The title of this article might have caught the eye of some readers, who may have thought it provides tips on managing pay for poor performers or offers a rationale for employing individuals without proper job qualifications. However, this article focuses on “disqualified individuals” in the context of IRS intermediate sanctions — IRC Section 4958 — and the management of compensation paid to those individuals. It is an area that receives considerable attention from the IRS and the general public. Failure to manage it well can result in lingering reputational damage, as well as punitive taxes and penalties for all involved.
The term “disqualified individuals” is defined as individuals in a position to exercise considerable influence or control over the affairs of an IRC Section 501(c)(3) or Section 501(c)(4) tax-exempt organization. They are singled out as individuals who might be in a position to exercise their influence or control over the organization for personal benefit at the expense or to the detriment of the organization with which they are associated. This personal benefit, defined as an excess benefit transaction by IRC Section 4958, could arise in almost any type of transaction involving the organization and a disqualified individual. Some examples include the purchase or sale of goods and services and the provision of special personal benefits. This article explores IRC Section 4958, disqualified individuals and excess benefit transactions as they apply to compensation.
Most commonly, questions regarding compensation for disqualified individuals will arise in the context of pay for an organization’s executive-level positions. These disqualified individuals, both individually and collectively, exercise great control over the affairs of an organization, including its financial resources. The organization’s principal executive officer (e.g., CEO or executive director) and principal financial officer (e.g., CFO or finance director) are almost always deemed disqualified individuals. There are, however, individuals in the management hierarchy of some organizations that might qualify as well, such as chief operating officer and top program executive. These other positions must be determined on a facts-and-circumstances basis to determine whether the individuals meet the criteria to be considered disqualified individuals.
The Section 4958 definition of disqualified individual is considerably broader than executive roles for the organization. The types of individuals and relationships that qualify and may be associated with compensation include:
Managing all forms of pay for disqualified individuals is the responsibility of the tax-exempt entity’s governing board (i.e., organization manager(s)). Section 4958 defines these individuals as any officer, director, trustee of an organization or individual (i.e., board members) who serve in that capacity. As stewards of the organization and its financial resources, board members are accountable for ensuring that pay for any individual is not unreasonable (i.e., results in an excess benefit transaction).
In the event of an excess benefit compensation transaction, the consequences are potentially costly for all involved, specifically:
These penalties are commonly referred to as “intermediate sanctions.” The intermediate sanctions provisions provide guidance to exempt organizations to avoid excess benefit transactions and offer possible protection from excise taxes and penalties that could arise from them. The guidelines, known as the rebuttable presumption of reasonableness, provide that if an organization meets the listed requirements, any payments it makes to a disqualified person under a compensation arrangement are presumed to be reasonable, and a transfer of property or the right to use property is presumed to be at fair market value. In other words, the organization will be presumed to have met the test for a reasonable transaction and the burden of proof will be placed on the IRS to prove it was not reasonable.
The requirements to meet the rebuttable presumption of reasonableness are:
It should be noted that the organization’s Form 990 and Schedule J filings include annual declarations about an organization’s adherence to each of the three broad requirements of the rebuttable presumption of reasonableness.
The most common difficulties in complying with these factors include:
BDO has recently undertaken a significant campaign to create a special compensation survey covering the CEO and CFO positions for nonprofit organizations of all types. These two positions are where disqualified individuals are found in nearly all exempt organizations. If we obtain a high level of participation, this survey could become a valuable and pertinent source of information for use in the compensation governance process.
Judy Canavan has provided the following information about the survey. Organizations that complete the online questionnaire for their CEO and CFO positions will receive a complimentary copy of a report with the compiled survey results for the nonprofit participating organizations. Of course, individual data submitted will be kept confidential and only participating organizations will receive the report. The survey will accept completed questionnaires from June 15 through August 15 with a report in mid- to late October pending timely participant submission of information. More details about the survey and the online questionnaire for participation can be found here.
Written by Mike Conover an Judy Canavan. © 2023 BDO USA, LLP. All rights reserved. www.bdo.com