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Overview & Checklist

Legal Counsel for Philanthropy and the Nonprofit Sector

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Overview & Checklist

Intermediate Sanctions: A Brief Overview for Tax-Exempt Organizations

The Internal Revenue Service recently imposed extensive regulations governing certain tax-exempt organizations and their top officials. These new regulations allow the IRS to impose penalties when it determines that such officials have received excessive compensation from their organization. The penalties can be severe as shown below:

  • Initial penalty as high as 25% of the excess benefit
  • The individual who benefited from the transaction may be personally liable
  • Further penalties equal to 200% of the excess benefit may be imposed if the transaction is not corrected in a timely manner
  • Additional penalties are also possible

It is therefore important for tax-exempt organizations to be aware of the regulations and, when appropriate, to take the necessary compliance steps.

To determine whether or not your organization is in compliance, the IRS has issued a three-part test:

  1. Is your organization an "applicable" organization?
    • "Applicable" organizations are defined as 501(c)(3) and 501(c)(4), or were such organizations at any time during the five years before the excess compensation was made.

    If you answered "yes" to question #1, and your organization is covered by the intermediate sanctions, proceed to question #2.

  2. Is the official who received the compensation in question a "disqualified person"?
    • "Disqualified persons" are those who are in a position to exercise substantial influence over the affairs of the organization, during the five years before the excess compensation was made.
    • "Disqualified persons" would include, for example, voting members of the governing body, and presidents, chief executive officers or chief operating officers, treasurers, and chief financial officers.
    • Also included as "disqualified persons" are certain family members of a disqualified person, and 35% controlled entities of a disqualified person.
    • Other people could also be considered "disqualified persons," depending upon the relevant facts and circumstances that show substantial influence over the organization, such as a founder, substantial contributor, or manager of a substantial portion of the organization's activities.

    If you answered "yes" to question #2 (the person under consideration is a disqualified person), proceed to question #3.

  3. Is the compensation under consideration an "excess benefit"?
    • Fair market value is the standard by which the IRS will determine whether a benefit given to an official is "excessive."
    • Compensation provided by tax-exempt organizations is not excessive if it is "reasonable." Reasonable compensation is the value that would ordinarily be paid for like services by like organizations under like circumstances.
    • Payments under a compensation arrangement are presumed to be reasonable, if the following requirements are satisfied:
      1. The transaction is approved by an authorized body of the organization, composed of individuals who do not have a conflict of interest;
      2. Prior to making the compensation, the authorized body obtained and relied upon comparative data from other similar organizations as to reasonableness; and
      3. The authorized body adequately documented the basis for its determination.
    • The IRS regulations set out a step-by-step procedure that the organization can follow to show that it has met the above requirements. When properly followed and adequately documented, this procedure creates a "presumption of reasonableness", providing the organization and its employees a "safe harbor" from the penalties.
    • The IRS may only overcome the presumption of reasonableness if it develops sufficient evidence to rebut the comparability data relied upon by the organization.

    If you answered "yes" to question #3, or you have concerns that these regulations may cover your organization, you may be at risk of violating the intermediate sanction regulations. Please do not hesitate to contact us if you would like to review the specifics of your executive compensation packages.