Overview of Intermediate Sanctions
What are Intermediate Sanctions?
The IRS Intermediate Sanctions impose penalties where the IRS finds that a non-profit executive (or “disqualified person”) received unreasonable compensation (an “excess benefit”).1 Interestingly, these penalties are not imposed on the organization itself, but rather on the benefit recipient (at a minimum), and in some cases, those individuals who approved the excess benefit (board members, senior executives, etc., or “organizational managers”). The sanctions are referred to as the Intermediate Sanctions because, while they serve as a warning to the organization and its constituents, the sanctions fall short of revoking the organization’s tax-exempt status.2 However, the IRS has indicated that an organization found to repeatedly approve excess benefit may ultimately lose their tax-exempt status.3
Who pays the penalties?
The penalties are imposed on the disqualified person who received an excessive benefit, and in some cases, the organizational manager(s) who participated in approving the excessive benefit. An organizational manager, who appropriately opposes a compensation arrangement consistent with his or her duties to the non-profit, will not be subject to penalties that would otherwise be imposed.4 On the other hand, an organizational manager who opposes a compensation arrangement but fails to do so in a manner that satisfies his or her duties to the non-profit will be subject to the penalties.
Penalties on the Disqualified Person
A disqualified person who received an “excess benefit” (the benefit paid to the disqualified person in excess of the value of the services performed in exchange for such benefit)5 will be subject to an “initial tax” equal to 25% of the excess benefit.6 An “additional tax” equal to 200% of the excess benefit is imposed if the initial tax is not paid within the “taxable period.”7 If the excess benefit is corrected during the 90-day period after the notice of the deficiency is mailed, then the “additional tax” will not be imposed.8
Penalties on the Organizational Manager
An organizational manager who approves an excess benefit transaction knowingly, willfully, and without reasonable cause, is liable to pay a penalty equal to the lesser of (i) 10% of the excess benefit or (ii) $10,000.9
An organizational manager “knowingly” participates in a transaction only if the person (i) has actual knowledge of sufficient facts so that, based solely upon those facts, such transaction would be or is an excess benefit, (ii) is aware that such a transaction under these circumstances may violate the tax law governing excess benefit transactions or (iii) negligently fails to make a reasonable attempted to ascertain whether the transaction is an excess benefit transaction.10 Evidence tending to show that an organizational manger had reason to know of a particular fact or a particular rule is relevant in determining whether the manager had actual knowledge of such a fact or rule. The IRS bears the burden of proof in cases involving the issue of whether an organizational manager knowingly participated in an excess benefit transaction.
1. See generally I.R.C. § 4958 (1996); Treas. Reg. § 53.4958 (2002).
2. Not all non-profits are subject to intermediate sanctions. In fact, only those organized under I.R.C. § 501(c)(3) or certain non-profits organized under I.R.C. § 501(c)(4) are affected. Certain private foundations, governmental entities and certain foreign organizations are not subject to these sanctions. See Treas. Reg. § 53.4958-2.
3. See preamble to 1998 Section 4958. The Treasury Department listed four factors that the IRS would consider in determining whether to revoke a non-profit’s exempt status: (i) whether the non-profit has been involved in repeated excess benefit transactions; (ii) the size and scope of any excess benefit transactions; (iii) whether after excess benefit transaction, the non-profit implemented safeguards to prevent recurrences; and (iv) whether there was compliance with other applicable laws.
4. See I.R.C. § 4958(a)(2); Treas. Reg. § 53.4958-1(d).
5. See Treas. Reg. § 53.4958-1(b).
6. If more than one disqualified person is liable for the tax then all such persons are jointly and severally liable for that tax.
7. The “taxable period” begins on the date of the excess benefit transaction and ends on the earlier of (i) the date the IRS mails the notice of deficiency or (ii) date on which tax imposed under I.R.C. § 4958(a)(1) is assessed. If only part of initial tax is paid during the taxable period, then an amount equal to 200% of only the unpaid portion of the excess benefit will be due. See Treas. Reg. § 53.4958-7.
8. See Treas. Reg. § 53.4958-1(c)(2)(iii). See also I.R.C. § 4962 regarding mitigation of the initial tax.
9. If more than one organizational manager is liable for the tax then all such persons are jointly and severally liable for that tax.
10. See Treas. Reg. § 53.4958-1(c)(2)(iii).