Tax - Exempt Organizations Should Review Compensation Packages

The Internal Revenue Service released the final regulations regarding taxation of excess benefit transactions on January 22, 2002. The regulations set forth rules governing transactions between public charities and social welfare organizations, and directors, officers, employees, related organizations and other "insiders". The regulations impose an excise tax on those insiders who receive impermissible benefits from exempt organizations. Although the final regulations offer few significant changes from temporary regulations issued in the past, their release should prompt a comprehensive review of compensation packages and other transactions between tax-exempt organizations and their insiders.

• Intermediate sanctions impose an excise tax on insiders of organizations described in section 501(c)(3) or section 501(c)(4), except private foundations, if the insider receives an excess benefit, such as excess compensation.

• The 1st tier excise tax imposed on a disqualified person is 25% of the excess benefit. There is a 2nd tier tax of 200% if the excess benefit transaction is not "corrected" in a timely manner. The disqualified person can correct the transaction by undoing the transaction or taking the necessary steps to place the organization in the same financial position as prior to the transaction.

• A "rebuttable presumption" of reasonableness is available for exempt organizations, provided three criteria are met. Generally (1) an independent board must make the decision regarding the dollar amounts of the transaction/compensation package; (2) the decision must be based upon comparable situations entered into by comparable nonprofit and for-profit organizations; and (3) the board's decision must be documented at the time the decision is made.

• There is a broad exception to these rules for initial contracts entered into between the organization and an unrelated person. Essentially any new contract between a previously unrelated person and an exempt organization is not subject to the excise tax, but the organization remains subject to the inurement and private benefit rules.

• One example of a "disqualified person" in the regulations is a health care management company that is ultimately responsible for supervising the management of a hospital, which is consistent with the function of a president or chief executive officer.

• The regulations do not cover revenue sharing arrangements. Instead, revenue-sharing transactions are to be analyzed under the general rules under section 4958 and a facts and circumstances determination as to whether the economic benefits provided to the disqualified person exceeds the value of the services rendered.

We suggest that officers of section 501(c)(3) and (c)(4) organizations identify their "insiders" and carefully review the compensation packages of key individuals, as well as the procedures used for determining such compensation to ensure compliance with the statute and regulations. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.