Excess Benefit Transaction: Rules and Penalties

An excess benefit transaction occurs when a tax-exempt organization provides an economic advantage to an insider that exceeds the value of what the organization receives in return. These rules, established under Internal Revenue Code Section 4958, are designed to prevent private inurement, where a nonprofit’s assets are used for personal gain. Known as intermediate sanctions, this framework allows the Internal Revenue Service (IRS) to penalize the individuals involved directly. This approach targets specific instances of abuse without necessarily revoking the organization’s tax-exempt status, focusing accountability on those who benefit from or approve the transaction.

Defining an Excess Benefit Transaction

These rules primarily apply to public charities and social welfare organizations, specifically those recognized under sections 501(c)(3) and 501(c)(4) of the Internal Revenue Code. The regulations cover a wide range of arrangements where an organization’s assets are not used appropriately.

A central element is the “disqualified person,” which is any individual in a position to exercise substantial influence over the organization’s affairs within a five-year period leading up to the transaction. This category automatically includes board members, officers, and their family members. Family members include spouses, parents, children, grandchildren, great-grandchildren, siblings, and their respective spouses. The definition also extends to any entity in which such individuals hold more than a 35% ownership or beneficial interest.

The most common example of an excess benefit transaction is unreasonable compensation, where the salary and benefits paid to an executive exceed fair market value for their services. Other examples include selling an organization’s property to an insider for less than fair market value or leasing property from an insider at an above-market rate. Any transaction resulting in an unfair economic advantage to a disqualified person can be scrutinized.

Benefits provided indirectly are also captured. If a tax-exempt organization directs a subsidiary to enter into an excessive payment arrangement with a disqualified person of the parent organization, it is treated as if the parent organization made the payment directly. The IRS evaluates the entire economic arrangement to determine if the value exchanged was fair to the nonprofit.

Tax Consequences for Participants

When an excess benefit transaction occurs, the primary tax consequence falls on the disqualified person who received the benefit. The IRS imposes a first-tier excise tax equal to 25% of the “excess benefit,” which is the amount by which the benefit received exceeds the value of the consideration provided. This tax is a direct penalty on the individual.

Organization managers, such as directors or officers who knowingly participated in the transaction, also face penalties. A separate first-tier tax of 10% of the excess benefit amount can be levied on each participating manager, capped at a maximum of $20,000 per transaction. A manager’s participation is considered “knowing” only if they were aware it was an improper transaction and is not considered willful if it was due to reasonable cause, such as relying on a reasoned written opinion from a professional.

A second-tier tax is applied if the transaction is not corrected in a timely manner. If the disqualified person fails to repay the excess benefit within a specified period, they become liable for a punitive tax of 200% of the excess benefit amount. This penalty creates a powerful incentive for the disqualified person to undo the transaction and restore the organization’s financial health. These taxes are reported and paid personally by the individuals involved, not by the tax-exempt organization.

Correcting the Transaction

Correction requires the disqualified person to undo the financial harm to the organization by repaying the excess benefit amount. This repayment must also include any earnings the excess benefit generated while in the disqualified person’s possession. The goal is to place the tax-exempt organization in a financial position no worse than it would have been if the transaction had been conducted at fair market value.

To avoid the 200% second-tier tax, the correction must be completed within the “taxable period.” This period begins on the date the transaction occurred and ends on the earlier of two dates: the date the IRS mails a notice of deficiency for the first-tier tax, or the date the first-tier tax is assessed. This timeline creates a clear window for the disqualified person to act before penalties escalate.

Establishing a Rebuttable Presumption of Reasonableness

A tax-exempt organization can protect itself and its managers from penalties by establishing a “rebuttable presumption of reasonableness” for its transactions with disqualified persons. This legal safe harbor shifts the burden of proof to the IRS, requiring it to demonstrate that a transaction was excessive. To secure this protection, the organization must follow three procedures before finalizing the arrangement.

• The transaction must be approved by the organization’s governing body or a committee composed entirely of individuals who do not have a conflict of interest.
• The independent body must obtain and rely on appropriate comparability data before making its decision, such as salary surveys for compensation or independent appraisals for property sales.
• The board or committee must adequately document its decision-making process concurrently with the determination, recording the transaction’s terms and the data relied upon in the meeting minutes.

Required IRS Reporting

Excess benefit transactions and the associated excise taxes must be reported to the IRS using Form 4720, Return of Certain Excise Taxes. The organization may also have a filing requirement for this form to report the transaction, even if it does not owe tax.

Filers must provide the names and taxpayer identification numbers of the disqualified persons and any participating organization managers. The form also requires a description of the transaction, the date it occurred, the fair market value of the benefit provided, the value of any consideration received, and the calculation of the excess benefit amount and resulting tax.

The form must be filed by the disqualified person and any organization managers liable for the tax. The filing deadline is the 15th day of the fifth month after the end of the person’s tax year in which the transaction occurred. For an individual using a calendar year, the deadline is May 15 of the following year.