Preparing for an excess benefit transactions audit

by Terri Rexrode

The Internal Revenue Service (IRS) has identified executive compensation as a primary focus of future audits. In this article — which is part one of a series about executive compensation issues — we’ll discuss a particularly sticky compensation issue: excess benefit transactions.

What is an excess benefit transaction?

An excess benefit transaction is one in which the economic benefit provided by a tax-exempt organization, either directly or indirectly, exceeds the value of the consideration (including the performance of services) received for providing the benefit.

In other words, tax-exempt organizations — while they are entitled to pay a “reasonable compensation” for the services they receive — may allow key executives too great a voice in determining their own compensation. These key executives may be awarding themselves “excess benefits.”

This is illegal, according to section 4958 of the IRS code, which Congress enacted in 1996 to prevent individuals from using their influence over a public charity or civic league (but not a private foundation) to unfairly compensate themselves at the expense of the organization.

Note that while excess benefits can take the form of compensation, they can also be perks, such as the personal use of employer-provided property, including cars, computers, cell phones and pagers. This latter category has been the IRS’s primary concern thus far. Any economic benefit that is not compensation is automatically considered excess benefit transaction unless there is written substantiation that the benefit was intended to be compensation.

Who can be guilty of an excess benefit transaction?

First, only a “disqualified person” can commit an excess benefit transaction. A disqualified person is anyone who is in a position to exercise “substantial influence” over the affairs of the tax-exempt organization; that person’s family; and any other entity in which the person and family have a combined ownership of at least 35% (i.e., a corporation, LLC, partnership, trust or estate).

A few individuals will always meet the definition of a disqualified person by exercising “substantial influence” over the affairs of the organization. These include individuals serving as voting members on the governing body of the organization; individuals who have the power or responsibilities of the president, chief executive officer or chief operating officer of the organization; and individuals who have ultimate responsibility for managing the finances of the organization, such as its treasurer and chief financial officer.

A few people are definitely not disqualified persons. An individual who has managerial authority or serves as a key advisor to a person who has managerial authority does not have substantial influence. Nor does an independent contractor — such as an attorney, accountant or investment advisor — who does not receive more than a reasonable compensation for the services he or she provides.

The tax-exempt organization’s managers (which include officers, directors, trustees or other individual having similar powers, regardless of title) can also commit an excess benefit transaction if they knowingly participate in the transaction.

What are the penalties for excess benefit transactions?

If the IRS determines that there has been an excess benefit transaction, the individual receiving the benefit must pay 25 percent of the benefit back to the tax-exempt organization, with interest; if he or she does not do so, a 200 percent penalty on the amount of the excess benefit will apply. And any of the tax-exempt organization’s managers, as defined above, can be subject to a 10 percent penalty if they knowingly participate in an excess benefit transaction.

Recommended actions

In order to prepare for the possibility of an IRS audit, tax-exempt organizations, including hospitals, should take several steps.

First, identify all disqualified persons. They include any individuals who are or were disqualified persons at any time during the last five years.

Second, identify all economic benefits. They include both cash and non-cash benefits that are received by each disqualified person.

Third, make sure there is substantiation to show that any benefits were received as compensation for services rendered. Any benefits that were intended to be part of a compensation package must be approved in accordance with the organization’s policies and treated accordingly in its books, records and tax returns. Appropriate substantiation includes reporting the value as compensation on Form W-2 or Form 1099, as well as on Form 990.

We can assist you with this; please contact your nearest Wipfli office for details.

Terri Rexrode is a tax manager in Wipfli’s Green Bay office with more than 10 years of experience in tax accounting and business consulting. She can be reached at (920) 662-2831 or trexrode@wipfli.com.