Excess Benefit Transactions(p64)

A disqualified person who benefits from an excess benefit transaction, such as compensation, fringe benefits, or contract payments from certain section 501(c)(3) or 501(c)(4) organizations, may have to pay an excise tax under section 4958. A manager of the organization may also have to pay an excise tax under section 4958. These taxes are reported on Form 4720.

The excise taxes are imposed if an applicable tax-exempt organization provides an excess benefit to a disqualified person and that benefit exceeds the value of the benefit an organization received in the exchange.

There are three taxes under section 4958. Disqualified persons are liable for the first two taxes and certain organization managers are liable for the third tax.

Taxes imposed on excess benefit transactions apply to transactions occurring on or after September 14, 1995. However, these taxes do not apply to a transaction under a written contract that was binding on September 13, 1995, and at all times thereafter before the transaction occurred.

An excise tax equal to 25% of the excess benefit is imposed on each excess benefit transaction between an applicable tax-exempt organization and a disqualified person. The disqualified person who benefited from the transaction is liable for the tax. See definition of Disqualified persons, earlier, at Disqualified persons.

If the 25% tax is imposed and the excess benefit transaction is not corrected within the taxable period, an additional excise tax equal to 200% of the excess benefit is imposed on any disqualified person involved.

If a disqualified person makes a payment of less than the full correction amount, the 200% tax is imposed only on the unpaid portion of the correction amount. If more than one disqualified person received an excess benefit from an excess benefit transaction, all such disqualified persons are jointly and severally liable for the taxes.

To avoid the 200% tax, a disqualified person must correct the excess benefit transaction during the taxable period. The 200% tax is abated (refunded if collected) if the excess benefit transaction is corrected within a 90-day correction period beginning on the date a statutory notice of deficiency is issued.

The taxable period means the period beginning with the date on which the excess benefit transaction occurs and ending on the earlier of:

• The date a notice of deficiency was mailed to the disqualified person for the initial tax on the excess benefit transaction, or
• The date on which the initial tax on the excess benefit transaction for the disqualified person is assessed.

If tax is imposed on a disqualified person for any excess benefit transaction, an excise tax equal to 10% of the excess benefit is imposed on an organization manager who knowingly participated in an excess benefit transaction, unless such participation was not willful and was due to reasonable cause. This tax cannot exceed $20,000 ($10,000 for transactions entered in a tax year beginning before August 18, 2006), for each transaction. There is also joint and several liability for this tax. A person can be liable for both the tax paid by the disqualified person and the organization manager tax.

An organization manager is any officer, director, or trustee of an applicable tax-exempt organization, or any individual having powers or responsibilities similar to officers, directors, or trustees of the organization, regardless of title. An organization manager is not considered to have participated in an excess benefit transaction where the manager has opposed the transaction in a manner consistent with the fulfillment of the manager's responsibilities to the organization. For example, a director who votes against giving an excess benefit would ordinarily not be subject to the 10% tax.

A person participates in a transaction knowingly if the person:

• Has actual knowledge of sufficient facts so that, based solely upon those facts, such transaction would be an excess benefit transaction;
• Is aware that such a transaction under these circumstances may violate the provisions of federal tax law governing excess benefit transactions; and
• Negligently fails to make reasonable attempts to ascertain whether the transaction is an excess benefit transaction, or the manager is in fact aware that it is such a transaction.

Knowing does not mean having reason to know. The organization manager ordinarily will not be considered knowing if, after full disclosure of the factual situation to an appropriate professional, the organization manager relied on the professional's reasoned written opinion on matters within the professional's expertise or if the manager relied on the fact that the requirements for the rebuttable presumption of reasonableness have been satisfied. Participation by an organization manager is willful if it is voluntary, conscious, and intentional. An organization manager's participation is due to reasonable cause if the manager has exercised responsibility on behalf of the organization with ordinary business care and prudence.

An excess benefit transaction is a transaction in which an economic benefit is provided by an applicable tax-exempt organization, directly or indirectly, to or for the use of any disqualified person, and the value of the economic benefit provided by the organization exceeds the value of the consideration (including the performance of services) received for providing such benefit. The excess benefit transaction rules apply to all transactions with disqualified persons, regardless of whether the amount of the benefit provided is determined in whole or in part by the revenues of one or more activities of the organization.

To determine whether an excess benefit transaction has occurred, all consideration and benefits exchanged between a disqualified person and the applicable tax-exempt organization, and all entities it controls, are taken into account. For purposes of determining the value of economic benefits, the value of property, including the right to use property, is the fair market value. Fair market value is the price at which property, or the right to use property, would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy, sell, or transfer property or the right to use property, and both having reasonable knowledge of relevant facts.

