How Officers and Directors of Non-Profits
Can Stay out of Trouble
Under the Excess Benefit Rules

An Explanation and Checklist for Non-Lawyers(1)

by Lisa Nachmias Davis
Attorney at Law
129 Church Street, Suite 805
New Haven, CT 06510
203-776-4400
fax 203-774-1060 or 776-4411
davis@sharinglaw.net

          In 1996 Congress adopted Section 4958 of the Internal Revenue Code, also known as the "intermediate sanctions legislation" or the "excess benefit rules." The new law was designed to give the IRS an additional weapon with which to fight corruption in the charitable sector. Previously, the IRS could only threaten to revoke an organization's tax-exempt status, which might cause those helped by the organization to lose much-needed benefits. The new rules were intended to attack the "bad apples" rather than the charities. Instead of punishing the organization, individuals who took advantage of their influence to obtain "excess benefits" would be punished. In January 2002, the IRS issued its final version of the regulations it will use to implement the intermediate sanctions legislation.

          What is an Excess Benefit? The basic idea of Section 4958 is a penalty that the IRS can impose on "insiders" and those connected to them, known as "disqualified persons" ("DQs"), who receive "excess benefit" from transactions with a tax-exempt organization exempt under either Section 501(c)(3) -- "charities" -- or 501(c)(4) -- advocacy organizations. "Excess benefit" occurs whenever "the value of the economic benefit provided exceeds the value of the consideration received for providing the benefit," without regard to motive or intent. Even if a DQ is involved, however, there is no "excess benefit transaction" and no IRS problem so long as the benefit to the DQ does not exceed the consideration. In other words, if an organization enters into a contract with John Jones, member of the board, to supply cleaning fluid, and the compensation is reasonable for the cleaning fluid provided, no problem. There is nothing wrong with this, from the IRS point of view, even if there were 200 other companies that wanted to provide cleaning fluid at the same price and John Jones got the deal because he "knew the right people" by sitting on the board.

          "Indirect Benefit" a/k/a Kickbacks. On the other hand, even if the non-profit pays a reasonable price, a secret "kickback" arrangement to a DQ will result in "excess benefit" to the DQ, because the DQ did not provide the consideration. Continuing with the example, if the Karl Kyser company gets the contract at the going price, but "kicks back" 10% to John Jones under the table, there is excess benefit to John Jones.

          "Unreasonable" Employee Compensation is an Excess Benefit Too. "Unreasonable" compensation is also an "excess benefit." This is an area of great anxiety for large nonprofit organizations like hospitals, universities, and national organizations trying to lure and retain highly-compensated professionals and managers. Unfortunately, even the regulations don't explain very well what would be "excess," although at least they explain that the whole package gets counted, not just the paycheck. The regulations also don't explain very well how the DQ could "return" the excess compensation in order to escape further penalties.

          Who IS a "DQ"? "Excess benefit" can occur only when the transaction involves a DQ, that is, an insider, an insider's family member, or an entity 35% controlled by insiders. ("Insider" in this case is not a legal term, but is a good way to describe what the IRS means by "any person [including a corporation] who was, at any time during the 5-year period ending on the date of [the] transaction, in a position to exercise substantial influence over the affairs of the organization," for example, an officer, director, or highly compensated employee.)

          One relationship that apparently worries the non-profit community itself more than lawmakers is an unpaid position on the board of a second, unrelated non-profit organization. Assuming that both organizations qualify as exempt, this membership on two boards should not itself cause a problem under the excess benefit rules with respect to transactions (including grant awards) between the organizations. Many in the non-profit community feel, however, that the situation creates an image problem or potential for "pass-through" indirect benefit to individuals. For this reason, it is probably a good idea in these cases to follow the rules that apply to DQs, even if not strictly necessary under the IRS rules.

          "Initial Contract" Exception.  Because the "influence" issue has been a tricky one for the IRS in past court cases over revocations of exempt status, the final regulations include an "initial contract" exception. In other words, the first time a contract is entered into that gives influence over the non-profit to a private party -- for example, a "revenue-sharing" contract whereby the private party that controls the inflow gets 60% of the returns -- the private party should not become an insider or other DQ simply by virtue of that control. However, the next time the contract is up for modification or renewal, that party is now a DQ and the rules will apply.

          Who Pays the Penalty? Under the law, the penalty is imposed on the DQ, in the example, John Jones, and not the organization. In the example above, John Jones must pay a "first tier" penalty at the rate of 25% of whatever is found to be "excess," and if he doesn't pay back the actual "excess" amount (plus penalty) within ninety days from getting an IRS notice, the penalty increases to a "second tier" of 200% of the excess. In theory, excess benefit of $4,000 not repaid could mean fines of $8,000 plus the $4,000 to be repaid for a total of $12,000.

          Members of Management may also be on the hook. Anyone in a control position who "participates knowingly" faces a 10% tax. That could mean other board members who voted to approve the transaction even if they didn't benefit. While most laws require organizations to "indemnify" or repay board members for fines connected to service on the board (see my related article on this topic), that won't help John Jones if the organization is bankrupt, and it also won't help John Jones if he violated his duties as a director and therefore, by law, isn't entitled to indemnification.

