Disqualified Persons and the Intermediate Sanctions Excise Tax Regime

Disqualified Persons and the Intermediate Sanctions Excise Tax Regime[1]

Part of the price of having tax exempt status is that tax exempt organizations are subject to more significant scrutiny and regulation of their activities than their for-profit counterparts. Directors and managers of nonprofits may not be aware that as a part of this regulation there is a prohibition against transactions between the organization and certain insiders that result in private inurement to the insider(s).  The prohibition against private inurement is enforced through excise taxes imposed on certain insiders who qualify as “disqualified persons” as a result of their relationship with the organization.[2]

Prior to 1996, revocation of tax exempt status was the only sanction available to the IRS for organizations that engaged in private inurement.  The law and regulations known as “intermediate sanctions” were enacted to provide an “intermediate” option between doing nothing and revocation of tax exempt status.  This change enables the IRS to impose an excise tax on insiders who improperly benefit from a transaction with a §501(c)(3) public charity or §501(c)(4) social welfare organization.[3]  The improper benefit received is referred to as an excess benefit and occurs in situations when a disqualified person transacting with the organization receives greater value then what they provided as a part of a transaction or exchange.  Disqualified persons who engage in an excess benefit are subject to an initial 25% tax on the excess benefit.  If the excess benefit isn’t corrected promptly enough (by repayment or otherwise putting the organization back in the same position it was in before the transaction occurred), then an additional 200% penalty applies.  Organizational managers that knowingly approve an excess benefit are potentially subject to a 10% tax on the benefit.

Because the penalties are significant and unforgiving, it is important for organizations to understand what makes a person or an entity a disqualified persons with respect to their organization.  When an organization is aware of who the disqualified persons are, then they can take steps to prevent a determination by the IRS that an excess benefit transaction occurred.  Disqualified persons are people who, because of their relationship with the organization, may have had the opportunity to use the organization to their own advantage.  This includes people that were in a position of substantial influence or control over an organization at the time of a transaction, or at any time in the five years prior to the transaction.  Certain people are disqualified persons by definition: 

• significant donors[4] and their family members;[5]
• an entity that is 35% controlled by a significant donor or their family member;[6]
• someone who fits into one of the prior categories with respect to a supporting organization of the organization that engaged in the transaction;
• voting members of the governing body; the President/CEO/COO (essentially the person with ultimate responsibility for implementing the decisions of the board or for supervising the organization’s operations - regardless of title); and the Treasurer, CFO, or person who holds similar powers (again, regardless of title). 
• Certain persons are, by definition, not disqualified persons: §501(c)(3) organizations (in reference to both other 501(c)(3)s and 501(c)(4)s, certain §501(c)(4) organizations (in reference to other §501(c)(4)s), and employees who do not fit into one of the categories described earlier and are not paid at least a specified amount ($130,000 in 2021).

Unfortunately, the analysis as to whether someone is a disqualified person does not stop at the above.  Even if someone is not a disqualified person by definition, they can still be considered a disqualified person based on other factors.  Factors tending to indicate that someone has substantial influence (and is thus a disqualified person) includes: the person founded the organization; the person receives revenue-based compensation from the organization; or the person has control over a significant portion of the organization’s operations, budget, etc.  Factors that tend to indicate that a person does not have substantial influence over an organization include: the person has taken a bona fide vow of poverty; they are a contract or solely providing professional advice and without decision-making authority (like a lawyer or a CPA); the direct supervisor of the person is not a disqualified person; and any benefits they receive as a result of their donation is the same as offered to other donors giving comparable amounts.  There is unfortunately no clear formula to compare the above factors and other factors relevant to whether someone has substantial influence, and so the determination should always be made with care.

The intermediate sanction excise tax regime and the penalties that it imposes in situations in when there is an excess benefit transaction are not meant to completely prevent organizations from entering into transactions with insiders.  Instead, the purpose is to make sure that those transactions are fair to the organization and that funds are properly devoted to the organization’s tax exempt purposes.  Knowing who the people (or entities) are enables the organization to slow down and follow procedures to try to ensure the transaction is proper before proceeding.