Serving on a Charitable Nonprofit Board -- Are You at Risk for IRS Penalty Taxes?*

A dedicated and hardworking board of directors is a critical component of a successful nonprofit organization. If you are one of these (most likely volunteer) directors then you understand and appreciate the rewards from serving on a nonprofit board. What is often not so apparent to nonprofit boards are the potential liabilities facing both the organization and the individual directors by not adopting and adhering to standard policies and procedures.** The Internal Revenue Service’s (IRS) adoption in January 2002 of final regulations imposing personal liability for penalty taxes on directors and officers of charitable organizations provides an excellent opportunity for organizations, their directors and officers, and those of us representing such individuals and organizations to review the policies and organizations to review the policies and procedures designed to avoid such liability. (See Income Tax Reg. Sections 53.4958-1 through 53.4958-8.)

One significant risk common to nonprofit organizations is the organization’s decision to enter into a transaction with an “insider” — someone who exerts substantial influence over the affairs of the nonprofit organization such as a board member, an officer, a key employee or a major donor, their family members, and controlled entities. A transaction between the organization and an insider is by itself not prohibited. The problem arises when the benefit to the insider exceeds the fair market value of the transaction (an “excess benefit transaction”). When an excess benefit transaction occurs, besides recovering the excess benefit, the IRS can impose an excise tax on both the insider and others, including board members, who participate in the transaction. The tax on the insider is 25% of the excess benefit; if not timely corrected, an additional tax of 200% is imposed. The tax to be paid by the directors personally is 10% of the excess benefit up to a cumulative total of $10,000.

Is This Your Board?

To put all this in context, the following is an example of how the above situation might arise at a board meeting of a nonprofit organization. A three-year old charitable organization, whose purpose is to help find homes for stray animals, finally has grown in both donations and program activity to where it is necessary to hire a full-time executive director. A board member, who is also the founder and the president of the organization, is the best person and the logical choice for the job. She states that in order for her to take the job, her compensation would have to be at least comparable to what she is making now as the chief executive officer of a prominent local business. Another board member, the owner and manager of an executive search firm, states his belief to the board that the president’s current compensation is in line with, if not less than, what comparable executives are making in the local market. The other members of the board highly value the president and understand how difficult it would be to find a replacement for her talent, skill and knowledge of the organization. The terms of the transaction sound reasonable to the board members and, even if the salary is a little higher than they might otherwise have paid an executive director, the president has been working tirelessly for the organization for three years without pay.

Is this an excess benefit transaction for which the IRS will seek an excess benefit tax from the new executive director and the participating board members? The answer based on the above facts is: perhaps. The answer depends on information neither present here nor before the board members prior to their making a decision. A better question at this point is: what should the organization and the participating board members have done differently to ensure that this same transaction could be accomplished without fear of an excess benefit transaction tax being imposed by the IRS?

By taking the following steps the board members could significantly minimize their potential individual liability for excess benefit transactions:

1. It is highly recommended that all boards implement conflict of interest guidelines and an excess benefit checklist to help identify insider and potential conflict of interest transactions and to provide mechanisms for the handling of such transactions. Often these guidelines and checklist are included in a board of directors manual. The conflict of interest guidelines should be followed so that the compensation arrangement is approved in advance by members of the board who do not have a conflict of interest with respect to the compensation arrangements.
2. It is imperative that the board obtains and relies upon appropriate comparability data and any other information it feels is necessary to make an informed decision that the compensation arrangement is reasonable. One crucial piece of the information the board must have to make an informed decision is the compensation of other executive directors of similar nonprofit organizations. The board should not have relied solely on the general comment of another board member as to how other local executives are compensated, even if this is within his expertise. Depending upon the amount of the transaction and the organization’s finances, the board should have either conducted a salary survey itself or relied on an independent expert to conduct a survey for them. Under the IRS regulations governing excess benefit transactions, a board’s actions are deemed to be reasonable when it has relied on a written opinion of legal counsel, accountants and independent valuation experts.
3. Accurate and timely records must be kept, documenting, among other things, the basis for the board’s decision. Therefore, the approving board members should be sure to observe all corporate formalities in making such determinations and, most importantly, hold a meeting where all the above issues and the reasons for their decision are discussed and accurately recorded.

The above discussion is a brief overview of a technical area of tax law and regulations and is not intended as a comprehensive discussion of director liability. What this article has hopefully provided to you is the understanding that by the relatively simple steps of implementing and following standardized guidelines and practices, an organization, its board and its officers can minimize the risks from excess benefit transactions. This, in turn, will allow everyone to enjoy the rewards that come from helping a nonprofit organization meet its public benefit purposes.

Nonprofit Law Update is a publication of the Business Department of Downey Brand LLP.