Certain Compensation Treated as Automatic Excess Benefit For Purposes of 'Intermediate Sanctions'

The amount of executive compensation that can be paid to executives and other employees of exempt organizations is a very difficult problem.  Total compensation paid to executives of such entities is limited to the "reasonable compensation" standard under Section 162 of the Internal Revenue Code.  However, since comparable salary statistics are sometimes unavailable or are very expensive to obtain, exempt organizations sometimes find it difficult to determine reasonableness of compensation.

The IRS has recently added more fuel to the fire by stating that unless certain written requirements are followed, an economic benefit provided to executives of exempt organizations will be treated as an automatic excess benefit and thus subject to monetary sanctions under §4958.

Section 4958 imposes monetary sanctions, also known as "intermediate sanctions," on certain "disqualified persons" and foundation managers of certain exempt organizations who engage in impermissible private benefit transactions ("excess benefit transactions") with a §501(c)(3) organization.   Disqualified persons are defined under the statute as those individuals in a position to exercise substantial influence over the exempt organization.  Section 4958 plays an important role in the area of compensation paid to disqualified persons.  A §501(c)(3) entity can pay reasonable compensation to a disqualified person under the guidelines set forth in §162 without penalty. 

The IRS has now stated that the economic benefit paid to an executive employee would be treated as compensation under §4958 only if the exempt organization providing the benefit clearly indicates its intent to treat the benefit as compensation for services when the benefit was paid.  If the benefit is treated as compensation under §4958, the IRS will consider the benefit along with any other compensation the disqualified person may have received to determine whether total aggregate compensation was reasonable.

The IRS further stated, however, that if such economic benefit is not treated as compensation to the disqualified person by the exempt organization, the economic benefit will be treated as an "automatic" excess benefit transaction, even if the economic benefit is considered reasonable.  There is a "reasonable cause" exemption in certain cases.

Certain benefits are excluded from "automatic" excess benefit treatment.  For example, reimbursements paid to a disqualified person by an exempt organization under an "an accountable plan" under Regs. §1.62.2(c)(2) are disregarded for purposes of the automatic excess benefit computation.

Intent to treat an economic benefit as compensation for services can only be shown if the exempt organization provided written substantiation that is contemporaneous with the transfer of the particular benefit.  Regs. §53.4958-4(c)(1).  There are several ways that an exempt organization can clearly show its intent to treat an economic benefit as compensation.  One method of providing contemporaneous written substantiation is by timely reporting of the economic benefit as compensation, either by (1) the exempt organization on federal information tax return (Form 990, Form W‑2, or Form 1099) or by an amended federal tax return filed prior to an examination by the IRS or (2) the disqualified person on Form 1040 or on an amended Form 1040 prior to the commencement of an examination by the IRS.

Another method of clearly showing intent to treat an economic benefit as compensation is through an approved written employment contract executed on or before the date of transfer.  An employment contract is considered approved if an appropriate decision-making body or authorized officer of the exempt organization approved the transfer of compensation in accordance with established procedures.  If any of the above requirements are satisfied, the economic benefit is treated as compensation and added to a disqualified person's other compensation in determining whether total compensation is unreasonable.

This recent IRS pronouncement now imposes strict requirements on §501(c)(3) organizations and disqualified persons to thoroughly document all compensation paid or accrued to disqualified persons or risk that an economic benefit will be classified as an "automatic excess benefit," even if total compensation to the disqualified person is otherwise reasonable. 

THE ABOVE ADVICE WAS NOT INTENDED OR WRITTEN TO BE USED, AND IT CANNOT BE USED, BY YOU FOR THE PURPOSE OF (1) AVOIDING ANY PENALTY THAT MAY BE IMPOSED BY THE INTERNAL REVENUE SERVICE OR (2) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY TRANSACTION OR MATTER ADDRESSED HEREIN.  IF YOU DESIRE SUCH AN OPINION, PLEASE SO ADVISE.