The Excess Benefits Tax is designed to penalize those who profit unfairly from their relationship with a nonprofit organization. Many times the tax will be triggered by a transaction the participants thought was perfectly ordinary. Indeed, some transactions that might be ok between an owner and his business, would trigger the tax when they're between a nonproft and a related party.
The best way to understand what the IRS is looking for, is to look at examples:
(d) PERSONS DEEMED NOT TO HAVE SUBSTANTIAL INFLUENCE
A person is deemed not to be in a position to exercise substantial influence over the affairs of an applicable tax-exempt organization if that person is described in one of the following categories:(1) Applicable tax-exempt organizations described in section 501(c)(3). This category includes any other applicable tax-exempt organization described in section 501(c)(3).
(2) Employees receiving economic benefits of less than specified amount in a taxable year --
(i) In general. This category includes, for the taxable year in which benefits are provided, any employee of the applicable tax-exempt organization who --
(A) Receives economic benefits, directly or indirectly from the organization, of less than the amount of compensation referenced for a highly compensated employee in section 414(q)(1)(B)(i);
(B) Is not described in section 53.4958-3(b) or (c) with respect to the organization; and
(C) Is not a substantial contributor to the organization within the meaning of section 507(d)(2).
(ii) EXAMPLES
The following examples illustrate the category of persons described in this paragraph (d)(2):
Example 1. N, an artist by profession, works part-time at R, a local museum. In the first taxable year in which R employs N, R pays N a modest salary and provides no additional benefits to N except for free admission to the museum, a benefit R provides to all of its employees and volunteers. The total economic benefits N receives from R during the taxable year are less than the amount of compensation referenced for a highly compensated employee in section 414(q)(1)(B)(i). The part-time job constitutes N's only relationship with R. N is not related to any other disqualified person with respect to R. N is deemed not to be in a position to exercise substantial influence over the affairs of R. Therefore N is not a disqualified person with respect to any transaction involving N and R in that year.
Example 2. The facts are the same as in Example 1, except that in addition to the modest salary that R pays N in exchange for N's provision of services to R during the taxable year, R also purchases one of N's paintings for $90,000. The total economic benefits provided by R to N in that year exceed the amount of compensation referenced for highly compensated employees in section 414(q)(1)(B)(i). Consequently, whether N is in a position to exercise substantial influence over the affairs of R for that taxable year depends upon all relevant facts and circumstances.
(e) FACTS AND CIRCUMSTANCES GOVERN IN ALL OTHER CASES (1) In general. Whether a person who is not described in paragraph (b), (c) or (d) of this section is a disqualified person depends upon all relevant facts and circumstances. A person who has managerial control over a discrete segment of an organization may nonetheless be in a position to exercise substantial influence over the affairs of the entire organization.
(2) Facts and circumstances tending to show substantial influence. Facts and circumstances tending to show that a person has substantial influence over the affairs of an organization include, but are not limited to, the following --
(i) The person founded the organization;
(ii) The person is a substantial contributor (within the meaning of section 507(d)(2)) to the organization;
(iii) The person's compensation is based on revenues derived from activities of the organization that the person controls;
(iv) The person has authority to control or determine a significant portion of the organization's capital expenditures, operating budget, or compensation for employees;
(v) The person has managerial authority or serves as a key advisor to a person with managerial authority; or
(vi) The person owns a controlling interest in a corporation, partnership, or trust that is a disqualified person.
(3) Facts and circumstances tending to show no substantial influence. Facts and circumstances tending to show that a person does not have substantial influence over the affairs of an organization include, but are not limited to --
(i) The person has taken a bona fide vow of poverty as an employee, agent, or on behalf of a religious organization;
(ii) The person is an independent contractor, such as an attorney, accountant, or investment manager or advisor, acting in that capacity, unless the person is acting in that capacity with respect to a transaction from which the person might economically benefit either directly or indirectly (aside from fees received for the professional services rendered); and
(iii) Any preferential treatment a person receives based on the size of that person's donation is also offered to any other donor making a comparable contribution as part of a solicitation intended to attract a substantial number of contributions.
