The title of this article might have caught the eye of some readers, who may have thought it provides tips on managing pay for poor performers or offers a rationale for employing individuals without proper job qualifications. However, this article focuses on “disqualified individuals” in the context of IRS intermediate sanctions — IRC Section 4958 — and the management of compensation paid to those individuals. It is an area that receives considerable attention from the IRS and the general public. Failure to manage it well can result in lingering reputational damage, as well as punitive taxes and penalties for all involved.
The term “disqualified individuals” is defined as individuals in a position to exercise considerable influence or control over the affairs of an IRC Section 501(c)(3) or Section 501(c)(4) tax-exempt organization. They are singled out as individuals who might be in a position to exercise their influence or control over the organization for personal benefit at the expense or to the detriment of the organization with which they are associated. This personal benefit, defined as an excess benefit transaction by IRC Section 4958, could arise in almost any type of transaction involving the organization and a disqualified individual. Some examples include the purchase or sale of goods and services and the provision of special personal benefits. This article explores IRC Section 4958, disqualified individuals and excess benefit transactions as they apply to compensation.
Most commonly, questions regarding compensation for disqualified individuals will arise in the context of pay for an organization’s executive-level positions. These disqualified individuals, both individually and collectively, exercise great control over the affairs of an organization, including its financial resources. The organization’s principal executive officer (e.g., CEO or executive director) and principal financial officer (e.g., CFO or finance director) are almost always deemed disqualified individuals. There are, however, individuals in the management hierarchy of some organizations that might qualify as well, such as chief operating officer and top program executive. These other positions must be determined on a facts-and-circumstances basis to determine whether the individuals meet the criteria to be considered disqualified individuals.
The Section 4958 definition of disqualified individual is considerably broader than executive roles for the organization. The types of individuals and relationships that qualify and may be associated with compensation include:
- Other influential persons such as voting members of the governing body
- Family members of a disqualified individual, such as siblings, spouse, children, grandchildren, great grandchildren and the spouses of each.
Managing all forms of pay for disqualified individuals is the responsibility of the tax-exempt entity’s governing board (i.e., organization manager(s)). Section 4958 defines these individuals as any officer, director, trustee of an organization or individual (i.e., board members) who serve in that capacity. As stewards of the organization and its financial resources, board members are accountable for ensuring that pay for any individual is not unreasonable (i.e., results in an excess benefit transaction).
In the event of an excess benefit compensation transaction, the consequences are potentially costly for all involved, specifically:
- The individual receiving the excess benefit must repay the gross amount of the excess benefit (not just the net amount they were paid) to the organization with interest, to make the organization “whole.” An excise tax on the benefit amount ranging from 25% to 225% may also be levied on the individual.
- Members of the organization’s governing body (the organization managers) and management (disqualified individuals) who knowingly authorized the transaction may also be personally subject to penalties of up to $20,000 per occurrence.
These penalties are commonly referred to as “intermediate sanctions.” The intermediate sanctions provisions provide guidance to exempt organizations to avoid excess benefit transactions and offer possible protection from excise taxes and penalties that could arise from them. The guidelines, known as the rebuttable presumption of reasonableness, provide that if an organization meets the listed requirements, any payments it makes to a disqualified person under a compensation arrangement are presumed to be reasonable, and a transfer of property or the right to use property is presumed to be at fair market value. In other words, the organization will be presumed to have met the test for a reasonable transaction and the burden of proof will be placed on the IRS to prove it was not reasonable.
The requirements to meet the rebuttable presumption of reasonableness are:
- The transaction must be approved by an authorized body of the organization, composed of individuals who do not have a conflict of interest in the transaction (outside/independent board members). Many boards have a subcommittee focused on compensation composed of outside directors.
- Before authorizing the compensation, the authorized body must obtain and rely on comparable data and/or expert advice as to the reasonableness of the transaction. Board members may rely on published compensation surveys or Form 990 filings by other organizations for comparable positions in similar organizations as the basis for their decision.
- The authorized body must adequately document the proceedings that were the basis for its determination in a timely manner. Meeting minutes that meet this requirement must be thorough and include the following information: The comparability data obtained and relied on by the authorized body and how the data was obtained;
- The basis for any determination that reasonable compensation is higher or lower than the range of comparability data obtained;
- The members of the authorized body who were present when the transaction was debated;
- The identity of the members who voted on the transaction;
- The terms of the compensation and the date it was approved;
Any actions taken with respect to consideration of the transaction by a regular member of the authorized body who had a conflict of interest (for example, the conflicted party was excused from the meeting during the discussion);
Information related to the date the minutes were drafted as well as approved by those in attendance.
It should be noted that the organization’s Form 990 and Schedule J filings include annual declarations about an organization’s adherence to each of the three broad requirements of the rebuttable presumption of reasonableness.
The most common difficulties in complying with these factors include:
- Maintaining appropriate and timely documentation and not simply “checking the box” on the organization’s 990 filings; and
- Insufficient information about competitive compensation practices for similar positions among comparable organizations.
For more information or questions about disqualified individuals, please contact Matt McKinney via email at mattm@dhw.cpa or at 828.322.2070.