Prior to 1996, when the IRS found tax-exempt organizations in violation of the rule that those associated with the organization should not receive excessive compensation or benefits, there were only two actions available: ignore the violations or revoke the organization’s tax exempt status. Often, revocation was seen as too severe a penalty, as innocent parties in the organizations and the people it served were adversely affected. Congress created intermediate sanctions on July 30, 1996, as part of the Taxpayer Bill of Rights 2, adding another option to fall between the two extremes of ignoring the problem and penalizing the whole organization and its beneficiaries.
It took the Treasury Department until 2002 to issue temporary regulations on these “intermediate sanctions” which called for fines – known as "excise taxes on excess benefit transactions," to be assessed by the IRS when particular individuals associated with a tax-exempt organization receive compensation or benefits that exceed the value of services, goods, or donations they have provided the organization.
Only persons who are "in a position to exercise substantial influence over the affairs of" a 501(c)(3) or 501(c)(4) nonprofit organization and their family members – the definition of "disqualified persons"– are subject to this scrutiny. In general, these individuals are included:
- Organization's president, chief executive officer, chief operating officer, treasurer, and chief financial officer
- Voting members of the Board of Directors
- Substantial contributors
- Spouses and family members of “disqualified persons”
Organization managers who "knowingly, willfully, and without reasonable cause" participate in an excess benefit transaction can also be subject to intermediate sanctions.
The definitions of “excess benefit” and “disqualified person” are complicated, and nonprofits that become aware of possible excess benefit transactions must proceed carefully to avoid loss of tax exemption or severe fines. Seeking legal advice is strongly recommended.
Enroll in ERI Distance Learning Center's free self-paced course on Intermediate Sanctions for an in-depth study.
Impact on Charities
An excess benefit transaction can have serious implications for the disqualified person that entered into the transaction with the organization, any organization managers that knowingly approved of the transaction, and the organization itself. An organization tax-exempt under IRC section 501(c)(3), 501(c)(4), or 501 (c)(29) that becomes aware that it may have engaged in an excess benefit transaction needs legal advice. It is very important to correct the decision that led to the excess benefit and take any other actions needed to avoid substantial fines and continue the organization's tax-exempt status.
For disqualified persons, the excise tax for each excess benefit transaction is 25 percent of the amount over the true value of the services or item. An additional 200 percent can be charged if the excess benefit is not corrected by a certain date.
Organization managers who "knowingly, willfully, and without reasonable cause" participate in an excess benefit transaction are liable for 10 percent of the excess, not to exceed $10,000 per transaction.
The IRS provides guidance and detailed examples in Treas. Reg. § 53.4958-6(a)(c)(2)(iv).
Creating a Rebuttable Presumption on Executive Compensation
For compensation purposes, those responsible for setting compensation for top positions within charitable and social-welfare organizations can establish a rebuttable presumption of reasonableness regarding the compensation arrangement. (See Treas. Reg. § 53.4958-6(c).). When this presumption has been established, the burden of proof that that the organization has paid too much shifts to the IRS. (See Treas. Reg. § 53.4958-6(b).)
The criteria set by the IRS to establish that a transaction was not an excess benefit transaction – that is, to create the rebuttable presumption -- include the following:
- The transaction was approved in advance by an authorized body of the nonprofit organization composed of individuals who do not have a conflict of interest.
- Those authorized to make compensation decisions obtained and relied upon appropriate comparable data before making its decision.
- The authorized body adequately documented the basis for its determination at the time it made its decision.
If these criteria are met, it becomes the responsibility of the IRS to prove that an excess benefit transaction was made. More details on creating a rebuttable presumption can be found in ERI’s white paper on Setting Nonprofit Executive Compensation.
Intermediate Sanctions Enforcement
Today there are fewer employees charged with overseeing the nonprofit sector than there were a few years ago, but the IRS is increasing its use of data to target its investigations on the organizations that are the most likely to be in violation of the excess benefit rules. So, while efforts may be more limited in number, the IRS is more effectively using its resources. Of course, most states require nonprofits to register, and their departments of state and attorneys-general offices also regulate tax-exempt organizations. Contact regarding a tax-exempt organization’s activities that may violate rules and regulations may just as likely come from the state level as from the federal level.
Good Governance for Nonprofits
Oversight of executive compensation for reasonableness must be standard board practice. A thorough and well-thought-out process for evaluating executive compensation is more than merely establishing a rebuttable presumption.
All nonprofit board directors have a duty to act in an informed manner for the best interest of the organization. Establishing rational, thoughtful organizational goals relating to executive compensation is far more than a matter of reacting to governmental oversight. Good management practice should serve the organization well in achieving its goals and purpose, as well as ensuring compliance with government regulations. . A more detailed discussion of good board practices can be found in ERI’s Guide to Setting Nonprofit Executive Compensation.
For more in-depth analyses of executive compensation at tax-exempt organizations, see ERI’s Nonprofit Comparables Assessor software that uses compensation data from the IRS forms filed annually by all nonprofits – actually a census, rather than a survey. It can be used to determine competitive and reasonable cash compensation levels for CEOs, executive directors, and other executives at tax-exempt organizations. Users can also review the financial and executive pay histories of job titles for comparable organizations chosen as comparable.
Note: ERI's database is updated with the most recent data Form 990 data possible. However, ERI can only update its Form 990 database as quickly as we receive data from the IRS. While technological changes have expedited the process somewhat, there is still a time lag from the date the organization sends its annual form to the IRS and when the data are available from the IRS to input into ERI’s Nonprofit Comparables Assessor. A requirement for electronic filing of the form would reduce the time in accessing data, but requires a change in federal law.
Executive Compensation at For-Profit Organizations
While data from other nonprofit organizations are always acceptable as comparable, the IRS has also recognized that compensation data from for-profit companies may be relevant for some jobs in certain types of organizations. So, a nonprofit organization may want to include compensation data from for- profits and this is permitted by the IRS. (See Treas. Reg. § 53.4958-4(b)(1)(ii).)
For analyses of executive compensation at for-profit organizations, ERI’s Executive Compensation Assessor software provides salary data for over 500 executive jobs at both public and private organizations. Executive compensation data may be adjusted for geographic area, industry, organization size, pay strategy, and compensation valuation or planning date. This one-of-a-kind interactive software is relied upon by Compensation Committees across the United States to ascertain competitive salary levels that meet the requirements of reasonable executive pay packages. ERI also offers an online course that covers IRS Reasonable Executive Compensation in more detail.