This article first appeared in Bloomberg Tax on June 23, 2022. Reproduced with permission from Copyright 2022 The Bureau of National Affairs, Inc.
Excess benefit transactions to deter insiders
Until 1996, the IRS had a binary choice for tax-exempt organizations that had run afoul of their charitable purpose: Try to revoke the tax-exempt status of the organization or don’t. There was no intermediate ground—until Congress passed Section 4958 of the Internal Revenue Code.
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The purpose of the new statute was not to collect revenue but to “deter insiders of an organization from using their positions of influence to receive unreasonable compensation.” The target of these “intermediate sanctions” is not the tax-exempt organization, but rather insiders who may have benefited from the malfeasance.
Under Section 4958, the IRS may impose excise taxes for certain “excess benefit transactions” between a tax-exempt organization and certain insiders, known in the jargon of the statute as “disqualified persons.” The term “excess benefit transaction” means any transaction in which an economic benefit is provided by a tax-exempt organization “directly or indirectly to or for the use of any disqualified person, if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit.”
Tax imposed on disqualified persons and organization’s managers
The IRS may impose the tax on not only on the disqualified person but also on any organization’s managers participating in the excess benefit transaction, unless the manager’s participation “is not willful and is due to reasonable cause.”
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The amount of the tax on the disqualified person is 25% of the excess benefit, which is known as the first-tier tax. The law provides a significant incentive to pay up to recalcitrant insiders. If they do not correct the excess benefit and pay the first-tier tax within the taxable period, then the IRS is required to impose a 200% tax of the excess benefit on the disqualified person.
Intermediate sanctions can be imposed not only on traditional insiders such as officers and directors but also on family members, as well as a much broader category of individuals who are “in a position to exercise substantial influence over the affairs of the organization” during a five-year look-back period.
Disqualified persons includes persons without any official connection to the nonprofit
In Fumo v. Commissioner (T.C. Memo. 2021-61), the tax court considered whether disqualified persons included those without an official position with the organization. The court underscored that apart from those named in the law as disqualified persons who were obvious targets—such as directors and certain officers, members of their families, and certain affiliated entities—there may be others who qualify as “disqualified persons.” The question whether an individual is a disqualified person generally “depends upon all relevant facts and circumstances.” In Fumo, there were lots of facts and circumstances.
The petitioner on whom the tax for the excess benefit transaction was imposed objected that he was not a disqualified person. Yet he was intricately intertwined with the organization. Sure, he wasn’t an officer or director or employee. But according to his own testimony in his criminal trial (we’ll get to that in a moment), he “created” the tax-exempt organization, “gave it birth,” and “nursed it along.” He testified that “[i]f it weren’t for me, [the tax-exempt organization] wouldn’t exist.”
The petitioner was a politician who had been convicted on 34 counts related to a scheme to defraud the same tax-exempt organization. He had conspired to use the organization’s funds to purchase vehicles, farm equipment, tools, and consumer goods for his own use and make other expenditures on his behalf—e.g., for foreign travel, the services of a private investigator, and cellphone service for his chauffeurs and daughter. He had already been ordered to pay the organization more than $1.1 million in restitution.
Although an officer of the organization exercised day-to-day control over the organization’s affairs, the petitioner approved most significant projects and directed many major expenditures, including, for example, an office building that housed his first district office.
The tax court exhaustively reviewed the factors relating to whether the petitioner, who had no official capacity with the organization, could be a disqualified person. The status of most other individuals is governed by the “facts and circumstances” test of paragraph (e). Under that test, an individual can be a disqualified person even though they have no formal job title or formal affiliation with the charity. The regulations provide a laundry list of factors tending to show that a person has “substantial influence” over the organization.
Numerous facts supported the finding that the petitioner was a disqualified person. But “the clearest indication” that he was in a position to exercise substantial influence over the affairs of the organization was, according to the court, that “he in fact exercised such influence, and did so repeatedly over a period of many years.”
Disqualified persons should not use nonprofit’s credit card for personal expenses
The second recent case dealing with excess benefit transactions is a clearer example of a disqualified person. In Ononuju v. Commissioner (T.C. Memo. 2021-94), the petitioner’s husband was a medical doctor and president of a nonprofit established to operate a medical facility in Michigan. The clinic’s purported purpose was to provide medical examination and treatment services for individuals unable to afford such services.
The petitioner’s husband had received checks and other benefits from the organization of over $650,000 to defray the personal living expenses of his family, including the petitioner, her husband the doctor, and their eight children. The petitioner was also part of this gravy train. She received biweekly checks totaling $27,000 and monthly checks totaling $88,000.
The petitioner may have held some official position with the organization and was listed as the organization’s treasurer and secretary on an annual report filed with the state of Michigan. She was listed as its secretary and as a director on the Form 990. She had signature authority over at least three of organization’s bank accounts and regularly attended the organization’s board meetings during some of the relevant times.
She testified that her husband put her on the payroll, which is why she received the biweekly checks, but she offered no testimony or other evidence that she performed any services for the organization. She referred to the nonprofit as her husband’s “business” and as “the name of his medical practice.”
Her testimony regarding the monthly checks was no more believable. She argued that although the $88,000 of checks were made out to her, she did not personally benefit. She testified that she withdrew these funds from the organization’s account at her husband’s request, for distribution to needy people in town—e.g., to help them pay rent and utilities, to pay for children’s after-school programs, and to reward children who got good grades at school. She testified: “I was just like a messenger.”
It did not help her defense that she received compensation for services rendered to the nonprofit when she testified: “I don’t know anything about this case. I’m just a mother of eight children, and that was my job at that time.” She could supply no substantiation to show that the nonprofit intended to treat the $27,000, much less the $88,000, as compensation for her services.
The tax court was unimpressed, determining that it was “far more plausible” that the IRS’s conclusion that she used the $88,000 to defray personal living expenses of her family. As to whether she was a disqualified person, the tax court had no problem with finding that the petition was automatically deemed to be a disqualified person because she was the doctor’s spouse. The court did not reach any conclusion regarding whether she also qualified as a disqualified person because of being a director.
The tax court affirmed the finding that she was subject to a first-tier tax of $32,500 under Section 4958(a), and because the petitioner failed to correct the improper transactions during the applicable period, the IRS imposed a second-tier tax of a whopping $260,000.
The same guidance that goes for nonprofits goes for every legal entity: keep the entity separate. It may be obvious, but you should not use the nonprofit’s funds to buy groceries for the officers or directors or other insiders. You should not pay unreasonable compensation for the officers. In short, you should not use a nonprofit tax-exempt organization, which is subsidized by US taxpayers, as a personal piggybank for officers, directors, their families, or other insiders.