The federal self-dealing rules apply only to private foundations; however, community foundations and other public charities are subject to similar rules prohibiting excess benefit transactions with disqualified persons. These rules are sometimes referred to as the "intermediate sanctions" law. Here are things all grantmakers that are public charities should know about excess benefit transactions.
The excess benefit transactions rules provide for a penalty tax on "disqualified persons" who receive an "excess benefit" from a public charity. Generally, an excess benefit transaction is a transaction in which a public charity provides an economic benefit to a disqualified person and receives less than the value of the benefit in return.
The definition of "disqualified persons" under the excess benefit transactions rules is different from the one used for private foundations under the self-dealing rules. In this context, a disqualified person is anyone who, during the five years preceding a transaction, was in a position to exercise substantial influence over the affairs of the organization. The term includes directors and high-level officers. With respect to community foundations or other organizations that sponsor donor-advised funds, the term also includes investment advisors, their family members and entities for which they control 35 percent of voting power, profits or beneficial interest.
Excess benefit transactions may include unreasonable compensation arrangements, leases, loans and sales between an exempt organization and a disqualified person. Excess benefit transactions can also arise indirectly through intermediary entities such as an exempt organization's taxable subsidiary.
The penalties for violations of the intermediate sanctions rules can be greater than for violations of the self-dealing rules. Disqualified persons who receive excess benefits must pay a tax equal to 25 percent of the amount of the excess benefit. If the transaction is not corrected, an additional penalty of 200 percent of the excess benefit is assessed.
Managers who knowingly approve an excess benefit transaction are also subject to an excise tax unless their participation in the transaction was not "willful" and was due to "reasonable cause." Managers are subject to a tax equal to 10 percent of the value of the excess benefit.
The intermediate sanctions rules include a procedure by which the charity may establish a "rebuttable presumption of reasonableness" for a transaction involving a disqualified person. A charity's appropriate use of the procedure shifts the burden to the IRS to prove that the charity's transactions with a disqualified person are not reasonable. Under the regulations implementing the intermediate sanction rules, three conditions must be satisfied to take advantage of the rebuttable presumption rules:
Approval by Disinterested Governing Board: The transaction must be approved in advance (before any payment) by the governing body or a committee of the organization composed entirely of individuals who do not have a conflict of interest with respect to the arrangement.
Reliance on Comparable Data: The board must obtain and rely on appropriate comparability data prior to making its determination. Relevant information for compensation arrangements includes, but is not limited to, current compensation surveys compiled by independent firms, compensation levels paid by similarly situated organizations for functionally comparable positions, and written offers from similar institutions competing for the services of the person under consideration. Most foundations rely heavily on salary and compensation surveys to guide them in finding a reasonable level of compensation. Commonly used surveys include the national Council on Foundations' annual grantmaker salary survey. It is common for foundations to compare compensation levels with specific foundations of similar size, operations and geographic location. It is not necessary to look only at nonprofit data. Data from comparable for-profit organizations may also be used.
For sales or leases, independent appraisals may be used.
Concurrent Documentation: The board must document the basis for its determination concurrently with making that determination (within 60 days of the decision or the date of the next meeting of the board, whichever is later). To qualify as concurrent documentation, written or electronic records of the board (such as meeting minutes) must note:
In addition to the transactions described above, the Pension Protection Act of 2006 added new categories of excess benefit transactions involving donor-advised funds and supporting organizations.
With respect to a donor-advised fund, the definition of an excess benefit transaction includes any grant, loan, compensation or similar payment from the donor-advised fund to the fund's donors, persons appointed by the donor as fund advisors, and entities in which such persons control 35 percent or more of the voting power, profits interest or beneficial interest. The amount of the excess benefit equals the entire payment, not only the amount that exceeds fair market value.
With respect to supporting organizations, excess benefit transactions include (a) any grant, loan, compensation or similar payment provided by the organization to a substantial contributor, family member of a substantial contributor, or a 35 percent controlled entity; and (b) any loan provided by the organization to a disqualified person. The excess benefit transaction is equal to the entire payment or loan amount, not merely any portion that exceeds fair market value.
Grantmakers should note that the rebuttable presumption procedure may not be used for transactions involving supporting organizations and donor-advised funds as described in this section. The transaction will be treated as an excess benefit even if it is fair and reasonable.
In addition to considering the tax implications, public charities should keep in mind applicable conflicts of interest laws and their own internal policies and procedures regarding conflicts of interest when considering transactions involving a disqualified person (see Conflicts of Interest).