Paying someone more than his or her worth, known as an excess benefit transaction, can have nasty tax implications for non-profit organizations.
What is an excess benefit transaction?
An excess benefit transaction occurs when the benefits or compensation received by someone in a decision-making position over a non-profit organization (called a “disqualified person”) exceeds the value of that person’s contributions. In other words, excess benefits means paying someone more than they’re worth.
What organizations does this apply to?
Most 501(c)3 and 501(c)4 non-profits. This includes organizations that were 501c3s or 501c4s within a 5-year period of the time that the excess benefit transaction occurred.
Who is a disqualified person?
Anyone who has had substantial influence over the non-profit organization within the past five years, including, but not limited to:
- The executive director/chief administrator of the organization
- The organization’s financial manager/accountant
- A substantial contributor
- An officer, director, or trustee or other voting member of the governing body
- Substantial owner of a business that is a major contributor
- A family member (spouse, child, grandchild, or great-grandchild) of any of the above
Other people who may have substantial influence include:
- The founder, even if not directly involved with the organization
- A department head, project manager, or other high-level employee
- The owner of the building the organization is leasing
What counts as a “benefit”?
All financial transaction, including:
- Payments as en employee (whether reported in a W-2 or not)
- Payments as an independent contractor (whether reported in a 1099 or not)
- Revenue-sharing models
- Severance pay
- Transfer of property
- Payment of insurance premiums
- “Perks” (such as dinners, entertainment, spouse’s travel costs, etc)
Remember that non-profit organizations can give benefits to employees, consultants, and board members (in the form of a dinner, for instance, not pay)… they just can’t be excessive benefits.
What happens if someone in my organization is getting excess benefits?
Your organization must file Form 4720 to inform the IRS about the Excess Benefit Transaction. Informing the IRS and correcting the problem as soon as you notice any excess benefits can save you taxes and penalties. Otherwise, you might get hit with “Intermediate Sanctions”:
- The disqualified person may have to pay a 25% tax on the excess benefits (or, failing to do so, may be penalized a 200% tax by the IRS!)
- Members of the governing body who approved the excess benefit may have to pay a 10% tax as well.
Isn’t this all a bit harsh?
Employee compensation and other financial benefits at most non-profit organizations are quite modest. Over the years, however, some unscrupulous non-profit organizations have eroded the public trust by paying their executive directors gigantic salaries or providing board members, who are supposed to be volunteers, with extravagant perks. In other words, some people have used non-profit organizations as a tax-sheltered way of funneling themselves money. And some people do perhaps have some charitable intention in mind, but are still excessively benefiting from their connections with a non-profit. The harsh penalties are the IRS’s way to create a disincentive for this sort of behavior – to help keep non-profits honest and maintain the public’s confidence in tax-exempt organizations.
How can I make sure my organization does not make excess benefit transactions?
Have disinterested board members (someone who doesn’t have a conflict of interest; for instance, not family members, nor people who would benefit from the transaction) review the transaction and officially document its approval it in the board minutes.
- For property: Make sure the cost of the property, or the cost of using the property, is the fair market value (the value of a property between a willing buyer and seller, neither of which must buy or sell the property or use of the property). An appraiser can help you determine FMV.
- For pay: Make sure the salary and benefits are comparable to what other, similar-sized nonprofits in the same geographic area are paying similarly ranked employees.
