The Latest
The IRS recently announced its intention to propose regulations relating to the 21 percent tax[i] imposed with respect to any “excess” executive compensation paid by certain tax-exempt organizations, including public charities and private foundations (i.e., charitable organizations),[ii] to their covered employees.[iii]
This news followed by almost a year the amendment to the definition of “covered employee” made by OBBBA,[iv] which represents Congress’s latest effort at trying to limit the amount of executive compensation payable by a charitable organization.
TCJA
You may recall this tax was added to the Code by the 2017 Tax Cuts and Jobs Act (“TCJA”).[v] As enacted, it was imposed upon an ATEO (“applicable tax-exempt organization”) with respect to the excess compensation paid by the ATEO to any of its five highest-compensated employees for the taxable year in question.[vi] The term “excess compensation” for a taxable year was defined as (i) so much of the compensation paid to such an employee for the year in excess of $1 million, plus (ii) any excess parachute payment made to the employee.[vii]
It appeared at first glance that the tax was enacted in order to eliminate what the legislators may have believed was the “unfair advantage” that a large tax-exempt charitable organization enjoyed under prior law over a “comparable” for-profit public corporation; specifically, the former’s ability to pay a larger salary to attract and retain an executive employee without being limited by any restrictions on the deductibility of such salaries,[viii] while the latter was so limited.[ix] Stated differently, the disallowance of the deduction meant that it cost a for-profit more to pay the same amount of salary to an executive than it did a nonprofit.
The foregoing was borne out by the Ways and Means Committee’s Report,[x] which also added the following:
“The Committee believes that tax-exempt organizations enjoy a tax subsidy from the Federal government because contributions to such organizations are generally deductible and such organizations are generally not subject to tax (except on unrelated business income). As a result, such organizations are subject to the requirement that they use their resources for specific purposes, and the Committee believes that excessive compensation (including excessive severance packages) paid to senior executives of such organizations diverts resources from those particular purposes.”
One Big Beautiful . . .
In 2025, OBBBA revised the definition of a covered employee to mean any employee of an ATEO; one need not be one of the five highest compensated employees of the organization for the taxable year in order to be a covered employee for such year.[xi]
Underlying this amendment was Congress’s belief that the excise tax on “excess compensation” within a tax-exempt charitable organization should apply with respect to any employee[xii] who, during a taxable year, is paid compensation in excess of $1 million or receives an excess parachute payment.
In general, an ATEO that, during a taxable year, pays over $1 million in compensation, or makes an excess parachute payment, to any of its employees, becomes liable for an excise tax equal to the product of (a) the current federal corporate income tax rate, and (b) the sum of (i) the amount of compensation (other than an excess parachute payment) in excess of $1 million paid to the employee, and (ii) any excess parachute payment made to the employee.[xiii]
What’s Past Is . . . Not Quite Prologue
According to Congress,[xiv] a tax-exempt charitable organization’s funding should be used to further its tax-exempt purpose, and should not be used to provide numerous employees with what many in Washington believed were exorbitant salaries.
Although few would disagree with this statement regarding the use of funds donated to or earned by charitable organizations, many would challenge the $1 million of compensation at which Congress has drawn the line.
Some may even question whether Congress strayed too far from the concerns that originally caused it to monitor and set guidelines for the payment of compensation by tax-exempt charitable organizations.
There may be some basis for their concern.
Long Ago
Congress has long recognized the potential for abuse that is inherent in transactions – including the payment of compensation for services – between a tax-exempt, nonprofit, charitable organization and certain persons who may be described as “insiders” with respect to the organization.