For a donor advised fund, an excess benefit transaction includes a grant, loan, compensation, or other similar payment from the fund to a:

• Donor or donor advisor,
• Family member of a donor, or donor advisor,
• 35% controlled entity of a donor, or donor advisor, or
• 35% controlled entity of a family member of a donor, or donor advisor.

The excess benefit in this transaction is the amount of the grant, loan, compensation, or other similar payment. For additional information see the Instructions for Form 4720.

For any supporting organization, defined in section 509(a)(3), an excess benefit transaction includes grants, loans, compensation, or other similar payment provided by the supporting organization to a:

• Substantial contributor,
• Family member of a substantial contributor,
• 35% controlled entity of a substantial contributor, or
• 35% controlled entity of a family member of a substantial contributor.

Additionally, an excess benefit transaction includes any loans provided by the supporting organization to a disqualified person (other than an organization described in section 509(a)(1), (2), or (4)).

The excess benefit for substantial contributors and parties related to those contributors includes the amount of the grant, loan, compensation, or other similar payment. For additional information see the Instructions for Form 4720.

Excess benefit transaction rules generally do not apply to transactions between a supporting organization and its supported organization that are described in sections 501(c)(4), (5), or (6).

An excess benefit transaction occurs on the date the disqualified person receives the economic benefit from the organization for federal income tax purposes. However, when a single contractual arrangement provides for a series of compensation or other payments to or for the use of a disqualified person during the disqualified person's tax year, any excess benefit transaction with respect to these payments occurs on the last day of the taxpayer's tax year.

In the case of benefits provided to a qualified pension, profit-sharing, or stock bonus plan, the transaction occurs on the date the benefit is vested. In the case of the transfer of property subject to a substantial risk of forfeiture, or in the case of rights to future compensation or property, the transaction occurs on the date the property, or the rights to future compensation or property, is not subject to a substantial risk of forfeiture. Where the disqualified person elects to include an amount in gross income in the tax year of transfer under section 83(b), the excess benefit transaction occurs on the date the disqualified person receives the economic benefit for federal income tax purposes.

An excess benefit transaction is corrected by undoing the excess benefit to the extent possible, and by taking any additional measures necessary to place the organization in a financial position not worse than what it would have been if the disqualified person were dealing under the highest fiduciary standards.

A disqualified person corrects an excess benefit by making a payment in cash or cash equivalents, excluding payment by a promissory note, equal to the correction amount to the applicable tax-exempt organization. The correction amount equals the excess benefit plus the interest on the excess benefit. The interest rate can be no lower than the applicable federal rate, compounded annually, for the month the transaction occurred.

A disqualified person can, with the agreement of the applicable tax-exempt organization, make a payment by returning the specific property previously transferred in the excess transaction. In this case, the disqualified person is treated as making a payment equal to the lesser of:

• The fair market value of the property on the date the property is returned to the organization, or
• The fair market value of the property on the date the excess benefit transaction occurred.

If the payment resulting from the return of property is less than the correction amount, the disqualified person must make an additional cash payment to the organization equal to the difference.

If the payment resulting from the return of the property exceeds the correction amount described above, the organization can make a cash payment to the disqualified person equal to the difference.

For a correction of an excess benefit transaction (discussed earlier), no amount repaid in a manner prescribed by the Secretary can be held in a donor advised fund.

An applicable tax-exempt organization is a section 501(c)(3) or 501(c)(4) organization that is tax-exempt under section 501(a), or was such an organization at any time during a 5-year period ending on the day of the excess benefit transaction.

An applicable tax-exempt organization does not include:

1. A private foundation as defined in section 509(a),
2. A governmental entity that is:
   1. Exempt from (or not subject to) taxation without regard to section 501(a), or
   2. Not required to file an annual return, or
3. A foreign organization, recognized by the IRS or by treaty, that receives substantially all of its support (other than gross investment income) from sources outside the United States.

An organization is not treated as a section 501(c)(3) or 501(c)(4) organization for any period covered by a final determination that the organization was not tax-exempt under section 501(a), but only if the determination was not based on private inurement or one or more excess benefit transactions.

A disqualified person is:

• Any person (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,
• A family member of an individual described in 1, and
• A 35% controlled entity.

The following persons will be considered disqualified persons along with certain family members and 35% controlled entities associated with them.

