Internal controls and exempt organization executive compensation arrangements.

• Author: Cowan, Mark J.

EXECUTIVE SUMMARY

* Executives (and other individuals) that receive an excess benefit from a tax-exempt organization, and individuals that participate in providing the excess benefit, may be subject to special excise taxes known as "intermediate sanctions." The IRS can also revoke an organization's exempt status if the organization engages in excess-benefit transactions.

An excess benefit results when the organization pays an employee more than reasonable compensation. Reasonable compensation is the fair market value of an employee's services, i.e., the amount that would ordinarily be paid for like services by like enterprises (whether taxable or tax exempt) under like circumstances.

A properly designed and functioning internal control system can greatly mitigate the risk of an organization's becoming subject to intermediate sanctions or revocation of the organization's exempt status due to excess-benefit transactions.

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As nonprofit organizations become more entrepreneurial in carrying out their missions, they are facing many of the same challenges as for-profit organizations in designing compensation and benefit packages that effectively recruit and retain executive talent. While compensation issues at larger nonprofits tend to receive more scrutiny from the public and the IRS, (1) the reality is that compensation policies are becoming more important for nonprofits of all sizes. The increased importance, size, and complexity of the compensation arrangements increase the risk of the organization's providing excess benefits.

Executives (and other individuals) that receive an excess benefit from a tax-exempt organization, and individuals that participate in providing the excess benefit, may be subject to special excise taxes, applied under Code provisions known as "intermediate sanctions." (2) More important, whenever an excess benefit is paid, the nonprofit risks losing its Sec. 501 (c)(3) tax-exempt status because of inurement. (3)

Both long-standing and recent tax law guidance confirm that robust internal controls are critical for nonprofits and their managers to avoid intermediate sanctions and loss of tax-exempt status. The IRS defines "internal controls" as "the taxpayer's policies and procedures to identify, measure and safeguard business operations and avoid material misstatements of financial information." (4)

This article provides an overview of the law of inurement and intermediate sanctions. It then reviews recently issued final regulations addressing when the IRS will both impose intermediate sanctions and revoke an organization's tax-exempt status due to inurement. These new regulations highlight the importance of internal controls in maintaining tax-exempt status. Finally, based on the law and general principles of internal controls, the article suggests some policies and procedures that nonprofits should consider adopting.

Inurement

Sec. 501(c)(3) specifically provides that an organization will be exempt from the federal income tax only if "no part of the net earnings of [the organization] inures to the benefit of any private shareholder or individual." Inurement normally results when compensation in excess of fair market value (FMV) is paid to, or other excessive or targeted benefits are received by, "insiders" at the organization. Insiders generally include organization founders, board members, and their families, as well as anyone else that is "the equivalent of an owner or manager." (5)

Strictly, any instance of inurement, regardless of amount, is cause for the government to revoke the organization's tax exemption. (6) For a Sec. 501(c)(3) organization, loss of tax exemption because of inurement can be disastrous--and in many cases fatal. The organization will be subject to the federal income tax on its net income. (7) More important, donors will no longer be able to deduct contributions to the organization and will lose faith in the organization's ability to manage its resources--thereby stifling, or even killing, fundraising efforts. Finally, the public at large will no longer trust the organization when, because of inurement, it loses the "halo" effect that comes from government-approved Sec. 501(c)(3) status. Accordingly, it is imperative that Sec. 501(c) (3) organizations have controls and procedures in place to help prevent any inurement from occurring.

Church of Scientology Case

Church of Scientology of California, (8) a case in which the court upheld the IRS's revocation of a church's tax-exempt status, provides an instructive example of how lack of controls can lead to inurement. The court found that the organization's net earnings had inured to the benefit of church founder L. Ron Hubbard and his family in the form of excess royalties and other payments. In addition, the court found that inurement resulted from the church's lack of control over substantial church funds. More than $3.5 million of church funds was transferred to an offshore corporation and its Swiss bank account. Hubbard and his wife controlled the account and Hubbard himself kept the checkbooks. Furthermore, approximately $2 million was transferred from the Swiss bank account to a locked file cabinet. The file cabinet was kept aboard the church's cruise ship, which served as the church's headquarters and the Hubbards' residence; Hubbard's wife kept the only set of keys to the file cabinet.

The church argued that the money in the file cabinet was never used to benefit Hubbard or his family. Even if true, however, the money in the accounts and the file cabinet still created inurement because Hubbard had "unfettered control over millions of dollars in money that originated with the Church." (9) Furthermore, the organization failed to produce receipts or other documentation showing how the Swiss bank account funds were raised or disbursed.

The overall lesson is that inurement can result not just from the payment of excess salaries to insiders but also from "[u]naccounted for diversions of a charitable organization's resources by one who has complete and unfettered control." (10) If the church had had internal control over the cash in the file cabinets and in the Swiss bank account, perhaps it could have reduced the risk of inurement (and loss of exemption).

Intermediate Sanctions

The IRS has been reluctant to revoke tax exemption for inurement except in egregious situations. This reluctance reflects the reality that revocation is a harsh, all-or-nothing penalty that punishes the organization's innocent donors, charitable beneficiaries, and employees rather than the insiders who benefited from the inurement and the managers who approved or allowed it. Recognizing this, Congress enacted Sec. 4958, which allows the IRS to impose "intermediate sanctions"--an excise tax regime that is not as draconian as revoking tax exemption--to discourage undesirable transactions, including those that could result in inurement. When inurement occurs, the IRS is free to impose intermediate sanctions and to revoke the organization's tax-exempt status. In many cases, however, intermediate sanctions will apply in lieu of revocation of tax-exempt status.

Definitions

Intermediate sanctions apply to excess benefits provided to disqualified persons. In general, a disqualified person is someone in a position to "exercise substantial influence" over the nonprofit. (11) Officers and board members would normally be considered disqualified persons. (12) An excess benefit is an economic benefit provided by a nonprofit to a disqualified person that is in excess of the value of the services that person provides. (13) Thus, intermediate sanctions apply when an influential person at the nonprofit receives compensation in excess of industry or other market norms.

Sec. 4958(a) imposes an initial tax on disqualified persons equal to 25% of the excess benefit they have received. If the disqualified person does not "correct" the problem, generally by repaying the excess benefit to the nonprofit, Sec. 4958(b) imposes an additional tax on the disqualified person equal to 200% of the excess benefit. This two-tier tax is designed to force the recipient of the excess benefit to restore such benefit to the organization. No tax is imposed on the organization itself.

Sec. 4958(a) also imposes a tax on organization managers who knowingly participate in providing the disqualified person with an excess benefit. (14) The tax is 10% of the excess benefit. Effective for tax years beginning after August 17, 2006, the maximum tax on managers for any one excess-benefit transaction is $20,000. (15)

Example 1: R Hospital is a Sec. 501(c) (3) organization operating a hospital that has grown significantly in recent years. P, the organization's longtime president, has been instrumental in the hospital's growth and success. Up until this year, P was paid a $200,000 annual salary. Recently, P demanded that her salary be raised to $700,000 or she would resign. The board of directors quickly entered into a new multiyear contract with P at the new level of compensation.

P is a disqualified person (16) and the board members who approved the new contract would be considered managers. (17) Assume...