“Always Look a Gift Horse in the Mouth”: How to Avoid an Excess Benefit Transaction
By Justin R. Coleman, Esq. and Robert Showers, Esq.
(SS Quarterly 2017 – 3rd Quarter)
Due to its charitable nature, churches and nonprofits often receive offers for goods and services from its members and donors. More often than not, these goods and services are offered for free because that member/donor wants to “bless” the ministry. However, there are times when those services are offered in exchange for compensation or the member offers to sell the good or goods to the ministry at a discounted rate. Naturally, the church/nonprofit wants to do business with its members/donors who will do a better job for a reduced price (or so they think). While the governing board (the “board”) may see these offers as a great benefit, there are a number of hidden dangers of which the church/nonprofit, and particularly its board, needs to be aware and steps it must take before accepting these offered goods or services. What is an excess benefit transaction and how do we avoid it?
- WHAT IS AN EXCESS BENEFIT TRANSACTION?
The Federal Code defines an excess benefit transaction as any “transaction in which an economic benefit is provided by an applicable tax-exempt organization, directly or indirectly, to or for the use of any disqualified person, and the value of the economic benefit provided by the organization exceeds the value of the consideration (including the performance of services) received for providing such benefit.” Internal Revenue Code (IRC) § 4958(c)(1)(A) (emphasis added).
Now, what does that mean?
- TAX-EXEMPT ORGANIZATION
A tax-exempt organization as any organization that would be meet the definition of a § 501(c)(3) or § 501(c)(4) entity at the time of the excess benefit transaction or any time in the 5 years prior to the date of the transaction. The IRS considers and treats churches as § 501(c)(3) tax-exempt organizations because of their inherent religious, educational, and charitable purposes. Thus, all churches are considered tax-exempt organizations for the purpose of excess benefit transactions.
- DISQUALIFIED PERSON
A disqualified person is 1) any person in a position to exercise substantial influence over the affairs of the organization; 2) a family member of an individual described in (1); and 3) a thirty-five percent (35%) controlled entity.
- A person of substantial influence would include a member of the organization’s governing body, its President, or another senior executive officer (i.e. CEO, CFO, COO, etc.). Essentially, any person with decision-making authority in the organization, or his/her family members, would be considered a disqualified person.
- A 35% controlled entity is 1) a corporation in which a disqualified person(s) owns more than 35% of the total combined voting power (directly or indirectly); 2) a partnership in which such persons own more than 35% of the profits interest (directly or indirectly); or 3) a trust or estate in which such persons own more than 35% of the beneficial interest (directly or indirectly).
Would either of these scenarios potentially create an excess benefit transaction?
- Hypothetical #1: An elder or board member is a general contractor. After the board discusses the need to expand the sanctuary, he speaks with the chair about serving as the general contractor for this project and what his estimated fee will be based on the board’s initial plans.
- Hypothetical #2: The building and grounds committee obtains bids from several local painting businesses for repainting the children’s sanctuary and nursery. Upon reviewing all of the bids, the committee presents their recommendation to the Council. The painting company recommended by the committee is co-owned by the church administrator’s husband.
- Hypothetical #3: A professional (attorney, accountant, realtor, engineer, etc.) who is also a leader in the organization wants to provide reduced fee services to the organization.
- YES TO ALL THREE BUT…
- CAN THE ORGANIZATION DEAL WITH A DISQUALIFIED PERSON WITHOUT IT BECOMING AN EXCESS BENEFIT TRANSACTION?
Yes, the church or nonprofit could still contract for goods or services with a “disqualified person” without it being considered an excess benefit transaction. The IRS provides a “safe harbor” for these types of transactions provided that the organization’s board takes certain steps in evaluating the proposed contract:
- The organization obtained offers for the same goods or services from similar individuals or organizations as the disqualified person and relied on those comparable offers (with the required expertise and experience needed) in making its decision;
- When making its decision, no member of the governing body had a conflict of interest in regards to the proposed contract; and
- The governing body kept a written record of its decision, including the basis as to why it determined the proposed contract was fair and reasonable to the church or nonprofit.
