May 31, 2012
Compensation Planning for Churches, Part 3
How to avoid costly penalties when setting pay
Editor’s Note: Today is part three of a multiple-part series reviewing church compensation planning that complies with IRS guidelines. Part one looked at why churches should carefully think through what qualifies as compensation and taxes on compensation. Part two described how to determine the compensation “umbrella”—the maximum amount that may be paid to an employee.
Nonprofit organizations, as a general rule, are prohibited from participating in transactions that are deemed to be excess benefit transactions. These are transactions that involve disqualified persons and the provision of benefits in excess of what the organization receives in return for the benefit.
An organization is not allowed to pay more compensation than is reasonable for the services provided by the employee. Any compensation paid above reasonable compensation or above the "umbrella" to a disqualified person is considered to be an excess benefit transaction.
Disqualified persons are generally officers, directors, trustees, and key employees of an organization. In addition, the term also includes the family members of any of these individuals. This group is generally the movers, shakers, and decision makers of the organization and their families.
It is important that this group of people be identified so that the organization can properly handle any transaction related to a member of this group. Compensation is one of those areas that require special attention for this group.
As described above, payment of unreasonable compensation creates an excess benefit transaction for a disqualified person. Excess benefit transactions are subject to a set of penalties called intermediate sanctions. These sanctions are assessed to the recipient of the excess benefit and to anyone who agreed to it.
If an excess benefit occurs, the following consequences apply:
- The benefit is required to be repaid to the organization; and
- The disqualified person is required to pay a penalty or tax to the IRS of 25 percent of the amount of the benefit.
If the IRS discovers the transaction and that it has not been corrected, additional penalties may be assessed to the disqualified person equaling 200 percent of the benefit.
If someone else within the organization agrees to the transaction giving rise to the excess benefit transaction, they can be assessed a penalty of 10%. This includes such persons as other officers, directors, and trustees.
Nonprofit organizations are prohibited from entering into transactions that create inurement of benefit to control parties, i.e., disqualified persons. The Internal Revenue Code indicates that the mere existence of inurement of benefit is grounds for revocation of the organization's exempt status. Virtually all excess benefit transactions create inurement of benefit. Therefore, if an excess benefit transaction occurs, the IRS has grounds to revoke the tax exempt status of the organization.
Normally the IRS will use the above described sanctions to punish the guilty insider and not revoke tax exempt status unless the activity is egregious. However, the law allows the IRS to both revoke the tax exempt status of the organization as well as assess the individual penalties described above.
Defining the "umbrella" of reasonable compensation is critical to avoiding the creation of excess benefit transactions and the related consequences of such transactions as well as being vital to protecting the tax exempt status of the organization.
Next in the series: Noncash benefits must count as compensation
For more in-depth information on how the U.S. tax code relates to church compensation, see the 2012 Church & Clergy Tax Guide by Richard Hammar.