The Application of Excess Benefit Transactions Rules to Retirement Benefits

by Mary Hodges

In 1996, Congress enacted I.R.C. § 4958 in order to provide for intermediate sanctions in lieu of the harsher penalty of revoking the tax-exempt status of a non-profit organizations when private persons benefit from transactions with those organizations.

Intermediate Sanctions may be imposed on any disqualified person (explained below) who receives an excess benefit from a covered non-profit organization (those entities organized under 501(c)(3) and 501(c)(4)) and on each organization manager who approves an excess benefit.

Section 4958 provides that a disqualified person is: (1) any person who was, at any time during the five-year period ending on the date of the transaction involved, in a position to exercise substantial influence over the affairs of the organization (whether such influence is formal or informal); (2) a family member of an individual in the preceding category; or (3) an entity in which individuals described in the preceding categories own more than a 35 percent interest. Persons having substantial influence over the affairs of an entity are considered voting members of the governing body, employees holding executive positions or who have ultimate responsibility over the organizations financial affairs or implementing the decisions of the governing body, and persons with a material financial interest in provider-sponsored organizations.

A disqualified person is subject to an excise tax (called the “initial tax”) equal to 25 percent of the excess benefit. An additional tax in the amount of 200 percent of the excess benefit involved is imposed on the disqualified person if the initial tax was imposed and there was no correction within the taxable period.

An organizational manager that participated in the transaction, knowing that it was an excess benefit transaction, is subject to an excess tax equal to 10 percent of the excess benefit, up to a maximum amount of $20,000 per transaction. However, the tax on the organization manager is not imposed if participation in the transaction was not willful and was due to reasonable cause.

Generally, the type of transaction that is reviewed under section 4958 is the compensation of executives of non-profit organizations. Therefore, compensation provided to executives should be “reasonable.” Compensation includes all forms of payment such as salary, fees, bonuses, severance pay, deferred compensation, and retirement benefits, as well as non-cash compensation.

Under the safe harbor in the Internal Revenue Code, compensation is presumed to be reasonable and a property transfer is presumed to be at fair market value if: (1) the compensation is approved, in advance, by an authorized body of the exempt organization, composed entirely of individuals without a conflict of interest, (2) the board or committee obtained and relied upon appropriate data as to comparability in making its determination; and (3) the board or committee adequately documented the basis for its determination, concurrently with making the decision.

Therefore, a non-profit organization will often times rely on independent third-party consulting groups that perform comparability analyses on the disqualified person’s compensation arrangement and level of performance to determine if the compensation is reasonable.

An important facet of the regulation provides that compensation provided in one year can be in consideration for services performed in prior years. The type of compensation that comes to mind in this regard is retirement benefits. Often times, an executive’s compensation package includes various retirement benefits such as deferred compensation or other fringe benefits promised to the executive after his retirement. These benefits are usually promised to the executive in consideration for the services the executive performs over the course of his employment, despite being provided to the executive at the conclusion of his employment or in later years when the executive provides no services for the organization.

For example, assume the Chief Executive Officer (“CEO”) of an applicable tax-exempt organization has an employment agreement that provides for various retirement benefits including deferred compensation, contributions to a retirement plan, and medical insurance for the remainder of the CEO’s life. Also assume that the present value of these benefits equals $500,000. The CEO has been employed with the organization for ten years and these benefits were promised to the CEO in consideration for the services he provided during his tenure as CEO and as an incentive for his continued employment. By the CEO’s tenth year of employment a compensation analysis study provided that in order to be considered reasonable, the maximum level of the CEO’s compensation is $500,000 for that year.

In the tenth year of the CEO’s employment the CEO’s total compensation (not including any retirement benefits) equaled $400,000. Upon the CEO’s retirement in the tenth year, the organization also pays his promised retirement benefits as required by the employment contract. Although the CEO’s retirement benefits are being paid to the CEO in his tenth and last year of employment, these retirement benefits are in consideration for his ten years of employment. Due to the compensation analysis study, only applying these retirement benefits to the tenth year of employment would prohibit the CEO from receiving any other income in that year. One way of determining the reasonableness of all the CEO’s compensation is by is applying equal payments of $50,000 over the course of the CEO’s employment ten year employment. Therefore, in the CEO’s tenth year of employment, his compensation would total $450,000 and the payment of his retirement benefits in the tenth year is not considered an excess benefit transaction.

By taking into account the CEO’s entire ten year tenure and prior years of service, he can be provided with various retirement benefits that are not paid until the conclusion of his employment or in later years when no services are performed without being considered an excess benefit transaction.