This concern is hardly unique to nonprofit entities. Indeed, the for-profit world presents its own opportunities for insiders to “misuse” or misappropriate the assets of the business, especially where the business is closely held or family-owned.[xv]
When insiders misuse the assets of a business, the IRS has several options at its disposal that may be used to “correct” the transaction in question,[xvi] to recharacterize it for tax purposes in a way that more closely reflects its economic substance,[xvii] or to punish the offending parties.[xviii]
The general principles and guidelines followed by the IRS in the context of such transactions – essentially, variations of the approach taken toward related party transactions – are intended to ensure that the economics of the transactions in question are comparable to those that would be achieved between unrelated parties acting at arm’s length in similar circumstances; a value-for-value proposition. In this way, each party’s “true” taxable income may be determined.
Nonprofits
It may be said that similar principles are applied in the case of dealings between a nonprofit entity and those who may be described as having influence over its operations, including the use and disposition of the nonprofit’s assets, but who have no ownership interest[xix] in such assets.
However, much more is at stake in the treatment of such a transaction than in the case of an owner’s dealings with the assets of their private business – in which the owner unquestionably has an economic interest – because the nonprofit is dedicated to a public purpose, and the general public has an interest in the nonprofit’s assets by virtue of the entity’s serving such a purpose.[xx]
Moreover, if the nonprofit has been recognized as exempt from income tax,[xxi] and as eligible to receive tax-deductible contributions from the members of the general public, by virtue of its charitable purpose and its activities in furtherance of such purpose,[xxii] the public has an interest in ensuring that the contributed funds, the assets acquired with such funds, the income produced by the investment of such funds,[xxiii] and the revenues generated by the nonprofit’s performance of its exempt activities, are not diverted from its public purpose and applied, instead, for the personal economic gain of one who, arguably, may be described as an “insider” with respect to the nonprofit.
Private Inurement
For that reason, the Code specifically conditions the tax-exempt status of a “charitable” organization on the requirement that the organization be organized and operated exclusively for exempt purposes and that no part of its net earnings inure to the benefit of any private shareholder or individual (the “private inurement test”).[xxiv]
Predictably, there has always been – and there always will be – some measure of prohibited private inurement, mankind being what it is.[xxv] In the past, when the IRS discovered the infrequently self-reported offending action, the agency was faced with the choice of either doing nothing or revoking the organization’s tax-exemption.
Congress eventually realized that the revocation of an organization’s tax exemption was probably too severe a consequence for most violations of the private inurement test, and should be reserved for only the most egregious or persistent misconduct. Consequently, the IRS found itself handcuffed for all intents and purposes.
How, then, could Congress ensure that the advantages of tax-exempt status ultimately benefitted the public and not private individuals?
Private Foundations
Initially, Congress sought to remedy this outcome by focusing on those charitable organizations that were typically controlled by a small group of related individuals,[xxvi] on whom such organizations were financially dependent – the grant-making private foundation. It was recognized that these individuals were in a position to direct the expenditure of their organization’s funds, or to cause it to transact, on other than an arm’s length basis, so as to improperly benefit certain private persons.
It was also recognized that the best way, perhaps, to discourage such bad behavior, short of threatening to revoke the foundation’s tax-favored status, was to threaten these individuals with the imposition of excise taxes whenever a “bad” act occurred, and to threaten more burdensome taxes if these acts were not corrected within a prescribed period of time.
Of particular interest to this post, in 1969 Congress enacted the self-dealing rules to address much of the above-described behavior, including the payment of unreasonable compensation.[xxvii]
Self-Dealing
Specifically, the Code was amended to provide that an excise tax would be imposed[xxviii] in respect of any of several specifically identified acts of self-dealing[xxix] between a “disqualified person”[xxx] and a private foundation.[xxxi]
Among these acts is the payment of compensation to a disqualified person, or the reimbursement of the expenses incurred by such a person in their foundation-related activities.