(f) EXAMPLES
The following examples illustrate the principles of this section. Finding a person to be a disqualified person in the following examples does not indicate that an excess benefit transaction has occurred, but only that any transaction with the applicable tax-exempt organization that provides benefits to the disqualified person directly or indirectly may be scrutinized to determine whether it is an excess benefit transaction:
Example 1. E is the headmaster of Z, a school that is an applicable tax-exempt organization for purposes of section 4958. E reports to Z's board of trustees and is the principal employee responsible for implementing the board's decisions. E also has ultimate responsibility for supervising Z's day-to-day operations. For example, E can hire faculty members and staff, make changes to the school's curriculum and discipline students without specific board approval. Because E serves as the chief executive officer of Z, E is in a position to exercise substantial influence over the affairs of Z. Therefore E is a disqualified person with respect to any transaction involving Z that provides economic benefits to E directly or indirectly.
Example 2. G is a program officer at community organization C, an applicable tax-exempt organization for purposes of section 4958. G's total compensation for the taxable year, including benefits, is less than the amount of compensation referenced for a highly compensated employee in section 414(q)(1)(B)(i). G is not related to any other disqualified person with respect to C. G does not serve on C's governing body and or as an officer of C. G makes a modest annual contribution to C, but is not a substantial contributor to C (within the meaning of section 507(d)(2)). G is deemed not to be in a position to exercise substantial influence over the affairs of C for this year because G is an employee who receives economic benefits for the year of less than the amount of compensation referenced for a highly compensated employee in section 414(q)(1)(B)(i). Therefore, for this year, G is not a disqualified person with respect to any transaction involving C that provides economic benefits to G directly or indirectly.
Example 3. Y, an applicable tax-exempt organization for purposes of section 4958, enters into a contract with B, a company that manages bingo games. Under the contract, B agrees to provide all of the staff and equipment necessary to carry out a bingo operation one night per week, and to pay Y q percent of the revenue from this activity. B retains the balance of the proceeds. Y provides no goods or services in connection with the bingo operation other than the use of its hall for the bingo game. The annual gross revenue earned from the bingo game represents more than half of Y's total annual revenue. B's status as a disqualified person is determined by all relevant facts and circumstances. B's compensation is based on revenues from an activity B controls. B also has full managerial authority over Y's principal source of income. Under these facts and circumstances, B is in a position to exercise substantial influence over the affairs of Y. Therefore B is a disqualified person with respect to any transaction involving Y that provides economic benefits to B directly or indirectly.
Example 4. The facts are the same as in Example 3, with the additional fact that the stock of B is 100 percent owned by P, an individual who is actively involved in managing B. Because P owns a controlling interest (measured by either vote or value) in and actively manages B, the facts and circumstances establish that P is also in a position to exercise substantial influence over the affairs of Y. Therefore P is a disqualified person with respect to any transaction involving Y that provides economic benefits to P directly or indirectly.
Example 5. A, an applicable tax-exempt organization for purposes of section 4958, owns and operates one acute care hospital. B is a for-profit corporation that owns and operates a number of hospitals. A and B form C, a limited liability company. In exchange for proportional ownership interests, A contributes its hospital, and B contributes other financial assets, to C. All of A's assets then consist of its membership interest in C. A continues to be operated for exempt purposes based almost exclusively on the activities it conducts through C. C enters into a management agreement with a management company, M, to provide day-to-day management services to C. M is generally subject to supervision by C's board, but M is given broad discretion to manage C's day-to-day operation. Under these facts and circumstances, M is in a position to exercise substantial influence over the affairs of A because it has day to day control over the hospital operated by C, A's ownership interest in C is its primary asset, and C's activities form the basis for A's continued exemption as an organization described in section 501(c)(3). Therefore, M is a disqualified person with respect to any transaction involving A, including any transaction that A conducts through C, that provides economic benefits to M directly or indirectly.
Example 6. T is a large university and an applicable tax- exempt organization for purposes of section 4958. L is the dean of the College of Law of T, a major source of revenue for T. The College of Law is important to T's reputation for excellent teaching and high quality faculty scholarship. T relies on this reputation to attract students and contributions from alumni and foundations. L plays a key role in faculty hiring and has authority to control or determine a significant portion of T's capital expenditures and operating budget because of L's position in the College of Law. L's compensation is greater than the amount of compensation referenced for a highly compensated employee in section 414(q)(1)(B)(i) in the year benefits are provided. Because of the importance of the College of Law to T and L's managerial control over that segment of T, L is in a position to exercise substantial influence over the affairs of T. Therefore L is a disqualified person with respect to any transaction involving T that provides economic benefits to L directly or indirectly.
