IRS Section 4958: Excess Benefit Transaction Penalties

Internal Revenue Code Section 4958 gives the IRS a way to address abusive transactions within tax-exempt organizations. Known as “intermediate sanctions,” these rules let the agency penalize individuals who improperly benefit, which is a less severe step than revoking the organization’s tax-exempt status. The framework is designed to discourage insiders from using their positions for personal gain. These regulations primarily apply to public charities and social welfare organizations.

Defining an Excess Benefit Transaction

The intermediate sanctions rules are directed at public charities exempt under Internal Revenue Code Section 501(c)(3) and social welfare organizations under Section 501(c)(4). These rules do not apply to private foundations, which are subject to a separate set of self-dealing rules. The focus of Section 4958 is on organizations that receive substantial support from the general public.

A disqualified person is any individual in a position to exercise substantial influence over the organization’s affairs within the five-year period before the transaction. This includes voting members of the governing body, presidents, CEOs, COOs, treasurers, and CFOs. The definition also includes their family members, such as spouses, ancestors, and descendants, and any corporation, partnership, or trust where a disqualified person and their family own more than a 35% controlling interest.

An excess benefit transaction occurs when an organization gives an economic benefit to a disqualified person that is worth more than what the organization receives in return. The most common example is unreasonable compensation, where a salary exceeds the fair market value of the services provided. Other examples include selling property to a disqualified person for less than fair market value or buying property from them for more than fair market value.

Organizations can establish a “rebuttable presumption of reasonableness” for compensation, which shifts the burden of proof to the IRS to show a transaction was improper. To secure this protection, the arrangement must be approved in advance by a body with no conflicts of interest. This body must use appropriate comparability data and document its decision-making process at the time.

The Excise Taxes Imposed

When an excess benefit transaction occurs, the Internal Revenue Code imposes a multi-tiered system of excise taxes. These taxes are the personal responsibility of the individuals involved in the transaction, not the organization itself.

The first penalty is a first-tier excise tax on the disqualified person who benefited. This tax is 25% of the “excess benefit,” which is the amount the benefit’s value exceeded the value of the consideration provided. For example, if a CEO is paid $500,000 for services valued at $400,000, the excess benefit is $100,000, and the tax would be $25,000.

A second-tier tax is imposed if the transaction is not corrected within the “taxable period,” which ends when the IRS assesses the first-tier tax. If the disqualified person fails to correct the transaction by this deadline, they are liable for an additional tax of 200% of the excess benefit. In the previous example, this would be a $200,000 tax, creating a strong incentive to resolve the matter.

A separate 10% excise tax may be imposed on “organization managers,” such as officers or directors, who knowingly participated in the transaction. This tax is paid personally by the manager and is capped at $20,000 for any single transaction. If multiple managers are involved, they are jointly and severally liable for the tax.

Correcting the Transaction and Abating Taxes

Section 4958 provides a clear path for resolving an excess benefit transaction through a process called “correction.” This process allows the involved parties to mitigate the most significant financial penalties associated with the rules.

Correction requires the disqualified person to undo the financial harm to the organization by repaying the full excess benefit amount. The individual must also pay interest to compensate the organization for the loss of its funds. The goal is to restore the organization to the financial position it would have been in had the transaction not occurred.

The primary incentive for timely correction is the abatement, or cancellation, of the 200% second-tier excise tax. If the disqualified person corrects the transaction within the taxable period, the 200% tax will not be applied. This encourages prompt repayment once an excess benefit transaction is identified.

Correction does not eliminate the initial 25% first-tier tax. While abatement of the first-tier tax is possible in rare cases, the main benefit of correction is avoiding the much larger second-tier penalty. This makes it an important step for any disqualified person facing an excess benefit determination.

Reporting Requirements

The individuals involved, not the tax-exempt organization, are responsible for reporting and paying excise taxes from an excess benefit transaction. They must use IRS Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code, to calculate and remit the penalties.

Both the disqualified person who benefited and any liable organization managers must file Form 4720. The disqualified person reports the 25% first-tier tax, while any manager who knowingly participated reports the 10% manager tax.

The form requires filers to provide details about the transaction and calculate the tax owed. The information reported on Form 4720 is kept private and is not subject to public inspection, protecting the financial details of the individuals involved.

The filing deadline for Form 4720 is tied to the filer’s personal tax year. The return is due on or before the 15th day of the fifth month after the end of the individual’s taxable year when the transaction occurred. For an individual using a calendar year, a transaction in one year requires filing Form 4720 by May 15th of the next year.