Fortunately, the Code goes on to provide an exception to this seemingly absolute prohibition; specifically, an act of self-dealing does not occur when the compensation is paid to a disqualified person for the performance of personal services that are reasonable and necessary to carrying out the exempt purpose of the foundation, provided the amount paid for such services is not “excessive.”[xxxii] In other words, the amount paid by the foundation must represent no more than “reasonable compensation” for personal services actually rendered by the disqualified person.[xxxiii]
Public Charities
Almost thirty years after the enactment of the Code’s self-dealing rules for private foundations, Congress acknowledged that instances of private inurement arose in the context of public charities more often than may have once been thought considering that, unlike the privately-supported foundation, these organizations depended upon the general public,[xxxiv] other charities, and the government for their financial support – i.e., spigots that may easily be turned off at the first suggestion of suspect behavior.[xxxv]
It also realized, as it had in the case of foundations so many years earlier, that the Code did not provide for the imposition of penalty taxes in cases where a public charity engaged in a transaction that resulted in private inurement, thereby leaving revocation of the organization’s tax-exempt status as the only sanction available.
Once again, Congress sought to avoid the choice of either doing nothing or of taking what, in most cases, would be the disproportionate act of revoking a public charity’s tax exemption in response to what may have been, hopefully, an isolated instance of private inurement.
Eventually, Congress enacted the “intermediate sanctions” rules to authorize the imposition of penalty taxes[xxxvi] in the case of any “excess benefit” transaction occurring between a public charity and certain insiders that resulted in private inurement.[xxxvii]
In general, the intermediate sanctions are the sole sanction imposed in those cases in which the excess benefit does not rise to a level where it calls into question whether, on the whole, the organization functions as a charitable or other organization. In practice, revocation of tax-exempt status would occur only when the organization no longer operates as a charitable organization.[xxxviii]
Excess Benefit Transaction
An “excess benefit transaction”’ is generally defined as any transaction in which an economic benefit is provided by a tax-exempt charitable organization to, or for the use of, a “disqualified person”[xxxix] if the value of the economic benefit provided directly by the organization (or indirectly through a controlled entity[xl]) to such person exceeds the value of the consideration (including the performance of services) received by the organization in exchange for providing such benefit.[xli]
Thus, an “excess benefit transaction” includes a transaction in which an individual, who is a disqualified person with respect to a charitable organization, provides services to the organization in exchange for which the organization pays the individual an unreasonable amount of compensation[xlii] considering the services rendered; basically, a transaction that violates the prohibition on private inurement.
The applicable regulations provide that the value of services is the amount that would ordinarily be paid for like services by like enterprises – “whether taxable or tax-exempt” – under like circumstances; i.e., reasonable compensation.[xliii]
This is consistent with Congress’s stated intention “that an individual need not necessarily accept reduced compensation merely because they rendered services to a tax-exempt, as opposed to a taxable, organization.”[xliv]
In determining the reasonableness of compensation, Congress intended, and the IRS subsequently provided by regulation, that existing tax law standards would be applied.[xlv]
“Safe Harbor”?
In recognition of the fact-specific and subjective nature of a “reasonableness determination,”[xlvi] Congress expressed its intention – which the IRS subsequently implemented by regulation[xlvii] – that the parties to the compensation arrangement be entitled to rely on a rebuttable presumption of reasonableness with respect to the arrangement if it was approved by a board of directors that:
(1) was composed entirely of individuals unrelated to, and not subject to the control of, the disqualified person(s) involved in the arrangement;
(2) obtained and relied upon appropriate data as to comparability (e.g., compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions; the location of the organization, including the availability of similar specialties in the geographic area; independent compensation surveys by nationally recognized independent firms; or actual written offers from similar institutions competing for the services of the disqualified person); and
(3) adequately documented the basis for its determination (for example, the record included an evaluation of the individual whose compensation was being established and the basis for determining that the individual’s compensation was reasonable in light of that evaluation and data).