Example 7. X is a radiologist employed by U, a large acute- care hospital that is an applicable tax-exempt organization for purposes of section 4958. X has no managerial authority over any part of U or its operations. X gives instructions to staff with respect to the radiology work X conducts, but X does not serve as supervisor to other U employees. X's total compensation package includes nontaxable retirement and welfare benefits and a specified amount of salary. X's compensation is greater than the amount of compensation referenced for a highly compensated employee in section 414(q)(1)(B)(i) in the year benefits are provided. X is not related to any other disqualified person of U. X does not serve on U's governing body or as an officer of U. Although U participates in a provider-sponsored organization (as defined in section 1853(e) of the Social Security Act), X does not have a material financial interest in that organization. Whether X is a disqualified person is determined by all relevant facts and circumstances. X did not found U, and although X makes a modest annual financial contribution to U, the amount of the contribution does not make X a substantial contributor within the meaning of section 507(d)(2). X does not receive compensation based on revenues derived from activities of U that X controls, and has no authority to control or determine a significant portion of U's capital expenditures, operating budget, or compensation for employees. Under these facts and circumstances, X does not have substantial influence over the affairs of U, and therefore X is not a disqualified person with respect to any transaction involving U that provides economic benefits to X directly or indirectly.
Example 8. W is a cardiologist and head of the cardiology department of the same hospital U described in Example 7. W does not serve on U's board and does not serve as an officer of U. W does not have a material financial interest in the provider- sponsored organization (as defined in section 1853(e) of the Social Security Act) in which U participates. W is compensated personally with a salary and retirement and welfare benefits fixed by a three-year renewable employment contract with U. W's annual amount of compensation exceeds the amount referenced for a highly compensated employee in section 414(q)(1)(B)(i). Whether W is a disqualified person is determined by all relevant facts and circumstances. W has managerial authority for the cardiology department. The cardiology department is a principal source of patients admitted to U and consequently a major source of revenue for U. W also has authority to allocate the budget for that department, which includes authority to distribute incentive bonuses among cardiologists according to criteria that he has authority to set. The pool for the bonuses is funded by a portion of U's revenues attributable to the cardiology department. Because of the importance of the cardiology department to U and W's managerial control over that segment of U, W is in a position to exercise substantial influence over the affairs of U. Therefore W is a disqualified person with respect to any transaction involving U that provides economic benefits to W directly or indirectly.
Example 9. D is an accountant who periodically provides accounting and tax advisory services as an independent contractor in return for a fee to M, a museum that is an applicable tax-exempt organization for purposes of section 4958. For several years, D has advised M's officers and members of M's governing body with respect to accounting and tax matters. D's firm also prepares tax returns on behalf of M. D has no relationship with M other than as a professional accounting and tax advisor. D is not related to any other disqualified person of M. D's firm has a policy prohibiting employees from providing professional advice with respect to a transaction from which they might economically benefit either directly or indirectly (aside from fees received for the professional services rendered). D abides by the firm's policy in all activities, including the work for M. Whether D is a disqualified person is determined by all relevant facts and circumstances. Because D acts only in D's capacity as an independent contractor providing occasional professional services to M and abides by the firm's conflict of interest policy, under these facts and circumstances, D is not a disqualified person with respect to any transaction with M.
Example 10. F, a repertory theater company that is an applicable tax-exempt organization for purposes of section 4958, holds a fund-raising campaign to pay for the construction of a new theater. J is a regular subscriber to F's productions who has made modest gifts to F in the past. J has no relationship to F other than as a subscriber and contributor. F solicits contributions as part of a broad public campaign intended to attract a large number of donors, including a substantial number of donors making large gifts. In its solicitations for contributions, F promises to invite all contributors giving $z or more to a special opening production and party held at the new theater. These contributors are also given a special number to call in F's office to reserve tickets for performances, make ticket exchanges, and make other special arrangements for their convenience. J makes a contribution of $z to F, which makes J a substantial contributor within the meaning of section 507(d)(2). F provides J with the preferential treatment described in its solicitation. Whether J is a disqualified person is determined by all relevant facts and circumstances. Under these facts and circumstances, any influence that may arise from the size of J's donation is limited by F's commitment to provide similar treatment to any other member of the public making a similar contribution and by the nature of the benefits being offered. Accordingly, the preferential treatment that J receives does not indicate that J is in a position to exercise substantial influence over the affairs of the organization. Therefore, barring a change in J's relationship with F, J is not a disqualified person with respect to any transaction involving F that provides economical benefits to J directly or indirectly.
