Management and Executive Compensation in Nonprofit Organizations: Part One

Many of us have both the privilege and the responsibility of serving as a board member or as a trustee of a charitable organization. Many of these charitable groups are organizations exempt from income tax as organizations described in Section 501(c)(3) of the Internal Revenue Code of 1986, as amended, (an "Exempt Organization"). Because these Exempt Organizations are exempt from tax and receive other income tax benefits, they are generally held to a higher standard of care and are subject to strict compliance rules in certain areas.

One example of this higher standard of care are the rules that apply to transactions between an Exempt Organization and persons who have control over the business of the Exempt Organization. Specifically, Section 4958 of the Internal Revenue Code imposes an excise tax on participants in an "excess benefit transaction" so that if an Exempt Organization pays more than the fair market value for goods or services, and the recipient of that payment is an officer, director or other controlling person, then the Exempt Organization is likely to have engaged in an excess benefit transaction. Both the recipient of the excess benefit as well as the persons approving the transaction can be subject to substantial excise taxes.

Excess benefit transactions can take many forms but the most common involves the determination of compensation of key employees. One of the functions of the governing body of an Exempt Organization is to determine the compensation of the key employees of the organization. The steps in the process are important because failure to follow these rules may result in the loss of a valuable defense to an IRS claim that the compensation in an "excess benefit transaction" that can result in an excise tax - an "intermediate sanction" - on both the person receiving the excess benefit, the key employee, and the person approving the excess benefit, the trustee or the board member.

Taxpayer Impact

In order to provide the best defense to the penalties imposed by the intermediate sanctions, appropriate documentation and information must be gathered relating to the compensation and benefits to be provided to the disqualified person. Based on this information, the compensation and benefits should be approved by independent members of the board of committee of the board.

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