• Donors of donor advised funds,
• Investment advisors of sponsoring organizations, and
• Disqualified persons of a section 509(a)(3) supporting organization for the organizations that organization supports.

Substantial contributors to supporting organizations will also be considered disqualified persons along with their family members and 35% controlled entities.

Investment advisor means for any sponsoring organization, any person compensated by such organization (but not an employee of such organization) for managing the investment of, or providing investment advice for, assets maintained in donor advised funds maintained by such sponsoring organization.

In general, a substantial contributor means any person who contributed or bequeathed an aggregate of more than $5,000 to the organization, if that amount is more than 2% of the total contributions and bequests received by the organization before the end of the tax year of the organization in which the contribution or bequest is received by the organization from such person. A substantial contributor includes the grantor of a trust.

Family members of a disqualified person include a disqualified person's spouse, brothers or sisters (whether by whole or half-blood), spouses of brothers or sisters (whether by whole or half-blood), ancestors, children (including a legally adopted child), grandchildren, great grandchildren, and spouses of children, grandchildren, and great grandchildren (whether by whole or half-blood).

The term 35% controlled entity means:

1. A corporation in which a disqualified person owns more than 35% of the total combined voting power,
2. A partnership in which such persons own more than 35% of the profits interest, or
3. A trust or estate in which such persons own more than 35% of the beneficial interest.

In determining the holdings of a business enterprise, any stock or other interest owned directly or indirectly shall apply.

Persons who hold certain powers, responsibilities, or interests are among those who are in a position to exercise substantial influence over the affairs of the organization. This includes, for example, voting members of the governing body, and persons holding the power of:

• Presidents, chief executives, or chief operating officers.
• Treasurers and chief financial officers.
• Persons with a material financial interest in a provider-sponsored organization.

Persons who are not considered to be in a position to exercise substantial influence over the affairs of an organization include:

• An employee who receives benefits that total less than the highly compensated amount in section 414(q)(1)(B)(i) and who does not hold the executive or voting powers mentioned earlier in the discussion on Disqualified Person, is not a family member of a disqualified person, and is not a substantial contributor,
• Tax-exempt organizations described in section 501(c)(3), and
• Section 501(c)(4) organizations with respect to transactions engaged in with other section 501(c)(4) organizations.

The determination of whether a person has substantial influence over the affairs of an organization is based on all the facts and circumstances. Facts and circumstances that show a person has substantial influence over the affairs of an organization include, but are not limited to, the following.

• The person founded the organization.
• The person is a substantial contributor to the organization under the section 507(d)(2)(A) definition, only taking into account contributions to the organization for the past 5 years.
• The person's compensation is primarily based on revenues derived from activities of the organization that the person controls.
• The person has or shares authority to control or determine a substantial portion of the organization's capital expenditures, operating budget, or compensation for employees.
• The person manages a discrete segment or activity of the organization that represents a substantial portion of the activities, assets, income, or expenses of the organization, as compared to the organization as a whole.
• The person owns a controlling interest (measured by either vote or value) in a corporation, partnership, or trust that is a disqualified person.
• The person is a nonstock organization controlled directly or indirectly by one or more disqualified persons.

Facts and circumstances tending to show that a person does not have substantial influence over the affairs of an organization include, but are not limited to, the following.

• The person has taken a bona fide vow of poverty as an employee, agent, or on behalf of a religious organization.
• The person is an independent contractor whose sole relationship to the organization is providing professional advice (without having decision-making authority) with respect to transactions from which the independent contractor will not economically benefit either directly or indirectly aside from customary fees received for the professional advice rendered.
• Any preferential treatment the person receives based on the size of the person's donation is also offered to others making comparable widely solicited donations.
• The direct supervisor of the person is not a disqualified person.
• The person does not participate in any management decisions affecting the organization as a whole or a discrete segment of the organization that represents a substantial portion of the activities, assets, income, or expenses of the organization, as compared to the organization as a whole.

In the case of multiple organizations affiliated by common control or governing documents, the determination of whether a person does or does not have substantial influence is made separately for each applicable tax-exempt organization. A person may be a disqualified person with respect to transactions with more than one organization.

Reasonable compensation is the value that would ordinarily be paid for like services by like enterprises under like circumstances. The section 162 standard will apply in determining the reasonableness of compensation. The fact that a bonus or revenue-sharing arrangement is subject to a cap is a relevant factor in determining reasonableness of compensation.