BENEFIT CONSIDERED COMPENSATION?
(4) Examples. The following examples illustrate the rules for an organization to establish its intent to treat an economic benefit as consideration for the performance of services:
Example 1. G is an applicable tax-exempt organization for purposes of section 4958. G hires an individual contractor, P, to design a computer program for it, executes a contract for that purpose, and pays P $1,000 in a timely manner pursuant to the contract. Before January 31 of the next year, G reports the full amount paid to P under the contract on a Form 1099 filed with the Internal Revenue Service. G has provided clear and convincing evidence of its intent to provide the $1,000 paid to P as compensation for the services P performed under the contract.
Example 2. The facts are the same as in Example 1, except that the services are provided by Corporation V. The contract executed by Corporation V and G and placed in G's files indicates that the payment made to Corporation V is in return for computer programming services provided by employees of Corporation V. G does not issue an information return to Corporation V because Corporation V is not an individual taxpayer. The contract constitutes clear and convincing evidence of G's intent to provide the payment as compensation for Corporation V's services.
Example 3. G is an applicable tax-exempt organization for purposes of section 4958. D is the chief operating officer of G, and a disqualified person with respect to any transaction involving G that provides economic benefits to D directly or indirectly. D receives a bonus at the end of the year. A copy of the letter from G to D describing the amount and the basis for D's bonus is placed in D's personnel file. Information provided to all employees in the personnel handbook clearly states that bonuses are treated as taxable income, and included in the total wages figure reported on each employee's Form W-2. G's accounting department determines that the bonus is to be reported on D's Form W-2. Due to a computer malfunction after data was entered incorrectly by personnel of G's accounting department, the bonus is not reflected on D's Form W-2. As a result, D fails to report the bonus on his individual income tax return. G acts to amend Forms W-2 affected as soon as G becomes aware of the data entry error and consequent computer malfunction. G's failure to report the bonus on an information return issued to D arose from events beyond G's control, and G acted in a responsible manner both before and after the failure occurred. Thus, because G had reasonable cause for failing to report D's bonus, G will be treated as having clear and convincing evidence of its intent to provide the bonus as compensation for services when paid.
SECTION 53.4958-5 TRANSACTION IN WHICH AMOUNT OF ECONOMIC BENEFIT DETERMINED IN WHOLE OR IN PART BY THE REVENUES OF ONE OR MORE ACTIVITIES OF THE ORGANIZATION.
Whether a "revenue sharing" transaction results in inurement and therefore constitutes an excess benefit transaction, depends upon all relevant facts and circumstances. A revenue-sharing transaction may constitute an excess benefit transaction regardless of whether the economic benefit provided to the disqualified person exceeds the fair market value of the consideration provided in return if, at any point, it permits a disqualified person to receive additional compensation without providing proportional benefits that contribute to the organization's accomplishment of its exempt purpose. If the economic benefit is provided as compensation for services, relevant facts and circumstances include, but are not limited to, the relationship between the size of the benefit provided and the quality and quantity of the services provided, as well as the ability of the party receiving the compensation to control the activities generating the revenues on which the compensation is based.
(d) Examples. The following examples illustrate the principles used in determining whether a revenue-sharing transaction constitutes an excess benefit transaction under the rules of this section:
Example 1. A is the manager of the investment portfolio of M, an applicable tax-exempt organization for purposes of section 4958. A and several other professional investment managers work exclusively for M in an office in M's building. A's compensation consists of a flat base annual salary, health insurance, eligibility to participate in a retirement plan, and a bonus that is equal to a percentage of any increase in the value of M's portfolio over the year (net of expenses for investment management other than the in-house managers' compensation). The revenue-based portion of A's compensation gives A an incentive to provide the highest quality service in order to maximize benefits and minimize expenses to M. A has a measure of control over the activities generating the revenues on which his bonus is based, but A can increase his own compensation only if M also receives a proportional benefit. Under these facts and circumstances, the payment to A of the bonus described above does not constitute an excess benefit transaction under the rules of this section.