If these three criteria were satisfied, penalty excise taxes could be imposed only if the IRS developed sufficient contrary evidence to rebut the probative value of the evidence put forth by the parties to the transaction.[xlviii]
The Tax
Where the rebuttable presumption is not available or is overcome by the IRS, the Code imposes excises taxes on the disqualified person to whom the excess benefit was directed – i.e., that portion of the compensation paid that exceeds the amount that would have been reasonable for the services rendered – and on any manager who participated in the excess benefit transaction knowing that it was such a transaction.[xlix]
Additional taxes would be imposed on a disqualified person if the excess benefit transaction was not corrected within a specified time period.[l]
For this purpose, the term “correction” means undoing the excess benefit to the extent possible and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.
Was Change Inevitable?
During the almost three decades since the enactment of the Taxpayer Bill of Rights 2,[li] the IRS has relied upon the intermediate sanctions rule and the attendant excise tax to dissuade public charities from paying unreasonable amounts of compensation to certain insiders, to punish those individuals that disregarded the rules, and to incentivize those persons to promptly rectify their violations.
Similarly, the agency has continued to rely upon the longstanding relied rule against self-dealing and its excise tax to discourage foundations from paying excessive compensation to insiders, to punish violators accordingly, and to encourage the quick correction of any adverse economic consequences to a foundation resulting from such self-dealing.
When the violation of the applicable rule has been sufficiently offensive, the IRS has properly exercised its authority to revoke the tax-exemption of the offending public charity or private foundation.
It appeared Congress, by requiring strict compliance with the arm’s length standard of reasonable compensation, had achieved a workable framework for limiting the risk that a charitable organization as a service recipient would pay unreasonable compensation to a service provider who was a disqualified person.
Funny Thing Happened On the Way to . . .[lii]
Still, something occurred during those years that convinced Congress, in 2017, to look beyond whether the compensation paid by any of these tax-exempt organizations to a covered service provider[liii] was reasonable for the services actually rendered to the charitable organization; in other words, it no longer sufficed that the amount paid in exchange for the services in question represented a reasonable, arm’s length amount.
Diversion of Resources
Let’s consider again the statement from the Ways and Means Committee Report, quoted above, that charitable organizations “are subject to the requirement that they use their resources for specific purposes, and . . . that excessive compensation . . . paid to senior executives of such organizations diverts resources from those particular purposes.”
The Congressional report did not charge the organizations in question with violations of the intermediate sanction or self-dealing rules. Nor did it state that the organizations no longer served, or were at risk of no longer serving, a public rather than a private interest by virtue of their compensation arrangements.[liv]
Instead, the report stated the obvious, that these charitable organizations’ resources should be used in furtherance of their tax-exempt purposes, thereby implying there may be circumstances in which even the payment of reasonable compensation to an insider – i.e., that satisfied the intermediate sanction and self-dealing rules – may be “excessive,” but not so egregious as to jeopardize an organization’s exempt status.
Applying a “Moral” Standard?
Congress’s newer approach toward executive compensation at nonprofits may be attributable, in part, to the public’s own changing perspective.
As the public has become better informed of such matters, and as the press has become more vigilant in disseminating salary levels at certain nonprofits[lv] – especially in healthcare and higher education – there have been demands for more accountability as to how charitable funds are being used, including what percentage of the contributions made to a charity is being used for executive compensation.[lvi]
There has also been a visceral reaction among large segments of the public that the amounts paid to many executives are just too high, notwithstanding that the boards to which these executives report have determined the amounts to be reasonable.
These “morally-derived” economic concerns are magnified when viewed in light of the reality that the vast majority of charitable organizations are governed by self-perpetuating boards of directors,[lvii] which in turn hire the executive employees who manage and oversee the operations of these organizations on a day-to-day basis.
Drawing Lines
That being said, at what point does otherwise reasonable compensation become excessive? Where does one draw the proverbial line? How does one even formulate a standard by which to determine such a line when market rates are deemed per se excessive for whatever purpose the excise tax is purportedly intended to serve?
