Intermediate Sanctions on NPO Executives

Unreasonable compensation can bring an unexpected tax liability.

CONTINUED IRS ENFORCEMENT AND NEW Treasury regulations are focusing increased attention on a relatively new tax on executives of charitable organizations. Sometimes called an intermediate sanction, the tax can be a serious matter for these NPO executives as well as their family members and any family-controlled entities.

CONGRESS PASSED IRC SECTION 4958 IN 1996. Retroactive for transactions on or after September 14, 1995, it imposes an excise tax on the excess benefits received by a disqualified person—anyone in a position to exercise substantial influence over an organization’s affairs.

AN EXCESS BENEFIT IS ONE A DISQUALIFIED PERSON receives that exceeds the value of the benefit the qualifying organization gets in return—including the value of services the executive performs. When setting compensation, NPOs and their executives can use comparables from the for-profit area as well as for similar NPOs.

THERE ARE SEVERAL EXCEPTIONS TO THE SECTION 4958 rules, including a binding contract exception as well as an initial contract exception that is part of temporary and proposed regulations issued in January 2001. Binding contracts on September 13, 1995 are exempt until there is a material change. An initial contract between an organization and an unrelated party also is exempted from the rules.

CPAs CAN HELP PROTECT CLIENTS FROM THESE onerous rules. Compensation is presumed reasonable if it was approved by an unrelated board of directors who relied on appropriate data and maintained documentation of the basis for determining it.

NANCY ORTMEYER KUHN, JD, LLM, is of counsel to the law firm Powell, Goldstein, Frazer & Murphy, LLP, in Washington, D.C. She previously had worked for the IRS chief counsel’s office. Her e-mail address is .

relatively recent tax on executives in the charitable sector is getting attention due to vigorous IRS enforcement and extensive new Treasury regulations issued in January 2001. This tax, sometimes referred to as an intermediate sanction (the ultimate being revocation of the NPO’s exempt status), is imposed on executives whose compensation the IRS considers excessive. CPAs—and the NPO executives they advise —must plan carefully to avoid the tax. The law targets not only top executives but also their family members and family-controlled entities if any receive excess benefits.

How Much Compensation Is Reasonable?

Hourly wage (mean) Location
$56.73 Anchorage, Alaska
$60.34 Boston
$55.11 Denver
$19.84 Great Falls, Montana
$49.05 Huntsville, Alabama
$90.06 Los Angeles
$103.35 San Francisco
$21.30 Tallahassee, Florida
$45.54 Washington, D.C.

Source: A survey of top-level executives, Bureau of Labor Statistics, .

Congress had passed IRC section 4958 as part of the Taxpayer Bill of Rights 2 and made it retroactive for transactions on or after September 14, 1995. The rules gave the IRS a tool to regulate the activities of exempt organizations—with or without revoking the organization’s exempt status. CPAs should understand section 4958 and the new regulations to help guard against unexpected tax liability for NPO executives—the targeted taxpayers. (While NPOs themselves have no liability under section 4958, they are subject to other penalties.)


Section 4958 imposes an excise tax on excess benefits received by a “disqualified person”—anyone in a position to exercise substantial influence over a qualifying organization’s affairs. IRC section 501(c)(3) or 501(c)(4) entities are considered “qualifying organizations.” Section 4958 does not apply to individuals employed by private foundations; executives of such organizations are already subject to similar IRC section 4941 self-dealing penalties.

There is a five-year look-back period starting with the transaction date. This means the IRS can look back five years from the date the executive received the excess benefit and impose the tax if he or she was a disqualified person at any time during this period. The term disqualified person can apply to that person’s immediate family as well as to family-controlled entities. (The law defines control as 35% of the total combined voting power.) Congress clearly did not want executives to divert benefits to family members by way of family-controlled businesses or trusts. Independent contractors, including advisers, do not fall within these rules since they presumably do not hold positions of influence in the organization.

A parallel five-year look-back rule applies in determining qualifying organizations. If an entity was a section 501(c)(3) or (c)(4) organization at any time within the five years before the transaction date, section 4958(e) considers it a qualifying organization.

An excess benefit is one a disqualified person receives that exceeds the value of the benefit the organization gets in return, including the value of services he or she performs. For example, the IRS would consider an executive with a salary and benefits greater than those of comparable executives performing comparable work at similar organizations to be in receipt of an excess benefit subject to the section 4958 excise tax.

The legislative history shows that when valuing compensation, NPOs and their executives can use either for-profit or nonprofit comparables. In a footnote to the committee report accompanying the 1996 legislation, the House of Representatives said that “an individual need not necessarily accept reduced compensation merely because he or she renders services to a tax-exempt, as opposed to a taxable, organization.” The 2001 regulations also specify executives can use for-profit comparables.


A transitional rule in the 1996 legislation allows an executive to continue receiving excess benefits when there is a long-standing affiliation between a disqualified person and the organization. Congress included this exception for written contracts that were binding on September 13, 1995, and, at all times thereafter, up to and including the transaction date.