          Of course, just because John Jones pays doesn't mean the organization is home free. Giving inappropriate benefit to private parties, without getting equivalent goods or services in return (known as "private inurement" for insiders, or excessive "private benefit" in general), is still a violation of the organization's requirements under 501(c)(3) and can result in the IRS revoking the organization's tax exemption. Section 4958 works in addition to, not instead of, the IRS' existing remedies.

          Danger Lurks. What can seem like practical business advice may lead to serious trouble when transactions with DQs are involved. The problems are demonstrated by the recent case of Caracci v. Commissioner. A family set up a tax-exempt corporation to run home health agencies. Many years later, on their attorney's recommendation, the individual board members created an identical for-profit corporation and had the non-profit sell its assets to the for-profit in exchange for an assumption of liabilities, which looked like a wash. The IRS found, however, that the board had undervalued the non-profit's intangible assets, and that the for-profit now owed the non-profit $5 million. Because an excess benefit had accrued to a DQ (a for-profit owned entirely by the non-profit's board members, the "insiders"), the penalties to be paid by the for-profit were potentially another $1.25 million.

          The point is that these excess benefit penalties are not a slap on the wrist and must be taken very seriously. A further point is that the IRS has an economic incentive to enforce these penalties and the bigger the fish, the more it should fear the net. This does not mean, however, that small organizations can ignore the sanctions with impunity. From a funding perspective, the scandal that can swirl around any alleged impropriety may be as damaging as an all-out IRS assault.

          Safe Harbor Protections. Even though a transaction between a non-profit and a DQ may be perfectly legitimate, it always has the potential of looking "fishy." What seemed reasonable to the Board at the time of the transaction may seem unreasonable to the IRS after the fact. This is especially true of employee compensation. Because of this uncertainty, the regulations include "safe harbor" procedures that, if followed, will create a rebuttable presumption of propriety. That is, if the procedures are followed, the IRS will have to come up with pretty good evidence to show that something inappropriate was done.

          It stands to reason that organizations will prefer to keep to the safe harbor whenever possible. Unfortunately, the safe harbor provisions are lengthy and detailed. When the stakes are high, board members probably should seek the advice of an attorney familiar with the rules. For daily use and quick reference, therefore, I append a short procedural checklist. These practical "ground rules" approximate the safe harbors but should not be relied upon as definitive.

          Needless to say, Section 4958 and the regulations do nothing to make administration of a non-profit organization any easier. In trying to catch the bad guys, the IRS is putting the good guys through an enormous amount of anxiety and trouble. It is to be hoped that the regulations will prevent real abuses and not simply increase administrative costs.

===========================================================================

Appendix:

Board Checklist
Where There May Be a Conflict of Interest

  1. Disclosure. If there is any kind of potential financial benefit to a DQ, the insider involved should disclose to the Board the nature of the interest as well as any other relevant facts about the transaction that the board should know in making its decision. Management must make sure that parties to transactions, and board members, disclose all such connections so that a conflicting interest that may give rise to "excess benefit" is detected ahead of time. Regular disclosure requests are a must.

  2. Recusal. The DQ should not be present during the deliberations or the vote. Think of this as the "leave the room" requirement. (Answering questions is permitted.) This also applies to any vote regarding whether there is, or is not, a conflict of interest in the first place. The decision-makers must be composed entirely of (not just controlled by) individuals who do not have a conflict of interest. A board member who is an attorney for the disqualified person would also be considered to have an "interest" and should also leave the room. If (s)he stays, the organization may not be able to rely on the safe harbor's requirement that the transaction be approved by persons without a "conflict."

  3. Data. The Board should be sure to obtain enough documented data as to comparability, including competitive bids or some other thorough price comparison, before it decides to contract with the interested party. Whenever possible, at least three bids should be required (this is the safe harbor for organizations with gross receipts of less than $1 million annually). The IRS is especially skeptical about arrangements that have revenue-sharing, percentage-type compensation. "Reasonableness" isn't determined until the compensation becomes fixed. When entering into a deal with a flexible compensation arrangement, include a cap that the IRS can find reasonable.

  4. Advance Approval. The transaction must be approved in advance by an "authorized" body, usually the full board or a committee with authority to act. By implication, this means that the Board must be more cautious about delegating decisions on transactions to officers, although "committee" may include a committee of one. The approval should include a finding that the transaction is fair to the organization and if the transaction involves accepting a higher bid from a DQ than offered by an unrelated party, should explain the reasons for the decision.

  5. WHEN IN DOUBT, GET A PROFESSIONAL OPINION. The 10% penalty that can be imposed on management for "knowing" participation in an excess benefit transaction can be defended in part if "after full disclosure of the factual situation to an appropriate professional, the organization manager relies on a reasoned written opinion of that professional with respect to elements of the transaction within the professional's expertise." Note, however, that a professional opinion is no defense on the question of whether or not the transaction actually is an excess benefit transaction, only a defense against the 10% penalty on management.

  6. CONTEMPORANEOUS MINUTES. The minutes should document all of the preceding, and should be circulated no later than the next meeting (or within sixty days, if later), and approved "within a reasonable time," presumably by the following meeting. Board members concerned about their own liability should be particularly anxious to go on record as having voted against the transaction.

Caution:
This article is provided for general informational purposes only.
It should not used as legal advice applicable to a particular situation.
Always consult your own attorney.






* A version of this article was published in The Connecticut Lawyer, a publication of the Connecticut Bar Association, in October, 2002.  You can read this version too in PDF format.