In the TCJA, Congress found some kind of guidance or support in the deduction cap for executive compensation paid by public for-profit corporations,[lviii] and drew the line at $1 million of compensation. Likewise, Congress relied on the golden parachute rules that are applicable, for the most part, to widely weld C Corporations.[lix]
That is not to say Congress determined that annual compensation in excess of $1 million, or an excess parachute payment, was per se unreasonable. An exempt organization could still pay a key executive annual compensation that aggregated over $1 million without fear that the executive in question, or members of the organization’s board of directors, would be subject to excise taxes and a requirement to claw back (“correct”) a portion of such payment, provided the compensation paid was reasonable.
Instead, Congress decided to impose this additional excise tax on the tax-exempt charitable organization itself whenever an executive’s annual compensation was greater than $1 million, or when the executive received an excess parachute payment, notwithstanding the reasonableness of the total compensation paid to the executive.[lx]
Is it fair to say that Congress decided to subject otherwise tax-exempt organizations[lxi] to such an excise tax in order to encourage them to reduce the amount of compensation payable to insiders, or to dissuade such organizations from paying higher, albeit reasonable, salaries? How reasonable was it for Congress to expect such an outcome? Based on its experience with the deduction cap for compensation paid to executives of public corporations, not very.[lxii]
OBBBA then extended the reach of the new excise tax beyond the world of insiders (disqualified persons) to cover any individual service provider who was paid an “excessive” amount of compensation, as determined by Congress.
Did this change in coverage indicate a determination by Congress that an exempt organization’s payment of such compensation bestowed an impermissible private benefit (as distinguished from private inurement) upon a class of service providers?
Not if the compensation was reasonable. All that matters for purposes of the excise tax is that the annual compensation is greater than $1 million.
It should also be noted that the Act did not provide an exception for a payment that represents reasonable compensation.[lxiii] Thus, even where the payment is reasonable in light of the services provided by the employee in question, and would not be trigger an excise tax for either self-dealing or an excess benefit if such employee were a disqualified person, the excise tax will nevertheless be applied.
Parting Thoughts
If the amount is not reasonable, such that the excise taxes on self-dealing and excess benefits should be imposed, what is purpose of the new tax?
Is it intended to cause these organizations to modify their compensation arrangements? To raise additional revenue from such organizations? To punish them?
If the focus of Congress’s compensation policy toward tax-exempt charitable organizations has shifted away from just preventing private inurement toward also ensuring that these organizations dedicate as many of their resources as possible toward the accomplishment of their charitable mission, how does the excise tax on excess compensation and severance arrangements – which removes funds from the organization – accomplish that goal?
Of course, an organization will not be impacted by these provisions if it does not pay an employee enough remuneration to trigger the tax. Does this mean an exempt organization should not pay any of its executives an amount that would trigger imposition of the tax? Should it walk away from candidates whom the organization can only hire by paying a larger amount of compensation? Or should it seek out the best people, pay them a reasonable amount even if it triggers the tax, and accept the resulting liability as a cost of doing business?
Stay tuned – this issue hasn’t been resolved.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the firm.
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[i] Under IRC Sec. 4960. You might say, it mirrors the amount of tax that such an organization would have had to pay in respect of the “disallowed” portion of the compensation paid to the individual service provider if the organization were not tax-exempt.
[ii] “Applicable tax-exempt organizations.” Payments by certain related organizations are also included in determining compensation for this purpose.
IRC Sec. 4960 refers to organizations that are exempt from tax under IRC Sec. 501(a). Of course, this includes organizations described in IRC Sec. 501(c)(3); i.e., “charitable” in its generally accepted legal sense, which includes: relief of the poor and distressed or of the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening of the burdens of government; and promotion of social welfare by organizations designed to accomplish any of the above purposes. Reg. Sec. 1.501(c)(3)-1(d)(2).
This post will focus on such charitable organizations, which include public charities and private foundations for purposes of IRC Sec. 4960.
[iii] Notice 2026-36.
[iv] P.L. 119-21, One Big Beautiful Bill Act.
[v] P.L. 115-97. Effective for taxable years beginning after December 31, 2017.
