, or a number of other possibilities. The excess benefit may be given directly to the disqualified person, or indirectly, such as providing a benefit to an organization in which the person has a financial interest. Whether direct or indirect, the transaction will fall under Code § 4958 and have the same consequences for those involved.
Who counts as a disqualified person? There are 3 categories:
- Any person in a position to exert substantial influence over the affairs of the organization, formally or informally, at the time of the transaction or within the 5 years leading up to it.
- A family member of someone in category 1.
- An entity over which someone in category 1 or 2 has 35% or more control.
Certain people are automatically considered disqualified persons, such as members of your board of directors, those responsible for implementing decisions of the board (e.g. CEO or President), and those who manage the organization’s finances (e.g. CFO and treasurer). The IRS looks at the roles and responsibilities that individuals have in the organization, not the titles they hold. Other individuals may be considered disqualified, based on the facts and circumstances. Having substantial influence in the organization may be evidenced by:
- Having founded the organization
- Being a significant contributor to the organization. This includes making aggregate contributions of at least $5,000 in the current fiscal year or a preceding year, or contributions that total 2% of more of total contributions in the 5 years ending with the current year. When you file your Form 990, these contributors will be reported on Schedule B.
- Having authority over a significant portion of the organization’s budget, employee compensation, or capital expenditures
- Managing a distinct department or activity that makes up a substantial part of the activities or finances of the organization as a whole
If your organization engages in an EBT, the IRS will levy certain taxes, which fall into 3 categories:
- The disqualified person who benefitted from the EBT will be taxed 25% of the excess benefit. This is not necessarily the entire benefit, only the portion in excess of what the organization received in return. For instance, if an employee was paid $150,000, and the market rate for his or her work was $100,000, the excess benefit is $50,000, resulting in a tax of $12,500. If the individual purchased an asset from the organization for $2,000 that was worth $3,000, the excess benefit was $1,000, and the tax will be $250.
- The disqualified person must also return the excess benefit the organization, or will face an additional 200% penalty tax. In the examples above, this would be $100,000 or $2,000.
- If a manager in the organization knowingly and willfully participates in an EBT, he or she will face a tax of 10% of the excess benefit, limited to $20,000 for any single EBT. Participating in the transaction could include taking positive action, as well as silence or inaction in a situation where the manager should have stepped in. A manager can avoid liability here if he or she relied on written legal counsel evaluating the transaction and concluding that it would not be an excess benefit.
It is prudent to have policies and practices in place to prevent EBTs from occurring. Keep track of who would be considered a disqualified person, including family members outside the organization and related entities, and pay close attention to any transactions with them. Document what benefit the person or entity received, and what your organization received in return, and how you determined a fair value for it. For compensation, your organization can protect itself from charges of excess pay under the rebuttable presumption of reasonableness. This is not a 100% guarantee, but it puts the responsibility on the IRS to prove the compensation was unreasonable, rather than you having to prove otherwise.
Additional Resources
Article by the Society for Human Resource Management that provides additional examples (see yellow boxes)
Article by David Levitt of Adler & Colvin that provides questions and comments about applying EBT regulations (pages 4-7)