Example 2. L, an applicable tax-exempt organization for purposes of section 4958, enters into a contract with H, a company who manages charitable gaming activities for public charities. As a result of the contractual relationship, H becomes a disqualified person with respect to any transaction involving L that provides economic benefits to H directly or indirectly. Under the contract, H agrees to provide all of the staff and equipment necessary to carry out charitable gaming operations on behalf of L, and to pay L z percent of the net profits, which are calculated as the gross revenue less rental for the equipment, wages for the staff, prizes for the winners, and other specified operating expenses. H retains the balance of the proceeds after expenses and after paying L its z percent of the net profits. As manager, H controls the activities generating the revenue on which its compensation is based. In addition, because H owns the equipment and employs the staff needed to operate the charitable gaming activities, H controls what L is charged, including the profit H makes above the cost of these items. Therefore, H can also control the net revenues relative to the gross revenues from the gaming activity. The structure of the compensation H receives for its services does not provide H with an appropriate incentive to maximize benefits and minimize costs to L. H benefits whether expenses are high and net revenues are low or expenses are low and net revenues are high. By contrast, L suffers if expenses for the charitable gaming operation are high and net revenues are low. All of the gross revenues generated by the charitable gaming operation belong to L. The arrangement between H and L allows a portion of those revenues to inure to H. Therefore, this arrangement results in the inurement of L's net earnings to the benefit of H, and the entire amount paid to H under this arrangement constitutes an excess benefit under the rules of this section.
Example 3. R, a professor and faculty member at S, a university that is an applicable tax-exempt organization for purposes of section 4958, is the principal investigator in charge of certain scientific research at S. The research produces an invention. In accordance with S's agreement with its faculty, S owns the invention. R assists S in preparing a patent application. S receives a patent for R's invention, which S owns. Also in accordance with S's agreement with its faculty, S grants R the right to receive v percent of S's royalties on the patent, payable semi-annually. R also receives an annual compensation package of salary and benefits. The availability of revenue-based compensation under these circumstances does not give R any incentive or opportunity to act contrary to S's interests in accomplishing its exempt purpose. R receives the revenue-based compensation, i.e., the percentage of royalties, as an incentive and a reward for producing work of especially high quality. In addition, any time R benefits by receiving royalties, S benefits as well and to a proportionate degree. Finally, because the patent belongs to S, R has no control over how the patent is used nor the stream of revenue it generates. Under these facts and circumstances, S's payment of revenue- based compensation to R does not constitute an excess benefit transaction under the rules of this section.
FOR REBUTTABLE PRESUMPTION:
(iv) Examples. The following examples illustrate the rules for appropriate data as to comparability for purposes of invoking the rebuttable presumption of reasonableness described in this section:
Example 1. Z is a large university that is an applicable tax-exempt organization for purposes of section 4958. Z has had gross receipts of $200 million for the preceding three taxable years. Z is negotiating a new contract with its president because the old contract will expire at the end of the year. In determining the compensation for its president, the executive committee of the Board of Trustees relies on a national survey of compensation for university presidents; this survey does not divide its data by any measure of university size or any other criteria. None of the members of the executive committee has any particular expertise in higher education compensation matters, although many members have significant business experience. Given the lack of specificity in the data collected and the lack of relevant expertise and experience of the executive committee members, the data relied on by the executive committee does not constitute appropriate data as to comparability.
Example 2. X, a tax-exempt hospital that is an applicable tax-exempt organization for purposes of section 4958, has average annual gross receipts of $250 million. Before renewing the contracts of X's chief executive officer and chief financial officer, X's governing board commissioned a customized compensation survey from an independent firm that specializes in consulting on issues related to executive placement and compensation. The survey covered executives with comparable responsibilities at a significant number of hospitals. The survey data are sorted by a number of different variables, including the size of the hospitals and the nature of the services they provide, the level of experience and specific responsibilities of the executives, and the composition of the compensation packages. The board members were provided with the survey results, a detailed written analysis comparing the hospital's executives to those covered by the survey and an opportunity to ask questions of a member of the firm that prepared the survey. The survey, as prepared and presented to X's board, constitutes appropriate data as to comparability.
Example 3. W is a local repertory theater and an applicable tax-exempt organization for purposes of section 4958. W has had annual gross receipts ranging from $400,000 to $800,000 over its past three taxable years. In determining the next year's compensation for W's artistic director, the board relies on data compiled from a telephone survey of six other unrelated repertory theaters of similar size in various communities throughout the same geographic region. A member of the board drafts a brief written summary of the salary information obtained from this informal survey. This information is later included in a written report that also includes information about the membership of the board of directors, and an evaluation of the artistic director's prior salary and performance that is discussed and voted on by the board. The salary information obtained in the telephone survey is appropriate data as to comparability.
