Excess Benefit Transactions and IRC 4958, in Plain English

When a nonprofit gives an insider more than it gets back, such as pay above what the work is worth, the federal tax that can follow falls on people rather than on the organization. Section 4958 of the Internal Revenue Code taxes the insider who received the excess and can also tax the board members and other managers who participated knowing it was an excess benefit. The IRS calls these taxes intermediate sanctions.

This page explains which organizations and people the rule reaches, what counts as an excess benefit, what each person owes, and how a problem is corrected and reported.

Covered organizations

The rule covers 501(c)(3) public charities, 501(c)(4) social welfare organizations and 501(c)(29) CO-OP health insurance issuers, along with any organization that was one of these at any time in the five years before the transaction (§4958(e)). Private foundations are excluded, because the self-dealing tax in §4941 covers their insiders instead.

Who is an insider

The statute’s word for an insider is a disqualified person, meaning anyone who was in a position to exercise substantial influence over the organization’s affairs at any time in the five years ending on the date of the transaction (§4958(f)(1)). A former executive therefore stays covered for five years after leaving. Some people are treated as insiders because of their role (§53.4958-3(c)). Someone with one of the officer titles below is treated as one unless they can show otherwise.

• Voting members of the board.
• The president, chief executive or chief operating officer, whatever the title, meaning anyone with ultimate responsibility for carrying out the board’s decisions or running the organization.
• The treasurer or chief financial officer, meaning anyone with ultimate responsibility for managing the finances.

Their family members count too, meaning a spouse, brothers and sisters and their spouses, ancestors, and children, grandchildren and great-grandchildren and their spouses (§53.4958-3(b)(1)). So does any company, partnership or trust in which these people together hold more than 35% of the voting power, profits or beneficial interest (§4958(f)(3)).

For everyone else, it depends on the facts. The regulation lists signs of substantial influence such as these (§53.4958-3(e)(2)).

• The person founded the organization.
• The person is a substantial contributor.
• The person is paid mainly on revenue from activities they control.
• The person has or shares authority over a substantial part of the budget, capital spending or employee pay.
• The person runs a discrete part of the organization that is a substantial share of the whole.

An employee paid less than the IRS’s highly compensated employee amount is not a disqualified person if they hold none of the roles above, are not a family member and are not a substantial contributor (§53.4958-3(d)(3)). Other 501(c)(3) organizations aren’t disqualified persons either (§53.4958-3(d)(1)).

What counts as excess

A transaction is an excess benefit transaction when the economic benefit the organization provides to a disqualified person, directly or indirectly, is worth more than what it receives in return, services included (§4958(c)(1)). The excess is the difference. Pay is measured against reasonable compensation, meaning the amount that would ordinarily be paid for like services by like enterprises under like circumstances. Property is measured against fair market value (§53.4958-4(b)).

Reasonableness is judged on the whole pay package, which includes salary, fees, bonuses, severance, deferred compensation, insurance premiums, and taxable and nontaxable fringe benefits, with a few exceptions the regulation lists (§53.4958-4(b)(1)(ii)(B)). The usual excess benefits are these.

• Pay that is more than the work is worth.
• Personal expenses or perks the organization pays and never reports as pay.
• A loan to an insider at below-market interest.
• Buying or leasing property from an insider for more than it is worth, or selling to one for less.

Unreported benefits

Perks the organization never reported are risky because of a rule about intent. A benefit counts as pay for services only if the organization clearly showed, when it provided the benefit, that it meant it as pay (§53.4958-4(c)(1)), and the usual proof is a W-2, a 1099 or a Form 990 that reports it, or an approved written contract (§53.4958-4(c)(3)).

Without that record, the benefit isn’t treated as payment for the person’s work, so the value of the work can’t offset it. Advisers often call this an automatic excess benefit, because the whole value counts as excess, however reasonable the rest of the pay is. Nontaxable benefits such as employer health coverage don’t need the extra proof (§53.4958-4(c)(2)).

Initial contracts

Fixed payments under an initial contract, meaning a binding written contract with someone who was not a disqualified person just before signing it, are outside the rule (§53.4958-4(a)(3)). A material change, such as a renewal (unless the executive is exercising an option the contract already gave) or a more than incidental change in pay, makes it a new contract. The new contract is tested again. Because the person is by then a disqualified person, the exception usually no longer applies.

What is owed

Three taxes can apply, two on the insider and one on the managers.

An organization manager is any officer, director or trustee, or anyone with similar powers (§4958(f)(2)). The manager tax applies only when the 25% tax is imposed on the disqualified person (§4958(a)(2)). When more than one person owes a tax, they are jointly and severally liable for it (§4958(d)(1)).

Not every board member who was in the room owes the manager tax. One who opposes the transaction in a way consistent with their duties hasn’t participated in it (§53.4958-1(d)(3)). One who relied on a reasoned written opinion from a lawyer, CPA or qualified independent valuation expert, given with the full facts, is ordinarily not “knowing” (§53.4958-1(d)(4)(iii)), and neither is one whose board met the requirements of the rebuttable presumption of reasonableness (§53.4958-1(d)(4)(iv)).

A worked example

In this made-up example, a board approves a $260,000 salary for its executive director, and the IRS later shows that $200,000 was reasonable, so the excess benefit is $60,000.

The $15,000 is a tax the director pays to the IRS. Paying the $60,000 back to the organization, with interest and in time, is what corrects the transaction and keeps the $120,000 tax from applying (§4958(b); §53.4958-7).

Correcting it

If an excess benefit has already happened, correcting it in time spares the executive the further 200% tax. “In time” means within the taxable period, which ends when the IRS mails a notice of deficiency for the 25% tax or assesses it. The law then allows a further 90-day correction period after the IRS mails a notice of deficiency for the 200% tax. A Tax Court case can extend that period (§53.4958-1(c)(2)(iii); IRC §4963(e)).

The disqualified person corrects it by repaying the excess benefit plus interest, at a rate no lower than the applicable federal rate, in cash or cash equivalents (§53.4958-7). With the organization’s agreement, property can be returned instead. The underlying contract doesn’t have to be canceled, though future payments may need to change.

Reporting it

The disqualified person and each manager who owes the tax file their own Form 4720. The organization also files a Form 4720 to report the transaction on its Schedule I (Form 4720 instructions). On its Form 990, it answers Part IV, lines 25a and 25b and describes the transaction on Schedule L, Part I (Form 990 instructions).

The organization owes no §4958 tax itself, but the IRS may propose revoking its exemption, whether or not it imposes the taxes (IRS, Intermediate sanctions). If the organization pays an insider’s §4958 tax, or insurance against it, that payment counts toward the insider’s compensation (§53.4958-4(b)(1)(ii)(B)).

Preventing it

For executive pay, the regulations describe a process called the rebuttable presumption of reasonableness, and pay approved through it is presumed reasonable. The guide to the rebuttable presumption explains its three requirements, while How to set nonprofit executive compensation walks a board through it from the first meeting to the minutes.

Informational only. Not legal, tax or compensation advice. No guarantee of accuracy.