What Is an Excess Benefit Transaction?

An excess benefit transaction occurs when a tax-exempt organization provides an economic benefit to an insider that is greater than the value of goods or services received in return. These rules, established under Internal Revenue Code Section 4958, are often called “intermediate sanctions.” They give the Internal Revenue Service (IRS) a tool to penalize individuals involved in improper dealings without revoking the organization’s tax-exempt status. The regulations primarily apply to 501(c)(3) public charities and 501(c)(4) social welfare organizations.

The core of the issue is preventing private inurement, where a nonprofit’s resources are used to benefit private individuals. These transactions can take many forms, from inflated salaries to skewed property deals, and the rules hold the individuals who benefit from and approve them accountable through targeted excise taxes.

Defining a Disqualified Person

The rules governing excess benefit transactions hinge on the definition of a “disqualified person.” A disqualified person is broadly defined as any individual who was in a position to exercise substantial influence over the organization’s affairs at any point within a five-year period preceding the transaction. This “lookback” period ensures that former influential individuals cannot immediately engage in transactions that would have been prohibited during their tenure. The IRS considers factors like holding a position as a voting member of the governing body, having responsibilities for implementing board decisions, or supervising management.

This definition extends beyond a single individual to include their family members. Family members automatically considered disqualified persons include an individual’s spouse, ancestors, siblings, children, grandchildren, and great-grandchildren, along with the spouses of their siblings and descendants. This provision prevents indirect benefits from flowing to an influential person through their relatives.

Furthermore, the definition encompasses entities, such as corporations or partnerships, where a disqualified person and their family members have a significant ownership stake. If disqualified persons collectively own more than a 35% interest in an entity, that entity itself becomes a disqualified person. This means that a transaction between the nonprofit and a company substantially owned by one of its directors could be scrutinized as an excess benefit transaction.

Identifying an Excess Benefit Transaction

The most common form of an excess benefit transaction is unreasonable compensation. This occurs when a disqualified person is paid a salary or receives benefits that exceed what would be considered reasonable for the services they provide. Reasonableness is determined by comparing the compensation package to what similar organizations pay for comparable services in the same geographic area. This analysis includes all forms of remuneration, such as bonuses, benefits, and expense allowances.

Another primary category involves non-fair-market-value transfers of property. This occurs if the organization sells or leases an asset to a disqualified person for less than its fair market value, or purchases or leases property from them for more than its fair market value. For example, if a nonprofit sells a building to a board member’s company for a price significantly below an independent appraisal, the difference between the sale price and the property’s actual value constitutes the excess benefit.

Revenue-sharing arrangements can also trigger scrutiny. These are agreements where a disqualified person’s compensation is tied directly to the organization’s income. While not automatically prohibited, such arrangements can become an excess benefit transaction if they result in an improper private benefit. The IRS examines whether the arrangement incentivizes actions that serve the insider’s financial interests over the organization’s exempt mission. The determination of an excess benefit transaction occurs on the date the disqualified person receives the economic benefit, and certain benefits like reasonable expense reimbursements for board members to attend meetings are generally disregarded.

Consequences of an Excess Benefit Transaction

When an excess benefit transaction is identified, the IRS imposes a series of excise taxes targeting the individuals involved. The primary penalty is a first-tier tax levied on the disqualified person who received the improper benefit. This tax is calculated at 25% of the “excess benefit” amount—the value the person received beyond the fair market value of the services or goods they provided.

Organization managers, such as directors or officers, who knowingly and willfully participated in the transaction also face a first-tier tax. This tax is 10% of the excess benefit amount, with a maximum penalty of $20,000 for each transaction. For this tax to apply, the manager must have been aware that the transaction was improper and their participation must not have been due to reasonable cause.

If the transaction is not corrected in a timely manner, a second-tier tax of 200% of the excess benefit amount is imposed on the disqualified person. The failure to correct the transaction within the taxable period, which generally ends when the IRS assesses the tax or mails a notice of deficiency, triggers this tax.

The Correction Process

Correcting an excess benefit transaction is a separate and distinct process from paying the associated excise taxes to the IRS. The fundamental goal of correction is to restore the tax-exempt organization to the financial position it would have been in had the improper transaction never occurred.

The primary action required for correction is the repayment of the excess benefit amount by the disqualified person to the organization. This repayment must be made in cash or cash equivalents. Simply paying the 25% first-tier tax to the government does not satisfy this requirement; the funds must be returned directly to the nonprofit.

In addition to repaying the principal amount, the disqualified person must also pay interest on that amount to compensate the organization for the loss of use of its funds. If the transaction involved property, correction might require the return of the specific property, provided it is possible to do so.

Establishing the Rebuttable Presumption of Reasonableness

Organizations can proactively protect themselves from allegations of an excess benefit transaction by establishing a “rebuttable presumption of reasonableness.” This is a safe harbor procedure outlined in Treasury Regulations that, if followed, shifts the burden of proof to the IRS.

The first requirement is that the arrangement must be approved in advance by an authorized body of the organization. This body, typically the board of directors or a designated committee, must be composed entirely of individuals who do not have a conflict of interest concerning the transaction. For example, when setting the CEO’s salary, the CEO cannot be part of the decision-making process or vote.

The second step is that the authorized body must obtain and rely on appropriate data to make its decision. For compensation, this could include reviewing salary surveys for comparable positions in similar organizations, or for a property transaction, it might involve securing an independent appraisal of the asset’s value.

Finally, the authorized body must contemporaneously document the basis for its determination. This means creating a written record, such as detailed board meeting minutes, at the time the decision is made. The documentation should state the terms of the transaction, the data relied upon, and the rationale for concluding that the arrangement was reasonable.