- RELIANCE ON COMPARABLE DATA
The organization’s board has a fiduciary duty to determine whether any contracts for proposed goods or services are necessary and whether its terms are fair and reasonable for the church or nonprofit. While this is a best practice for all proposed transactions, when debating a contract with disqualified person, it is requirement.
If the goods or services are necessary, then the board should conduct an open and competitive bidding process wherein the disqualified person submits a bit along with any other vendor in the area. In evaluating comparable offers, the other vendor(s) must be substantially similar to the disqualified person. Examples of “substantial similar” vendors would be, but not limited to, compensation levels paid by similarly situated organizations, similarly sized organizations, and the availability of similar services in the same geographical area.
- NO CONFLICT OF INTEREST
If a disqualified person submits a bid for a contract for goods or services, the board must then identify the disqualified person or persons and request that they recuse themselves from any discussion and vote on the proposed contract. That disqualified person may be asked to attend for the sole purpose of answering questions on the proposed contract, but is not permitted to stay once all questions have been answered.
If one of the organization’s board members believes he/she may have a conflict of interest in a proposed transaction, he/she should notify the board of it. This will allow the board to determine if one truly exists before proceeding any further. A board member would have a conflict of interest if he/she:
- Is a disqualified person or a family member of a disqualified person;
- Is an employee of a disqualified person that would benefit from the proposed contract;
- Receives compensation subject to approval by a disqualified person benefiting from the proposed contract;
- Has a material financial interest affected by the proposed contract; and
- Would approve a proposed contract for any disqualified person, who in turn would approve a transaction providing an economic benefit to that board member (a “quid pro quo”).
If any of the above are true, then that individual would be required to recuse himself/herself from all discussions and eventual vote on the proposed contract as well.
- WRITTEN DOCUMENTATION
The board should maintain minutes of their meetings, identifying any decisions made on matters before them. This written record is extremely important when it comes to dealing with disqualified persons. The reason why these decisions needs to be recorded (either written or electronic) is to provide proof that firstly, the board made an objective decision based on the information at hand, and secondly, why that decision was fair and in the best interests of the church or nonprofit.
Although the IRS does not provide or require that these minutes be in any specific format, it does provide what information must be included to evidence the objectivity of the board’s decision:
- The names of the board members present during the discussion and vote;
- That the goods or services were necessary and in the best interests of the organization;
- The approved provider and the terms of the approved contract;
- A summary of the comparable data obtained and relied on by the board, including how it was obtained; and
- Any actions taken by those board members who had a conflict of interest to the proposed transaction.
All of the above must be satisfied in order for the board to fall within the “safe harbor” and avoid potential penalties, both personally and to the organization, for an excess benefit transaction.
- WHAT ARE THE PENALTIES FOR AN EXCESS BENEFIT TRANSACTION?
If a proposed transaction with a disqualified person was approved by the board without following the “safe harbor” procedures outlined above, the IRS could impose a number of sanctions against the disqualified person, the board members, and the organization itself.
- EXCISE TAX ON THE DISQUALIFIED PERSON(S)
Upon discovering that a potential excess benefit transaction occurred, the IRS can impose an excise tax equal to 25% of the excess benefit for each excess benefit transaction received by the disqualified person. For example, if the contract required installment payments, the disqualified person would be required to pay the IRS 25% of the excess benefit received on each of those installment payments.
If the disqualified person does not correct the excess benefit transaction within the taxable period, the IRS will impose an additional 200% excise tax on the disqualified person. In regards to this excise tax, the taxable period begins on the date the excess benefit transaction occurs and ends on the earlier of 1) the date the IRS mails the deficiency notice to the disqualified person for the initial excise tax; or 2) the date on which the initial excise tax is assessed against the disqualified person.
