Section 4958 imposes excise taxes when a public charity or social welfare organization pays a disqualified person more than the value of what it receives. Executive compensation is the common case. The regulations give boards a procedure that shifts the burden to the IRS: follow three steps, document them on time, and the pay is presumed reasonable. For an auditor, the board minutes that show those steps are also evidence for the related-party and compensation disclosures.
The taxes
Under section 4958(a)(1), a tax of 25 percent of the excess benefit is imposed on each excess benefit transaction, paid by the disqualified person. Under section 4958(a)(2), an organization manager who knowingly participates in the transaction is subject to a 10 percent tax, unless the participation is not willful and is due to reasonable cause, with a maximum of $20,000 per transaction under section 4958(d)(2). If the excess benefit is not corrected within the taxable period, section 4958(b) imposes an additional tax of 200 percent of the excess benefit on the disqualified person.
The three requirements
Treas. Reg. 53.4958-6(a) presumes that payments under a compensation arrangement are reasonable, and that a property transfer is at fair market value, if:
- Approval in advance. The terms are approved in advance by an authorized body of the organization composed entirely of individuals who do not have a conflict of interest regarding the arrangement.
- Appropriate comparability data. The authorized body obtained and relied upon appropriate data as to comparability before making its determination.
- Concurrent documentation. The authorized body adequately documented the basis for its determination concurrently with making it.
If the three requirements are met, the IRS may rebut the presumption only by developing sufficient contrary evidence to rebut the probative value of the comparability data. For fixed payments, rebuttal evidence is limited to the facts and circumstances on the date the parties entered the contract.
Comparability data
Relevant information for compensation includes pay levels at similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions; the availability of similar services in the geographic area; current compensation surveys compiled by independent firms; and actual written offers from similar institutions competing for the person's services. For an organization with annual gross receipts, including contributions, of less than $1 million, the authorized body is considered to have appropriate data if it has data on compensation paid by three comparable organizations in the same or similar communities for similar services. The organization may average its gross receipts over the three prior years to apply this rule.
Documentation
The records must note:
- the terms of the transaction approved and the date;
- the members present during debate and those who voted;
- the comparability data relied upon and how it was obtained; and
- any actions taken by a member who had a conflict of interest.
If the body determines that reasonable compensation is higher or lower than the range of comparability data, it must record the basis. The records are concurrent if prepared before the later of the next meeting of the authorized body or 60 days after the final action, and they must be reviewed and approved by the body within a reasonable time.
Worked example
A charity with gross receipts of $780,000 proposes to raise its executive director's pay from $95,000 to $112,000. The board, without the executive director, reviews pay at three comparable organizations in the region: $104,000, $109,000 and $118,000. The board approves $112,000 at its March 12 meeting. The next meeting is April 9, and 60 days after March 12 is May 11.
- Increase: $17,000, or 17,000 divided by 95,000, about 17.9 percent.
- Comparable range: $104,000 to $118,000; $112,000 is within the range.
- Minutes must be complete before the later of April 9 and May 11, which is May 11, and approved by the board within a reasonable time.
Had the board approved $135,000, above the range, the minutes would need to record the basis for the higher figure.
Who is a disqualified person?
Under section 4958(f)(1), a disqualified person is anyone who, at any time in the five years ending on the date of the transaction, was in a position to exercise substantial influence over the organization's affairs. Family members of that person and 35-percent controlled entities are also disqualified persons. An organization manager under section 4958(f)(2) is an officer, director or trustee, or an individual with similar powers or responsibilities. If more than one person is liable for a tax, each is jointly and severally liable under section 4958(d)(1).
What counts as a conflict of interest?
A member of the authorized body has no conflict only if the member:
- is not a disqualified person participating in or benefiting from the arrangement, and is not a family member of one;
- is not in an employment relationship subject to the direction or control of a disqualified person participating in the arrangement;
- does not receive compensation or payments subject to approval by a disqualified person participating in the arrangement;
- has no material financial interest affected by the arrangement; and
- does not approve a transaction providing economic benefits to a disqualified person who has approved, or will approve, a transaction providing benefits to the member.
A member who only answers questions and then leaves the meeting during debate and voting is not counted as part of the body for that transaction. The authorized body can be the governing body, a committee of the governing body to the extent state law lets it act for the board, or another party the board authorizes under state law.
Bonuses and other payments that are not fixed
For a payment that is not fixed, the presumption arises only after the exact amount is determined or a fixed formula is specified, and the three requirements are then met. The regulation has one exception for a capped employment contract. The body can establish the presumption when the contract is signed if it first obtains data showing that a fixed payment up to a certain amount would be reasonable, and the maximum payable under the contract, fixed and non-fixed combined, does not exceed that amount.
Example: the comparability data supports total pay of up to $130,000. The contract sets base pay of $112,000 and a discretionary bonus capped at $18,000. The maximum is $112,000 plus $18,000, or $130,000, which does not exceed the supported amount, so the board can establish the presumption for the whole contract at signing. A cap of $25,000 would put the maximum at $137,000, above the supported amount, and the exception would not apply.
Reading the rebuttal rules
For a fixed payment, the IRS is limited to the facts and circumstances on the date the parties entered the contract, except in cases of substantial nonperformance. For other payments, rebuttal evidence can include facts up to the date of payment. Missing the presumption does not make a transaction an excess benefit transaction. Under paragraph (e), the facts are then judged on the merits, and the procedure does not excuse compliance with other federal or state law.
Audit procedures
- Read minutes for each year's approval of the CEO and officers, and match the approved amounts to payroll and the Form 990 Part VII.
- Check that conflicted members recused, as recorded.
- Inspect the comparability data in the file.
- Compare the compensation to disclosures under related party disclosures.
- Cross-check pay allocations to programs and administration against functional expense allocation.
- Apply the general procedures in related party transactions audit to loans and leases with insiders.
- Read for other transactions with insiders, such as leases and loans, because the presumption also applies to property transfers.
Sources
- Legal Information Institute, 26 CFR 53.4958-6, Rebuttable presumption that a transaction is not an excess benefit transaction: https://www.law.cornell.edu/cfr/text/26/53.4958-6
- Legal Information Institute, 26 U.S.C. 4958, Taxes on excess benefit transactions: https://www.law.cornell.edu/uscode/text/26/4958
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