In this article, we will explore the management of compensation for disqualified individuals within the framework of IRS intermediate sanctions, specifically IRC Section 4958. Effective management of compensation in this context is crucial to avoid reputational damage, as well as severe taxes and penalties imposed by the IRS.
The term "disqualified individuals" refers to individuals who hold influential or controlling positions within tax-exempt organizations under IRC Section 501(c)(3) or Section 501(c)(4). These individuals have the potential to use their influence to benefit themselves at the organization's expense. Such transactions, known as excess benefit transactions under IRC Section 4958, include various types of interactions involving the organization and a disqualified individual, such as the purchase or sale of goods, provision of personal benefits, or services.
Most inquiries about compensation for disqualified individuals revolve around executive-level positions within an organization. Individuals holding top executive and financial officer roles are almost always considered disqualified individuals. However, there may be other management positions within specific organizations that could also fall under this classification. The determination of disqualified individuals should be based on a careful assessment of the facts and circumstances.
Disqualified individuals extend beyond the executive level, encompassing other influential individuals, including voting members of the governing body, and family members of disqualified individuals (e.g., siblings, spouses, children, grandchildren, and their spouses). It is crucial to recognize the broader range of individuals and relationships that may impact compensation arrangements.
The governing board, which includes the organization's managers, bears the responsibility for managing compensation for disqualified individuals. These individuals are defined as officers, directors, trustees, or similar roles on the organization's board. Board members have a duty to ensure that compensation remains within reasonable limits to avoid excess benefit transactions. Failure to do so may result in severe consequences for all parties involved.
Penalties for non-compliance with compensation regulations are known as intermediate sanctions. Organizations can safeguard themselves from these penalties by meeting the criteria outlined in the rebuttable presumption of reasonableness. This guideline establishes that payments made to disqualified individuals are considered reasonable if specific requirements are fulfilled. The burden of proof then shifts to the IRS to demonstrate unreasonableness.
Requirements for the Rebuttable Presumption of Reasonableness:
To satisfy the requirements for the rebuttable presumption of reasonableness, organizations must:
- Obtain approval from an authorized body comprising individuals with no conflicts of interest.
- Rely on comparable data or expert advice to assess the reasonableness of compensation.
- Document the proceedings and basis of their determination thoroughly.
Maintaining suitable and timely documentation, rather than just fulfilling the filing requirements, can be a challenge. Additionally, obtaining comprehensive information about competitive compensation practices for comparable positions in similar organizations can be difficult. BDO has initiated a specialized compensation survey for CEO and CFO positions in nonprofit organizations, aiming to provide valuable information for the compensation governance process.
Proper management of compensation for disqualified individuals is crucial to avoid excess benefit transactions and their associated taxes and penalties. Compliance with the requirements for the rebuttable presumption of reasonableness and thorough documentation are essential. By meeting these obligations, organizations can mitigate risks and ensure transparency in compensation arrangements.