Additionally, if more than one disqualified person received the excess benefit, each person would be joint and severally liable for the initial 25% excise tax and additional 200% excise tax. As stated above, the excess benefit would be the monetary difference between the fair market value of the goods or services received by the organization as determined by the IRS and the amount of compensation paid to the disqualified person.
- EXCISE TAX ON THE ORGANIZATION’S BOARD MEMBERS
In addition to the excise tax on the disqualified person(s), the IRS will also impose an excise tax equal to 10% of the excess benefit on any member of the board who knowingly participated in approving the excess benefit transaction (up to $20,000/transaction). A board member “knowingly participates” if that person:
- Has actual knowledge of sufficient facts that it may be an excess benefit transaction;
- Is aware that under the circumstances the proposed transaction may violate federal law on excess benefit transactions; and
- Negligently fails to make a reasonable attempt to ascertain whether the proposed transaction is an excess benefit transaction, or is in fact aware that it is an excess benefit transaction.
As evidence by the above, this excise tax is imposed on those board members who are not exercising their fiduciary duties on behalf of the organization with ordinary care and prudence. As with the above excise tax on disqualified persons, if more than one board member is liable, each board member is jointly and severally liable for the excise tax. Further, if a disqualified person did not recuse himself/herself and knowingly participated in the proposed transaction, he/she may be liable for both the 25% and 10% excise tax.
- LOSS OF TAX-EXEMPT STATUS
If, based on the individual facts and circumstances, it is determined that the excess benefit transaction occurred repeatedly, was excessive in size and scope, or any other relevant factors, the IRS may revoke the church’s tax-exempt status.
Due Diligence, Transparency and Documentation are the keys to success here. As evidenced from the above hypotheticals, the organization must be “wise as serpents and as gentle as doves” when it comes to all proposed transactions, particularly when dealing with individuals inside the organization. In accordance with its fiduciary duties, the board should always have an open bidding process for all contracts. In short get at least three bids from qualified service providers and document all decisions and reasons for the decision.
If one of its board members, either individually or through an owned entity, submits a bid for the project, that individual must disclose it to the board either before or at the time of submitting the bid.
Further, if a member of the board believes that he/she may have a conflict of interest in discussing a proposed transaction, that member should also disclose it to the board immediately. The board will then be able to determine if a conflict of interest actually exists and whether that member needs to recuse himself/herself from further discussion and vote on the proposed transaction.
Again, as these matters are very nuanced but carry with them significant liabilities, the church or nonprofit should consult with knowledgeable counsel on any contracts for major projects, particularly if a disqualified person has submitted, or may consider submitting, a bid for the project.
Disclaimer: This memorandum is provided for general information purposes only and is not a substitute for legal advice particular to your situation. No recipients of this memo should act or refrain from acting solely on the basis of this memorandum without seeking professional legal counsel. Simms Showers, LLP expressly disclaims all liability relating to actions taken or not taken based solely on the content of this memorandum. Please contact H. Robert Showers, Esq. at email@example.com or Justin R. Coleman, Esq. at firstname.lastname@example.org for legal advice that will meet your specific needs.
 IRC § 4958(e).
 IRS Publication 1828.
 A “person” includes, but is not limited to, individuals, corporations, associations, trusts, partnership, etc. IRC § 7701(a)(1).
 IRC § 4958(f)(1) (emphasis added).
 Treas. Reg. § 53.4958-3(c).
 Treas. Reg. § 53.4958-3(b)(2).
 Treas. Reg. § 53.4958-6(a).(emphasis added)
 Caracci v. Comm’r, 456 F.3d 444 (5th Cir. 2006).
 Treas. Reg. § 53.4958-6(c)(1)(ii).
 Treas. Reg. § 53.4958-6(c)(1)(iii).
 Treas. Reg. § 53.4958-6(c)(3).
 IRC § 4958(a)(1).
 Treas. Reg. § 4958-1(c)(2)(ii).