How to Avoid IRS Intermediate Sanctions for Insiders
The IRS is very serious about preventing excessive compensation and sweetheart deals at nonprofits that benefit insiders.
The IRS is very serious about preventing excessive compensation of nonprofit employees and officers, sweetheart deals with insiders, personal use of nonprofit assets, and other abuses, To this end, Congress has given the IRS the power to impose monetary penalties against insiders it finds to have engaged in this type of prohibited conduct. The IRS calls these penalties “intermediate sanctions” because they are more than doing nothing, but fall short of revoking a nonprofit’s tax-exempt status.
These penalties can be substantial. Moreover, they are levied—not on the nonprofit—but on the individuals who participated in the prohibited transaction. This may include not only the people who benefited from a transaction, but those within the nonprofit who approved it as well. A nonprofit’s managers (directors, officers, or others) who approve a transaction that they know is improper may be subject to a 10% excise tax. And they have to pay these IRS penalties out of their own pockets!
How big can these penalties be? Very big. Consider this simple example: A small rape crisis prevention center pays Sam, its executive director, $90,000 in total compensation, for 20 hours of work per week. The compensation package is approved by Denise, Dave, and Donald, three of the nonprofit’s directors, even though they knew that similar nonprofits in the area paid $40,000 or less for similar work. The IRS receives a complaint from a former employee of the nonprofit stating that it is paying excessive compensation to Sam. The IRS audits the nonprofit and determines that reasonable compensation for Sam is only $40,000. Thus, Sam received an “excess benefit” of $50,000. Here’s what happens:
- Sam must pay the IRS a penalty tax equal to 25% of the excess benefit—in this case, $12,500
- Sam must pay the $50,000 excess benefit back to the nonprofit; if he doesn’t, he will have to pay an additional tax to the IRS equal to 200% of the excess benefit--or $100,000, and
- Denise, Dave, and Donald, the directors who knowingly approved Sam’s compensation, must jointly pay an excise tax equal to 10% of the amount of the excess benefit, up to a maximum of $20,000—in this case, $5,000 total between the three of them.
Thus, at a minimum, the IRS will receive $17,500 in penalty taxes--$12,500 from Sam out of his own pocket and $5,000 from Denise, Dave, and Donald. The IRS would receive an additional $100,000 if Sam failed to pay the $50,000 back to the nonprofit.
IRS sanctions are imposed only when insiders, such as board members, officers, or key employees siphon off a nonprofit’s money or assets for their personal enrichment---for example, a key employee is paid excessive compensation or a director sells or rents property to the nonprofit for more than its fair market value.
If you think that a proposed transaction with someone might result in IRS sanctions, consider getting a written professional opinion from an attorney, certified public accountant or accounting firm, or an independent qualified valuation expert. If the directors or other managers of your nonprofit obtain and follow an opinion, the IRS cannot impose sanctions on them if it later determines that the transaction was one for which sanctions should be imposed. To be relied upon, the opinion must explain why the transaction is not one for which sanctions should be imposed by the IRS.
For more on nonprofit taxes, see Nolo's book, Every Nonprofit's Tax Guide.