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Few nonprofit transactions look alarming on paper: an executive bonus, a lease with a board member, a property sale, or a loan.
But when an insider receives more economic value than the organization gets back, Section 4958 can turn an ordinary-looking deal into an Excess Benefit Transaction, bringing the IRS’s intermediate sanctions rules into play.
Congress added these rules in 1996, and Section 4958 applies to transactions occurring on or after September 14, 1995; the basic lesson for any tax exempt organization is that the Nonprofit vs For-Profit distinction matters when insiders are on both sides of the economics.
An Excess Benefit Transaction occurs when an applicable tax-exempt organization gives a disqualified person an economic benefit worth more than the value the organization receives in return. The rule applies to compensation, property transfers, contract payments, and other economic benefits, not just salary. Section 4958 authorizes the IRS to impose excise taxes on the insider and, in some cases, participating managers rather than immediately revoking exemption. The rules generally apply to certain 501(c)(3), 501(c)(4), and 501(c)(29) organizations. For valuation purposes, fair market value and reasonable compensation are the standards used to determine whether an excess benefit exists for federal purposes.
A disqualified person is someone who was in a position to exercise substantial influence over the organization during the five years before the transaction. That can include voting board members, chief executives, senior financial leaders, and others with significant decision-making authority, regardless of title. The definition also reaches certain family members and entities in which disqualified persons or their families own more than a 35% interest. Special rules can also cover donors, donor-advised fund advisers, and supporting-organization participants. The definition is broader than many boards expect because influence, ownership, family relationships, and prior roles can all create federal insider status.
Compensation is the most familiar risk, but it is far from the only one. Problems can arise through above-market salaries or bonuses, below-market sales of property, favorable leases, undocumented expense payments, personal use of nonprofit assets, loans with unusually favorable terms, or payments to businesses controlled by insiders. The IRS also considers all forms of compensation, including fringe benefits, deferred compensation, severance, and certain foregone interest. In more complicated cases, Forensic Accounting may help reconstruct the economics of a transaction. Strong nonprofit governance matters because the key question is whether the organization received fair value in return for the benefit.
Section 4958 places the primary tax burden on the disqualified person, not automatically on the nonprofit. The initial excise tax is 25% of the excess benefit. If the transaction is not corrected within the applicable taxable period, an additional tax equal to 200% of the excess benefit can apply. An organization manager who knowingly, willfully, and without reasonable cause participates in the transaction may also face a 10% excise tax, capped at $20,000 for each transaction. Correction generally means undoing the excess benefit to the extent possible and restoring the organization to a financial position no worse than before.
A nonprofit can strengthen its position by following the IRS rebuttable presumption of reasonableness process before approving compensation or property transactions with insiders. First, an authorized body made up of people without conflicts of interest must approve the arrangement in advance. Second, that body must obtain and rely on appropriate comparability data, such as compensation studies, market information, or similar transactions. Third, it must document the decision and its basis contemporaneously, including who participated, what data was reviewed, and how conflicts were handled. If those steps are satisfied, the IRS must produce contrary evidence to overcome the presumption during review.
For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Alana Mueller, partner in Bennett Thrasher’s nonprofit accounting practice, or call us at 770.396.2200.
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