IRS Section 503 Prohibited Transaction Rules

Internal Revenue Code Section 503 establishes rules to prevent financial misconduct within specific types of tax-exempt organizations. Its core purpose is to ensure that individuals with significant influence over these entities cannot exploit their positions for personal financial gain. These regulations act as a safeguard, protecting the assets and income of the organization from being diverted away from their intended exempt purposes. By prohibiting certain transactions between the organization and its insiders, Section 503 helps maintain the integrity of these entities.

Organizations Subject to Section 503

The rules outlined in Section 503 apply to a specific group of tax-exempt organizations. Primarily, they govern supplemental unemployment benefit trusts, which are described under Internal Revenue Code Section 501(c)(17). Also covered are certain qualified pension, profit-sharing, and stock bonus plans that are part of a governmental or church plan, as referenced in Section 4975(g).

The vast majority of tax-exempt entities, including public charities and private foundations, are not governed by Section 503. Instead, these more common non-profits are subject to different sets of regulations. For instance, public charities must adhere to intermediate sanction rules under Section 4958, while private foundations face strict self-dealing rules under Section 4941, both of which serve a similar purpose.

Defining a Prohibited Transaction

A prohibited transaction under Section 503 involves specific dealings between the organization and influential individuals known as disqualified persons. These individuals include the creator of the organization (if it is a trust), any person who has made a substantial contribution, members of their families, and corporations they control. Family members are defined by Section 267 and include spouses, ancestors, and lineal descendants. A controlled entity is one where a disqualified person owns 50% or more of the voting power or value.

The Internal Revenue Code explicitly lists several types of forbidden transactions.

• Lending any part of the organization’s income or principal without receiving both adequate security and a reasonable rate of interest.
• Paying excessive compensation for salaries or personal services that is not reasonable for the services actually rendered.
• Making the organization’s services available on a preferential basis to a disqualified person.
• Making a substantial purchase of securities or any other property from a disqualified person for more than adequate consideration.
• Selling a substantial part of its assets to a disqualified person for less than adequate consideration.
• Engaging in any other transaction that results in a substantial diversion of the organization’s income or assets to a disqualified person.

“Adequate security” is defined as something more than just a promise to pay. It must be property that can be sold or liquidated if the borrower defaults, and its value must be sufficient to protect the organization from loss. A borrower’s own stock, for example, does not qualify as adequate security.

Consequences of a Prohibited Transaction

Engaging in a prohibited transaction carries a severe penalty for the organization: the loss of its tax-exempt status. The denial of exemption means the organization’s income becomes subject to federal income tax, fundamentally altering its financial operations and undermining the purpose for which it was established. This loss serves as a strong deterrent against the misuse of an organization’s funds by insiders.

The loss of tax-exempt status does not apply retroactively. The exemption is denied only for taxable years after the year in which the Internal Revenue Service (IRS) officially notifies the organization that it has engaged in a prohibited transaction.

There is an exception to this timing rule for particularly egregious cases. If the organization entered into the transaction with the specific purpose of diverting a substantial part of its income or principal from its exempt purposes, the loss of exemption can be made effective immediately. This allows the IRS to act more swiftly when a transaction represents a significant and intentional abuse.

Re-establishing Tax-Exempt Status

An organization that has lost its tax-exempt status due to a Section 503 violation is not permanently barred from exemption and can apply to have its status reinstated for future tax years. This process requires the organization to formally demonstrate to the IRS that it has corrected its course and will operate in compliance with the law.

To begin the process, the organization must file a new application with the IRS, typically using Form 1024, Application for Recognition of Exemption. This filing initiates a new review by the IRS, similar to the process the organization underwent when it first sought tax-exempt status.

As part of the application, the organization must satisfy the IRS that it will not knowingly engage in another prohibited transaction in the future. This often involves demonstrating that new internal controls, governance policies, or oversight procedures have been implemented to prevent a recurrence. Only after the IRS is convinced that the organization is committed to future compliance will it approve the claim and reinstate tax-exempt status for subsequent years.