What Is Schedule L and How Does It Apply to Interested Person Transactions?

Nonprofit organizations must be transparent about their financial dealings, especially when transactions involve individuals with significant influence. The IRS requires certain nonprofits to report these interactions on Schedule L of Form 990 to ensure accountability and prevent misuse of funds.

Understanding how Schedule L applies to transactions with interested persons is essential for maintaining compliance and avoiding penalties.

Filing Requirements

Organizations filing Form 990 must determine whether they need to complete Schedule L based on specific financial activities during the tax year. The IRS mandates disclosure if transactions meet reporting thresholds, which vary depending on the type of transaction and the individuals involved. Excess benefit transactions must be reported regardless of the amount, while loans to or from interested persons are subject to materiality thresholds.

Tax-exempt organizations under Sections 501(c)(3), (c)(4), and (c)(29) must comply with these reporting rules, as well as certain other entities filing Form 990. Private foundations, which file Form 990-PF, are not required to complete Schedule L but must disclose similar transactions elsewhere. Organizations filing Form 990-EZ may also need to report interested person transactions, though with fewer details.

Failure to disclose required transactions can lead to IRS scrutiny, penalties, and possible revocation of tax-exempt status. Omissions or misreporting may result in intermediate sanctions under Section 4958, imposing excise taxes on individuals who receive excess benefits and on organization managers who approve such transactions. The IRS may also levy fines of $100 per day, up to $50,000, for incomplete or inaccurate filings.

Transactions Involving Interested Persons

Schedule L requires nonprofits to disclose financial transactions involving individuals with substantial influence over the organization, including compensation arrangements, loans, and grants. The IRS examines these dealings to ensure they do not result in improper financial benefits that could jeopardize the organization’s tax-exempt status.

Excess Benefit Arrangements

An excess benefit transaction occurs when a nonprofit provides compensation or other financial benefits to a disqualified person that exceed fair market value. Under Section 4958 of the Internal Revenue Code, a disqualified person includes officers, directors, trustees, and key employees with significant control over financial decisions.

If an excess benefit is identified, the recipient must repay the excess amount with interest and may face a 25% excise tax. If not corrected promptly, an additional 200% tax may be imposed. Organization managers who knowingly approve such transactions can also be subject to a 10% excise tax, up to $20,000 per transaction.

To prevent these penalties, nonprofits should conduct comparability studies using independent salary surveys or compensation committees to ensure payments align with industry standards. Documentation should be retained to demonstrate compensation decisions were based on objective data.

Loans and Other Financial Deals

Nonprofits must report loans, advances, and other financial arrangements involving interested persons if they meet the IRS’s materiality thresholds. These transactions include direct loans, loan guarantees, and debt forgiveness. The IRS examines these dealings to prevent improper use of tax-exempt resources for private benefit.

For example, if a nonprofit lends $50,000 to its executive director at below-market interest rates, the difference between the actual interest charged and the applicable federal rate may be considered a taxable benefit. If the loan is forgiven or not repaid, it could be classified as an excess benefit transaction, triggering excise taxes.

To mitigate risks, organizations should document loan terms in formal agreements, ensure repayment schedules are followed, and charge interest rates that reflect market conditions. Loan agreements should be reviewed by legal counsel to confirm compliance.

Grants and Assistance

Nonprofits providing grants, scholarships, or financial aid to interested persons must disclose these transactions on Schedule L. The IRS requires transparency to ensure funds are distributed based on objective criteria rather than personal relationships or conflicts of interest.

For instance, if a nonprofit awards a $10,000 scholarship to a board member’s child without a competitive selection process, the transaction could be viewed as a private benefit. To maintain compliance, organizations should establish written policies outlining eligibility requirements, use independent review committees to evaluate applications, and document the decision-making process.

If grants are provided to entities controlled by interested persons, additional scrutiny may be required to confirm funds are used for charitable purposes rather than personal gain. Organizations should retain records detailing how grant recipients were selected and how funds were used.

Documentation for Compliance

Maintaining thorough records is essential for demonstrating compliance with IRS regulations and safeguarding tax-exempt status. Proper documentation serves as evidence that transactions align with the organization’s mission and are conducted at arm’s length.

Organizations should adopt written policies specifying how financial dealings with influential individuals are reviewed and authorized. These policies should outline approval procedures, recordkeeping responsibilities, and oversight mechanisms to prevent conflicts of interest.

Board meeting minutes are critical, particularly when financial transactions involve decision-makers. These records should include discussions on approval processes, dissenting opinions, and the rationale behind financial agreements. If an independent committee evaluates transactions, their findings and recommendations must be documented to demonstrate due diligence.

Nonprofits should also retain supporting materials such as independent appraisals, market comparisons, and signed agreements to substantiate that financial arrangements are reasonable and justifiable.

The IRS may request documentation during audits, making it important to maintain organized records for at least three years after filing Form 990. If tax-exempt status is at risk due to questionable transactions, well-documented procedures can help mitigate penalties by showing the organization acted in good faith. A centralized system for storing financial records, whether digital or physical, ensures timely retrieval if compliance issues arise.