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Excess Benefit Transactions

Magdalena M. Czerniawski, CPA, MBA, and Robert Lyons, CPA, MST
Published Date:
Jan 1, 2020

Excess benefit transactions (EBT) are an outgrowth of IRC section 4958, which was first introduced in 1996 and modified in 2003. Its purpose was to punish the wrongdoer but not necessarily revoke the exemption of what may be a perfectly good charitable organization with bad management. During the first several years of its existence, many articles were written about intermediate sanctions and their impact on an organization. Awareness was again heightened in 2008, with the redesign of Form 990, “Return of Organization Exempt from Income Tax,with the addition of Schedule L, “Transactions with Interested Persons.”  Part 1 of Schedule L called for the reporting of EBTs for organizations exempt under IRC sections 501(c)(3), 501(c)(4), and 501(c)(29).  Historically, EBTs were looked at from the point of view of misappropriation, squandering, and intentional dishonest acts on the part of management; however, while these acts fall within EBTs, other actions on the part of management are not as transparent.

EBTs Explained

An EBT is any transaction in which an organization provides an economic benefit directly or indirectly to, or for the use of, any disqualified person if the value of the economic benefit provided exceeds the value of the consideration received for providing such benefits. There are a number of exceptions. The penalty imposed on the disqualified persons has two levels:

  • a penalty imposed on the person who committed the infringement, and
  • in some cases, on the management that allowed it to happen.

The initial excise tax is 25% of the excess benefit, and if not corrected during the correction period, can go to 200%. At the same time, management could be subject to a 10% penalty not to exceed $20,000 per occurrence. These excise taxes are reported and paid with Form 4720, “Return of Certain Excise Taxes under Chapters 41 and 42 of the Internal Revenue Code.”

These types of transactions represent considerably more than theft or misappropriation. In some cases, they can be the result of a simple mistake or misunderstanding, but nevertheless are still as reportable.  Many transactions that fall below the scrutiny level are just as much violations.  Particularly in organizations run by founders, there is often a lack of separation between business and personal: They started the organization, and in their mind, it belongs to them. Of course, they gave up that right with the filing and acceptance of their application for exemption. Some examples may be the use of corporate jets or other forms of travel; this becomes especially true when there is a stronger personal motivation for the trip than a business reason. Another example: taking friends on trips or covering personal expenses at the cost of the organization.

There is no dollar threshold for transactions of this type. When they occur, they must be reported. Accountants sign as preparers and hold the return out as an honest representation of the organization’s history. One of their primary responsibilities to clients is to keep them out of the newspaper for inappropriate actions. EBTs are ripe for press exposure and can not only embarrass the parties, but also ruin the reputation of the organization. The donating public has a right to believe that their dollars are going toward a good purpose—not salaries of management that are beyond what’s considered reasonable in their role.

Three Important Considerations

In evaluating expenditures, organizations need to reflect on three qualities: “ordinary,” “necessary,” and “primary.” In looking at which transactions may be excessive; an organization must first consider what is ordinary and necessary in light of their exempt purpose. For example, one organization paid for very intricate security systems for the homes of all of its board members. While this may appear excessive in most cases, this particular nonprofit had an extremely high security risk, so the security measures were justified. Conceivably, what might be considered ordinary and necessary to one organization may be considered excessive to another.  In determining what is ordinary and necessary, expenditures are compared with what would be reasonable for a similar organization under similar circumstances. Generally, in order for an expense to be ordinary, it must be common or usual in a business of a similar nature. On the other hand, necessary is limited to expenses that help carry on the line of business in an efficient manner under like circumstances. Expenses that are ordinary and necessary are defined as business-related expenses and not personal in nature.

As noted earlier, there is also a second level of tax on the part of management for allowing the transactions to take place at all. In describing the board’s role, such words as “fully informed,” “fully involved,” and “fully engaged” should be associated with organization’s management. If these words do not fit the organization’s style, the board may want to step back and examine it responsibility to the organization and its funders/donors.   

Practical Application

During the course of preparing Form 990 or conducting the audit, preparers need to pay attention to the necessity of expenses as well as their amounts. It seems that a majority of the infractions fall in the travel and entertainment area. In cases where these expenses appear to be out of line or different from year to year, the nature of the expenses should be evaluated. In light of IRC section 4958, accountants have a responsibility to clients to make them aware of where there may be potential problems related to EBTs. This can hopefully help limit the embarrassment and the public reaction when these types of transactions surface.

Magdalena M. Czerniawski, CPA, MBA, is a partner at Marks Paneth LLP and a member of the firm’s nonprofit, government, and healthcare group. With over 15 years of nonprofit industry experience, she provides tax services to a wide array of nonprofits, including charitable organizations, schools, social welfare organizations, professional associations, and private foundations. Her experience includes serving clients with matters related to employee compensation and benefit plans, healthcare organizations and hospitals, affordable housing entities, and foreign tax filings.

Robert Lyons, CPA, MST, is a tax director, exempt organizations in the nonprofit, government & healthcare group at Marks Paneth LLP. He has more than 30 years experience providing tax and consulting services to his clients in the nonprofit, higher education, and public sector industries. His experience includes handling substantial exempt organization tax issues. He has led numerous training seminars for AICPA and received the AICPA Outstanding Discussion Leader Award in 2010 and 2013. He is also the current chair of the NYSSCPA Exempt Organizations Committee.