A written, binding contract becomes a new contract when it is materially modified. For example, if the parties change the length of the contract or the amount of compensation, then it is a new contract and the exception no longer applies. State law—not the IRS—determines whether a contract exists. Since many states are very liberal in this regard, CPAs advising clients on this issue should study the law in the applicable state. A binding contract can consist of many pieces of paper or be an incomplete paper trail if the parties’ intent is clear.

If an organization sets an executive’s compensation using an objective formula, the contract still is considered binding under most state laws. For example, the compensation of trustees of charitable trusts sometimes is determined by a formula found in state law. That law then becomes one of the factors that establishes the binding written contract. Such a contract is binding unless and until the state amends the law to change the compensation term (a material modification). If the state statute merely says a trustee is to receive “reasonable” compensation, it’s unlikely a binding contract exists unless there are additional factors that objectively establish the amount of the trustee’s compensation. One such factor would be a compensation history with only objective modifications, such as cost-of-living increases.


The Treasury Department issued temporary and proposed regulations in January 2001, which created an exception for initial contracts in response to litigation involving the United Cancer Council (UCC). The Seventh Circuit Court of Appeals held that an unrelated fundraiser was not an “insider” for purposes of determining whether a private benefit resulted from the relationship between a fundraiser and the UCC. In other words, the court ruled that the fundraiser, which had received a large percentage of the funds it raised on UCC’s behalf, was related to the organization only through an arms-length contract. There was no “private inurement” because the parties had adequately bargained the contract terms.

The Seventh Circuit essentially found that an unrelated party is entitled to the best deal it can negotiate on the first contract with an NPO without worrying about inurement. Since the initial contract exception would no longer apply, subsequent contracts would be subject to section 4958.

Thus the regulations provide that any first contract between an organization and an unrelated third party is exempt. For example, a tax-exempt health care group recruits a well-known surgeon to manage its hospital. To attract him, the hospital offers a compensation package that is exceedingly generous and includes a fixed annual salary over five years. The contract also provides a formula for an annual bonus if certain future contingencies occur. Even if the IRS determines they are excessive, the benefits the surgeon receives under this contract are not subject to the section 4958 excise tax because of the initial contract exception. If the surgeon enters into a second contract with the hospital, he will no longer be protected by the exception and will be subject to section 4958.


Section 4958 creates an inevitable conflict between the disqualified person and the NPO in cases where the IRS says an “excess benefit transaction” has occurred. The NPO has a substantial interest in what takes place between the IRS and the executive. For example, the organization may have money or other property returned in the form of a correction to the excess benefit. Or the executive might disclose information that results in IRS action against the NPO—including revoking its exempt status—if it sees evidence of inurement or private benefit. For these reasons, CPAs who work for NPOs should follow IRS proceedings carefully.

The NPO must report on Form 990, Information Return, excess benefit transactions and any section 4958 tax the IRS imposed on the organization’s managers or disqualified persons during the taxable year. However, the IRS and a disqualified person may not always discuss the matter with the NPO. The IRS will involve the NPO only if it is in the best interests of tax administration. The executive may not want the NPO’s representatives present during his or her meetings or closing agreement negotiations with the IRS and has the right to exclude them. However, the executive cannot entirely prevent the NPO from gaining access to his or her taxpayer information. Disclosing the executive’s taxpayer information to the NPO appears to fall within the exception in section IRC 6103(h)(4)(C) for prior transactional relationships and within section 6103(k)(6) for investigative purposes.


There is a way for CPAs to protect their clients from these onerous excise taxes. The House committee report set forth a clear legislative intent to establish a rebuttable presumption of reasonableness that executives and NPOs can rely on when establishing a compensation arrangement. As Congress instructed, the Treasury picked up this rebuttable presumption, almost verbatim, in the temporary and proposed regulations. The effect was to shift the burden of proof to the IRS, requiring it to establish sufficient contrary evidence that a compensation arrangement is unreasonable.

The regulations outline clear criteria for setting up the presumption. If the parties involved follow these steps, the presumption is in the executive’s favor and the IRS must prove the benefit was excessive.

An independent and authorized body of the organization, such as the board of directors, must approve the terms of the benefit in advance.

The board must obtain appropriate comparability data—for example, compensation packages of similarly situated executives.

The board must adequately document, in writing, the basis for its decision. The documentation must be prepared at the time the board makes the decision.

Another option is for the NPO to provide insurance for its well-compensated executives to cover any future excise tax liability should the IRS conduct an inquiry. The only pitfall is that the NPO must include the premium in the total compensation package and it becomes part of any alleged excess benefit transaction. The sidebar below explains how the excess benefit rules would apply to a typical transaction.

How to Apply Section 4958

Dr. Smith, a newly hired executive of a large hospital, received $450,000 in annual compensation and benefits for tax year 1998. In 1999 the parties negotiated a new contract giving her $500,000 in compensation and benefits. In 2000 the IRS determined—in a preliminary report—that reasonable compensation in 1998 and 1999, considering Dr. Smith’s background and responsibilities, would have been only $250,000.

