Tax exempt entities can lose their tax exempt status with the IRS if they are involved in private inurement which applies to exemptions under 501c3, 4, 6 and 7. It basically means that insiders can’t personally benefit in any way through the “use” of a tax exempt entity. Funds can be received from a tax exempt entity only if it is reasonable payment for goods or services.
The IRS established rules for “excess benefit transactions” (EBT’s) as a way to be more specific about individuals not benefiting from a tax exempt entity and also to offer a consequence by imposing taxes on these types of transactions. The IRS definition for an EBT is slightly different than the one for private inurement, but generally means the same thing- a disqualified person can’t receive something from a tax exempt entity that is worth more than whatever they are giving up in exchange. A disqualified person includes people who had substantial influence over the organization within the last 5 years (such as board members) as well as family members of those people. An example of an EBT is when a tax exempt entity sells a vehicle valued at $5,000 to a past board member for $1,000. It doesn’t matter what the value is to the organization (as the organization may feel that the vehicle is more trouble than it’s worth)- what matters is the fair market value.
Another common example of an EBT is excessive compensation. The key to avoiding any trouble from the IRS with the possible appearance of excessive compensation is this 3 step approach: (1) The Board should approve the compensation of top management in advance of paying them; (2) The Board should look at comparability data to prove that the compensation is reasonable; and (3) DOCUMENT that you did these things and the basis for your determination.
If your tax exempt entity did become involved in the vehicle sale EBT example above, you are required to report this on Schedule L of your Form 990 and you should correct it as soon as you become aware it happened. What is the tax on the EBT? 25% if you correct it within the year (which would be $1,250) or 200% if you do not correct it ($10,000!). How do you correct it? The purchaser of the vehicle should immediately pay the organization the additional $4,000. Who can be taxed? Anyone who approved the transaction can be taxed- the past board member, possibly the Executive Director, possibly board members, etc.
Board member and management awareness of this issue is key to knowing what transactions to not become involved in.
By Colette Kamps, CPA