Intermediate Sanctions

SUMMARY

Intermediate sanctions legislation was an important change in nonprofit law affecting tax-exempt organizations. The law was passed by Congress in 1996 as part of the Taxpayer Bill of Rights and added to the Internal Revenue Code as section 4958. The final Treasury Regulations were issued in 2001.

Section 4958 provides an alternative to revocation of the exempt status of an organization when private persons benefit from transactions with a nonprofit organization. Intermediate sanctions allow the IRS to impose excise taxes (i.e., penalties) on certain persons who improperly benefit from transactions with a tax-exempt organization. Intermediate sanctions penalize the people involved with an improper excess benefit transaction, rather than the organization.

Organizations Involved

The organizations covered by Section 4958 are charities and social welfare organizations that are tax-exempt under sections 501(c)(3) and 501(c)(4).

Individuals Involved

The persons on whom the sanctions may be imposed are called disqualified persons and consist of:

• Persons who are in a position to exercise substantial influence over the affairs of the organization
• Members of the disqualified persons' family (as described in a prior section)
• Entities in which individuals (as described in a prior section) own more than a 35% interest

These persons may be spelled out in the law or regulations, or be determined by a Facts and Circumstances Test.

Excess Benefit Transactions

The transactions that are covered by Section 4958 are called excess benefit transactions. A transaction can be classified in this category if the value of the economic benefit provided by the organization exceeds what it receives from the disqualified person. In this course, the focus is upon compensation. So, it can be stated that the compensation received is in excess of the value provided to the organization. The test is whether the compensation is deemed to be reasonable. The standards of reasonableness are those provided in Section 162(a).

The process of determining this is similar to finding the market wage for any position: use some sort of wage survey. The organization may rely on, amongst other things, wage surveys and compensation consultants to determine reasonableness.

Safe Harbor

There's a "safe harbor" in the regulations that provides a presumption of reasonableness if the following three criteria can be met:

• The transaction is approved by the board of trustees or similar body.
• The organization has obtained and relied on appropriate comparable data.
• They have adequately documented the process.

If these criteria are met, it's up to the IRS to prove that the transaction was not reasonable.

Penalties

The regulations call for excise taxes to be levied on the disqualified person and on the organization managers.

The penalty for the disqualified person is:

• correction by reimbursement of the excess compensation, plus interest
• initial excise tax of 25% on the excess compensation
• secondary excise tax of 200% if not paid within 90 days

For the organization manager(s), there is a tax of 10% up to a maximum of $20,000 in total. These taxes may be abated, provided:

• correction is made promptly
• the transaction was made due to reasonable cause and not to willful neglect

In the end, careful pay planning with the use of competitive compensation data and reliable compensation specialists is as crucial today for nonprofits as it is for for-profit organizations. For more resources on this topic, please click on Reference in the links on the left of the page.