This preliminary determination leaves Dr. Smith with an excess benefit of $200,000 for 1998 and $250,000 for 1999. Due to the initial contract exception in the new regulations, she is not liable for the section 4958 excise tax on the 1998 excess benefit. However, section 4958 imposes a 25% first-tier tax of $62,500 for 1999. If the law considered Dr. Smith an “organization manager” who had approved the transaction intentionally and willfully, section 4958 would impose yet another 10% tax (up to $10,000 per transaction). (In this example, Dr. Smith was not an organization manager.)

The IRS plans to issue a notice of deficiency to Dr. Smith by January 2002. If she corrects the excess benefit by returning the $250,000 plus interest to the hospital before she receives the notice, Dr. Smith can avoid the second-tier tax. If she does not return the money, the IRS will impose a 200% second-tier tax and she will be personally liable for an additional $500,000 excise tax. Without a timely correction, Dr. Smith will owe the U.S. Treasury $562,500 based on her 1999 salary and benefits of $500,000—not a happy outcome. The IRS can abate the excise taxes—and must abate the second-tier tax—if the deficiency is corrected. Although the IRS does not frequently abate first-tier excise taxes, it may do so if the excess benefit transaction was due to reasonable cause.

A long-term binding contract could have changed this outcome. Assume Dr. Smith had been in her position at the hospital since 1995 and had a written contract outlining a compensation schedule for the next 10 years. She received a $500,000 compensation package in 1999, with a 10% increase each year. The contract was binding before September 13, 1995. Although the IRS finds the compensation to be excessive, the binding-contract exception applies and Dr. Smith has no excise tax liability through the end of the contract in 2005.


An excess benefit need not be in the form of compensation. As demonstrated by petitions filed in the U.S. Tax Court in late 1999, the IRS determined there was an excess benefit transaction when three exempt organizations that provided home health care were “sold” to for-profit entities owned by individuals who were disqualified persons. All were members of the same family. As consideration for the sale, each new entity assumed the old organization’s liabilities. The assets were primarily intangible, and no money changed hands.

The IRS alleged the exempt entities received inadequate consideration for the sale of the assets, and, therefore, family members who owned the for-profit entities received excess benefits. At least six family members filed petitions with the Tax Court contesting the IRS’ determination of section 4958 excise tax liability. Additionally, the IRS revoked the exempt status of the three health care organizations. Those organizations, along with the for-profit S corporations, also filed Tax Court petitions. The taxpayers alleged, based on a negative value assessment by an outside CPA firm, that the health care businesses had no value. Therefore, they argued, assuming the liabilities was more than adequate consideration.

The IRS valued each of the three businesses at more than $5 million each; one was valued at $7.79 million. The joint and several liability the IRS determined for each family member was approximately $41 million, based on the sale of the three exempt organizations.

The court consolidated these cases for trial under the name Caracci v. Commissioner, TC no. 17340-99. A trial before the Tax Court took place in March 2001; legal briefs were filed in June. At the time of this writing (September 2001), an opinion was not yet available but was expected in the near future.

There was nothing “intermediate” about these sanctions. The cases demonstrate the IRS’s willingness to reevaluate the merits of a transaction and use both the revocation and excise tax tools given them by Congress.


The tax is self-assessing, and, as stated earlier, an organization must report any excess benefit transactions on its form 990. If the NPO accurately reports a transaction, the statute of limitations for the IRS to assess the 4958 tax against a disqualified person is three years. If the NPO underreports the excess benefit by more than 25% or does not report it at all, the time for the IRS to assess the tax is six years. If the organization fails to file an information return, the IRS can levy the excise tax on the executive at any time—there is no statute of limitations.

The individual reporting the excess benefit transaction also can file Form 4720, Return of Certain Excise Taxes on Charities and Other Persons Under Chapters 41 and 42 of the Internal Revenue Code, and self-assess the excise tax. However, there seems to be little benefit in doing so. If more than one disqualified person took part in an excess benefit transaction, one can file form 4720, and list the others, prorating the payment among them. However, each disqualified person could be liable for the entire amount of the excise tax on the excess benefit transaction since the liability is joint and several. The IRS can choose to go after the executive with the deepest pockets. A disqualified person would have to correct the transaction by returning the excess benefits before filing form 4720, or he or she would be subject to the 200% excise tax since the taxable period ends on the date of self-assessment. If the organization fails to report an excess benefit transaction on form 990, it can expect the usual penalties for failure to file timely or complete returns under IRC section 6652 (c)(1)(A).


It’s very important for CPAs to properly document the process that occurs when their clients negotiate compensation packages with NPOs or when other types of economic transactions occur. There is safety in numbers, and if the CPA can locate for-profit and nonprofit comparables, he or she can establish the compensation arrangement as reasonable and comfortably outside the reach of these not-so-intermediate sanctions. Otherwise, the client should be prepared for the IRS to impose sometimes onerous penalties.

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