The IRS issued a final rule (PDF) providing factors that it will consider in determining whether a 501(c)(3) organization that engages in excess benefit transactions will lose its tax-exempt status. The rule explains the interaction between the “intermediate sanctions” rule, which governs excess benefit transactions, and the public benefit rule, which requires that 501(c)(3) organizations must serve a public rather than a private interest. The rule provides examples to demonstrate the types of benefits that could result both in excise taxes on an excess benefit transaction and in an organization losing its exempt status. Organizations will find the guidance helpful in setting their own procedures for establishing executive compensation and for correcting problems when they are discovered.

The regulations list factors that the IRS will consider when deciding whether to revoke an exemption, including: the size of the excess benefit transactions in relation to the size and scope of the organization’s regular exempt purpose activities; whether the organization has engaged in multiple excess benefit transactions; whether it implemented safeguards to prevent excess benefit transactions; and whether the excess benefit transaction has been corrected.

The final rule largely follows proposed regulations (PDF) released in September 2005.

IRS Issues Guidance on Excess Benefit Transactions
In late December 2003, the IRS issued guidance (PDF) on when nonprofit officer or director compensation will automatically be considered an excess benefit transaction under the intermediate sanctions rule. If a nonprofit organization fails to provide sufficient indication that a benefit, such as a vacation paid for by the organization, is intended as compensation, the IRS will automatically consider it an excess benefit, subject to penalty, without regard to whether the benefit is reasonable.

The guidance provides steps that an exempt organization can take to insure that an economic benefit will be considered as compensation. These steps include reporting the benefit as wages and withholding the proper amount of income tax. This intent can be substantiated with the Form 990, Form W-2, Form 1099, or Form 1040. An approved written employment contract or documentation from an officer or decision-making body authorized to approve compensation may also be considered acceptable substantiation.

Intermediate Sanction rules (Section 4958 of the Internal Revenue Code) were established as a way to provide sanctions short of revoking a 501(c)(3) or a 501(c)(4) organization’s tax-exempt status in cases where the organization’s assets are misused by officers, directors, or other persons with substantial influence over for an insider’s benefit. Under this rule, the IRS can fine the offending officer directly, and avoid revoking the organization’s status.

Read the guidance (PDF) in full.

IS Position
In addition to adhering to the intermediate sanctions rules, Independent Sector urges also encourages members of the nonprofit community to visit the website of the Panel on the Nonprofit Sector, which has released its Principles for Good Governance and Ethical Practice: A Guide for Charities and Foundations (PDF). The Guide outlines 33 practices designed to support board members and staff leaders as they strive to meet high standards of ethics and accountability.

Last updated: March 31, 2008