Reasonable compensation rules.

• Author: Schwartzman, Randy A.
• Position: Tax exempt organizations

On Aug. 4, 1998, regulations were proposed addressing "reasonable compensation" for certain influential insiders of tax-exempt organizations. Sec. 4958 authorizes a penalty excise tax as an intermediate sanction on "designated organizations" exempt under Sec. 501(c)(3) (except private foundations) or (c)(4). The tax is imposed when a designated organization engages in an "excess benefit transaction" with a "disqualified person." In these situations, both the disqualified person and the organization's managers may be subject to onerous taxes. Generally, Sec. 4958 is effective for excess benefit transactions occurring after Sept. 13, 1995 (see

News Notes, "Intermediate Sanctions" T-FA, October 1998, p. 656).

Disqualified Person

A disqualified person is any person, who, at any time during the five-year period ending on the date of the transaction, was in a position to exercise substantial influence over the organization's affairs. Any disqualified person who engages in an excess benefit transaction is liable for a 25% tax on the excess benefit. In addition, if an excess benefit is not corrected within the taxable period, a disqualified person is liable for a 200% tax on the excess benefit. Moreover, any organization manager (officer, director, trustee, etc.) who knowingly participates in an excess benefit transaction is liable for a tax equal to the lesser of $10,000 or 10% of the excess benefit.

Excess Benefit Transaction

An excess benefit transaction is a transaction in which a designated organization provides a direct or indirect economic benefit to (or for the use of) a disqualified person (or certain related parties), if the value of the economic benefit provided exceeds the value of the consideration the organization receives for providing that benefit. For example, if the compensation paid to a disqualified person exceeds the value of the services performed for such compensation, an excess benefit transaction results. Accordingly, to avoid imposition of these onerous taxes, compensation to a disqualified person must be reasonable.

Reasonable Compensation

Under Prop. Regs. Sec. 53.4958-4(b)(3), compensation paid for services is reasonable if it represents an amount that a similar enterprise under similar circumstances would pay for similar services. Generally, the circumstances to be taken into account are those existing when the contract for services was made. However, if reasonableness of compensation cannot be determined based on those circumstances, this determination is made based on all the facts and circumstances up to and including the payment date. The IRS cannot consider circumstances that exist when the issue is raised on examination.

The fact that...