[vi] It also included anyone who was a covered employee of the ATEO for any preceding taxable year beginning after December 31, 2016.
Final regulations were issued under IRC Sec. 4960 by T.D. 9938 in 2021.
[vii] It’s worth noting that the “golden parachute” rules with which most of us are familiar[vii] do not apply to payments made by a corporation that is described in Section 501(c) of the Code, provided such organization is subject to an express statutory prohibition against inurement of net earnings to the benefit of any private shareholder or individual; in other words, a tax-exempt charitable corporation. Reg. Sec. 1.280G-1 Q&A-5.
[viii] In general, a tax-exempt organization is less concerned about its ability to claim a deduction for an expenditure, such as compensation paid to employees, for purposes of determining its income tax liability.
[ix] IRC Sec. 162(m). I find it difficult to believe that the worlds of large for-profit corporations and tax-exempt nonprofit organizations are in serious competition with one another over the hiring and retention of talented executives and other employes. There may be one exception – hospitals.
[x] H. Rep. 115–409, 115th Cong., 1st Sess. 333 (Nov. 13, 2017). This report stated: “The Committee further believes that alignment of the tax treatment of excessive executive compensation (as top executives may inappropriately divert organizational resources into excessive compensation) between for-profit and tax-exempt employers furthers the Committee’s larger tax reform effort of making the system fairer for all businesses.”
The Joint Committee on Taxation’s General Explanation of the 2017 Act [JCS-1-18] begins its discussion of the then newly enacted IRC Sec. 4960 excise tax with a description of the deduction limits applicable to for-profit public corporations, and then adds the following: “[t]hese deduction limits generally do not affect a tax-exempt organization.”
[xi] Effective for taxable years beginning after December 31, 2025.
[xii] Not only the five highest-paid employees.
[xiii] Accordingly, the excise tax applies as a result of an excess parachute payment even if the covered employee’s remuneration does not exceed $1 million.
Please note that the excise tax imposed under IRC Sec. 280G with respect to an excess parachute payment is contingent upon a change in control, not necessarily a separation from service.
The tax under IRC Sc. 4960 is contingent upon a separation from service, which makes sense in the context of a nonprofit..
[xiv] See, for example, the Report of the Committee on the Budget, H.R. 119-106.
[xv] It is not uncommon for an owner of such a business to use its assets for personal benefit; for example, they may cause the business to satisfy personal liabilities of the owner that have no nexus to the business; they may cause the business to overpay the owner (or a related person) for their services, for the use of their property, or for the purchase of such property; or they may cause the business to undercharge the insider (or a related person) for the use of business assets (including, for example, money, as in the case of a below market loan).
[xvi] For example, by applying the principle of substance over form, or the arm’s length standard.
[xvii] For example, to treat the flow of excess benefit to an insider as a nondeductible dividend distribution or as additional compensation.
[xviii] For example, by denying the employer entity a deduction for unreasonable compensation or for an excess parachute payment, while still treating the employee-insider as having received compensation taxable as ordinary income; or the imposition of an excise tax (under IRC Sec. 4999) on the recipient of an excess parachute payment.
[xix] In terms of a legally enforceable right or entitlement.
[xx] Which interest is protected under state law by the attorneys general of the states in which the nonprofit is organized or operates.
[xxi] IRC Sec. 501(a).
[xxii] IRC Sec. 170.
[xxiii] IRC Sec. 512(b)’s adjustments.
[xxiv] Reg. Sec. 1.501(a)-1.
[xxv] Over the last 30 and almost 40 years, respectively, I’ve often reviewed in vain many IRS Forms 990 and 990-PF in search of excess benefit and self-dealing transactions, respectively, that I was told had occurred yet were not disclosed. Some folks prefer a “quiet correction.”
[xxvi] IRC Sec. 509(a).
[xxvii] IRC Sec. 4941, the regulations promulgated thereunder, and the many public and private rulings interpreting these.