To determine the reasonableness of compensation, all items of compensation provided by an applicable tax-exempt organization in exchange for performance of services are taken into account in determining the value of compensation (except for economic benefits that are disregarded under the discussion Disregarded benefits, later). Items of compensation include:

• All forms of cash and noncash compensation, including salary, fees, bonuses, severance payments, and deferred noncash compensation,
• The payment of liability insurance premiums for, or the payment or reimbursement by the organization of penalties, taxes, or certain expenses under section 4958, unless excludable from income as a de minimis fringe benefit under section 132(a)(4),
• All other compensatory benefits, whether or not included in gross income for income tax purposes,
• Taxable and nontaxable fringe benefits, except fringe benefits described in section 132, and
• Foregone interest on loans.

An economic benefit is not treated as consideration for the performance of services unless the organization providing the benefit clearly indicates its intent to treat the benefit as compensation when the benefit is paid.

An applicable tax-exempt organization (or entity that it controls) is treated as clearly indicating its intent to provide an economic benefit as compensation for services only if the organization provides written substantiation that is contemporaneous with the transfer of the economic benefits under consideration. Ways to provide contemporaneous written substantiation of its intent to provide an economic benefit as compensation include:

• The organization produces a signed written employment contract,
• The organization reports the benefit as compensation on an original Form W-2, Form 1099, or Form 990, or on an amended form filed before starting an IRS examination, or
• The disqualified person reports the benefit as income on the person's original Form 1040, or on an amended form filed before starting an IRS examination.

If the economic benefit is excluded from the disqualified person's gross income for income tax purposes, the applicable tax-exempt organization is not required to indicate its intent to provide an economic benefit as compensation for services.

Payments under a compensation arrangement are presumed to be reasonable and the transfer of property (or right to use property) is presumed to be at fair market value, if the following three conditions are met.

1. The transaction is approved in advance by an authorized body of the organization (or an entity it controls) which is composed of individuals who do not have a conflict of interest concerning the transaction.
2. Before making its determination, the authorized body obtained and relied upon appropriate data as to comparability. (There is a special safe harbor for small organizations. If the organization has gross receipts of less than $1 million, appropriate comparability data includes data on compensation paid by three comparable organizations in the same or similar communities for similar services.)
3. The authorized body adequately documents the basis for its determination concurrently with making that determination. The documentation should include:
   1. The terms of the approved transaction and the date approved,
   2. The members of the authorized body who were present during debate on the transaction that was approved and those who voted on it,
   3. The comparability data obtained and relied upon by the authorized body and how the data was obtained,
   4. Any actions by a member of the authorized body having conflict of interest, and
   5. Documentation of the basis of the determination before the later of the next meeting of the authorized body or 60 days after the final actions of the authorized body are taken, and approval of records as reasonable, accurate, and complete within a reasonable time thereafter.

The following economic benefits are disregarded for section 4958 purposes.

• Nontaxable fringe benefits that are excluded from income under section 132.
• Benefits provided to a volunteer for the organization if the benefit is provided to the general public in exchange for a membership fee or contribution of $75 or less.
• Benefits provided to a member of an organization due to the payment of a membership fee or to a donor as a result of a deductible contribution, if a significant number of disqualified persons make similar payments or contributions and are offered a similar economic benefit.
• Benefits provided to a person solely as a member of a charitable class that the applicable tax-exempt organization intends to benefit as part of the accomplishment of its exempt purpose.
• A transfer of an economic benefit to or for the use of a governmental unit, as defined in section 170(c)(1), if exclusively for public purposes.

Section 4958 does not apply to any fixed payment made to a person under an initial contract.

A fixed payment is an amount of cash or other property specified in the contract, or determined by a fixed formula that is specified in the contract, which is to be paid or transferred in exchange for the provision of specified services or property.

A fixed formula can, generally, incorporate an amount that depends upon future specified events or contingencies, as long as no one has discretion when calculating the amount of a payment or deciding whether to make a payment (such as a bonus).

An initial contract is a binding written contract between an applicable tax-exempt organization and a person who was not a disqualified person immediately before entering into the contract.

A binding written contract, providing it can be terminated or canceled by the applicable tax-exempt organization without the other party's consent (except as a result of substantial nonperformance) and without substantial penalty, is treated as a new contract, as of the earliest date any termination or cancellation would be effective. Also, if the parties make a material change to a contract, which includes an extension or renewal of the contract (except for an extension or renewal resulting from the exercise of an option by the disqualified person), or a more than incidental change to the amount payable under the contract, it is treated as a new contract as of the effective date of the material change.

For more information, see the Instructions to Forms 990 and 4720. The rules listed above also apply to Section 501(c)(29) organizations.