Alliance for Children and Families, December 15, 2008
Explain All Executive Benefits … Or Else
IRS penalizes for unfair automatic excess benefits
Ever since the mid 1990s, the Internal Revenue Service (IRS) has had the power to impose penalties on exempt organization insiders who abuse their positions of authority and control.
These provisions, found in Section 4958 of the Internal Revenue Service Tax Code, are known as “intermediate sanctions” because they allow the IRS to impose a penalty instead of revoking the organization’s exemption, and the penalty is imposed on the wrongdoer rather than the organization itself.1
Part of the “intermediate sanctions” regulatory scheme allows the IRS to impose a sanction on what are called “automatic excess benefit transactions.” These are transactions between the organization and its insiders,2 and they involve benefits that should have been documented as part of the insider’s compensation, but were not.
The insider that I’m referring to in this article is the chief executive of a 501(c)(3) tax-exempt organization. If you are your organization’s CEO, president, or executive director, this means you. It is immaterial that your organization might be classified as a public charity as opposed to a private foundation.3 The scheme works with equal application to both.
If you are an insider, there are three ways that you can get in trouble with automatic excess benefits:
1. Agreements that provide hidden and untaxed benefits or that add up to unreasonable compensation when taken as a whole;
2. Loans that are too generous, not properly documented, or not repaid; and
3. Expense reimbursements, paid to or on behalf of the insider, that are not properly documented, authorized, and/or taxed.
The IRS is willing to back down when you can demonstrate reasonable cause for your failure, but there have to be significant mitigating factors involved. It is always best when you identify in advance any potentially problematic transaction, and document how you deal with it, before the IRS comes knocking at your door.
Penalties are Severe
Correction begins with repayment of 100 percent of the benefit, or payment of income taxes on it if the benefit won’t be repaid. In addition, the IRS imposes an excise tax equal to 25 percent of the excess benefit on each transaction. An interesting feature is that the entire amount is treated as excess, regardless of whether it would have been fair compensation had it been handled properly. The insider is liable for the tax.
If the excess benefit transaction is not corrected (either paid back or taxes paid on the income) within the “taxable period,”4 an additional excise tax equal to 200 percent of the excess benefit is imposed.
There are many IRS rules about how the excise tax is imposed and how it might be mitigated or abated. The main point is that, to avoid the imposition of the 200 percent tax, you must correct the excess benefit transaction during the taxable period.
Safe Harbors are Available
Yes, there is a “safe harbor” to prevent excess benefit transactions. The safe harbor always consists of a proactive response: identifying a troublesome transaction, making sure that it is corrected, and determining what taxes (including excise taxes) must be paid to the government.
What the IRS looks for is “written contemporaneous substantiation” of compliance. That means what it says: You need to document how you handled the transaction both in writing and at the time you take corrective action. Let’s look at how you can comply with this requirement.
Executive Agreements. The IRS looks for hidden benefits in the following kinds of executive agreements: employment, deferred compensation, bonus, retirement, severance, and purchase or lease of goods and services.
It asks: When the benefits provided in these agreements are added to the executive’s known compensation, is the executive being paid too much overall? When it audits a potential excess benefit, it asks for a tabulation of all elements of compensation for the executive, from every source. When all elements of compensation are totaled, the IRS goes through its own evaluation as to whether the insider’s total pay satisfies its reasonableness standard. You need to do your own assessment of reasonableness, using the prescribed method, on a regular basis.5
Loans. The IRS looks for loans that are undocumented, unsecured and/or unenforced. It asks: Are the terms so liberal and the likelihood of payback so remote that this constitutes compensation rather than a true loan?6 When it audits, the IRS wants to see a signed, dated note that has the following information in it: (1) original amount, (2) balance due, (3) maturity date, (4) repayment terms, (5) interest rate, (6) security provided, and (7) purpose of the loan. You need to make sure that any outstanding loans meet this test.
Expense Reimbursements. The IRS looks for expense reimbursements that have been made without an “accountable” (that is, compliant) plan in place or that have been made despite the fact that the insider did not comply with an accountable plan’s mandates.
You need to know what constitutes a “fully accountable reimbursement plan” under the IRS Code.7 If you have no plan, then all reimbursed expenses are income to the insider and all are automatic excess benefits. If you have a fully accountable plan but it was not followed, the result is the same. Be sure you have a fully accountable reimbursement policy for all reimbursable expenses, and be sure you enforce it against your insiders. (See sidebar for sample policy.)
It should be noted that all improperly structured insider agreements, loans, and expense reimbursement are penalized whether or not the underlying amounts are fair or would have been proper with appropriate systems in place.
I should also note that there are many nuances to the system that are too complex to be included in this short article, and which might affect the ultimate outcome. The important thing to remember is this: The “automatic excess benefit” system has been created to make sure insiders comply with IRS requirements and that they do not use their position to advantage themselves at the organization’s—or the taxpayer’s—expense.
Go to the Alliance for Children & Families Magazine Web site at www.alliance1.org/magazine (click on “Columnists”) to review Vanden Berk’s fall 2002 article on intermediate sanctions, a “rebuttable presumption of reasonableness” white paper on intermediate sanctions, and sample mobile phone policies.