Intermediate Sanctions

It is important that members of nonprofit governing boards understand the implications of the intermediate sanctions regulations on executive compensation.

Intermediate sanctions are measures that the Internal Revenue Service can use to penalize individuals improperly benefitting from transactions with nonprofit organizations. This can include excessive executive compensation.

Prior to the enactment of the intermediate sanctions regulations in 1996, the only penalty available to the IRS for punishment of inappropriate expenditures in nonprofits was revocation of the nonprofit status of the organization in question. Since in most situations this would be overly punitive, the remedy was rarely if ever used. The penalties provided by the intermediate sanctions gave the IRS a needed tool to promote fiscal responsibility in nonprofits.

Intermediate sanctions penalties apply to disqualified persons or organization managers who receive an excess benefit from a nonprofit organization. Disqualified persons and organization managers are persons who are in a position to exercise substantial influence over the affairs of the organization. Examples are directors or trustees of the board, founders, executive officers such as the president or chief financial officer, or anyone else who has a material financial interest in the organization.

Penalties for excess benefit transactions are substantial. The recipient must return the excess benefit amount plus interest. In addition, the recipient is subject to a penalty of 25% of the excess benefit amount (200% if the amount is not returned within the taxable period). Further, each orgnanization manager who approved the transaction (including board members) may be liable for penalties of up to $10,000.

There are steps you can take to avoid excess benefit transactions. When authorizing the intermediate sanctions, Congress provided an important safe harbor provision. Under this provision, compensation is assumed to be reasonable if a) the compensation is approved in advance by a group (such as a board committee) comprised entirely of individuals without a conflict of interest; b) the committee or group relied on appropriate competitive compensation data in making its determination; and c) the basis for the decision was adequately documented.

If all of the above criteria are met, the burden of proof (that the compensation in questions was unreasonable) shifts to the IRS, which then must provide sufficient contrary evidence. This is known as a rebuttable presumption.

Go here for the IRS explanation of excess benefit transactions and here for the final regulations as published by the Treasury Department.