When someone in your organization receives far more benefit from a transaction than the nonprofit does, it can result in an “excess benefit transaction.” These self-serving transactions are not taken lightly by the IRS.
Not only is the person who receives the excess benefit penalized, but the person or persons who authorized the transaction are also held liable. Here’s a scenario that shows just how serious this situation can be:
Acme Computers is owned by the sister of World Charity’s board chair. Acme Computer contracts with World Charity for IT services. The contract is for $200,000 a year, but the going rate for similar services is just $100,000.
The IRS determines that the services contract provides unreasonable compensation to an “insider” or “interested person” — in this case, the sister of World Charity’s board chair. Based on surveys of what similar organizations in the same geographic area pay for comparable services, the IRS rules that an excess benefit transaction has occurred. Acme Computers must now pay back the $100,000 in excess benefit.
In addition, the IRS assesses Acme Computers a penalty of 25 percent of the excess benefit, or $25,000. If Acme Computers doesn’t pay the full $125,000 promptly, an additional penalty equal to 200 percent of the unpaid portion of the excess benefit — in this example, another $200,000 — will be due for a total penalty of $325,000 on a $100,000 excess benefit. Interest would also apply.
But it gets even worse: Any of the World Charity managers who “knowingly approved” the transaction must pay a penalty tax equal to 10 percent of the excess benefit.
Avoiding such conflicts of interest begins with effective compliance policies and procedures. A good place to start is with a strong code of ethics and a conflict of interest policy that establish expectations of lawful conduct.