Congress also enacted the taxable expenditure rules, applicable to a transaction undertaken by a private foundation that does not accomplish a charitable purpose. IRC Sec.4945.
[xxviii] A tax is imposed on the participating disqualified person and on any foundation manager who participated in the act knowing it was an act of self-dealing.
An additional, and more severe tax is imposed if the act is not “corrected” (in general, undone to the extent possible) within a statutorily prescribed period.
[xxix] Acts of self-dealing include:
- Sale, exchange, or leasing of property, except when the leasing of property by a disqualified person to a foundation is without charge[xxix]
- Lending money or other extension of credit, except when the lending of money or other extension of credit by a disqualified person is without interest or other charge[xxix]
- Furnishing of goods, services, or facilities, except when the furnishing of goods, services, or facilities by a disqualified person to a foundation is without charge[xxix]
- Transferring foundation income or assets to, or for the use by or benefit of, a disqualified person[xxix] except when a disqualified person receives an incidental or tenuous benefit from the use by a foundation of its income or assets.[xxix]
Aside from the specific exceptions, these rules are applied without regard to whether the transaction in question is conducted on an arm’s length basis – in fact, it is immaterial whether the transaction results in a benefit or a detriment to the foundation.[xxix] In other words, the identified acts of self-dealing are be to be avoided in all circumstances.[xxix]
[xxx] As defined in IRC Sec. 4946. It generally includes the following: (a) a “substantial contributor” to the foundation, (b) a “foundation manager,” (c) a more than 20% owner of a business entity or trust which is a substantial contributor to the foundation, (d) a “member of the family” of any of the preceding individuals, (e) a corporation/partnership/estate-trust with respect to which any of the foregoing persons owns or holds more than 35% of the voting power/profits interest/beneficial interest, respectively.
[xxxi] The Code also prohibits “indirect” self-dealing – it seeks to prevent transactions from taking place indirectly (for example, through an organization controlled by a private foundation) that could not be accomplished directly between the private foundation and a disqualified person. Reg. Sec. 53.4941(d)-1(b).
That being said, the regulations contain several important exceptions to the indirect self-dealing rules.
[xxxii] As defined in Reg. Sec. 1.162-7.
[xxxiii] For a thorough discussion of the factors considered in determining the reasonableness of compensation, see https://www.irs.gov/pub/irs-lbi/Reasonable%20Compensation%20Job%20Aid%20for%20IRS%20Valuation%20Professionals.pdf.
[xxxiv] Including receipts generated from the performance of the services that provided the basis for the organization’s tax-exemption.
[xxxv] After all, who wants to be associated with a charitable organization with a reputation for being less than charitable? Wait, don’t answer that.
[xxxvi] In such cases, the intermediate sanctions (the penalty taxes) could be imposed on certain disqualified persons (basically, insiders) who improperly benefitted from an excess benefit transaction and on organization managers who participated in such a transaction knowing that it was improper.
[xxxvii] IRC Sec. 4958, enacted in 1996 by the Taxpayer Bill of Rights 2 (P.L. 104-168).
The Act also enhanced the oversight and public accountability of nonprofit organizations through additional reporting of information by nonprofit organizations to the IRS and increased public access to documents filed by such organizations with the IRS.
[xxxviii] To prevent avoidance of the penalty excise taxes in cases of private inurement of assets of a previously tax-exempt organization, the bill provides that an organization will be treated as an applicable tax-exempt organization subject to the excise taxes on excess benefit transactions if, at any time during the 5-year period preceding the transaction, it was a tax-exempt organization described in section 501(c)(3), or a successor to such an organization.
[xxxix] “Disqualified person” was defined to mean any individual who is in a position to exercise substantial influence over the affairs of the organization, whether by virtue of being an organization manager or otherwise. In addition, disqualified persons include certain family members and 35-percent owned entities of a disqualified person, as well as any person who was a disqualified person at any time during the five-year period prior to the transaction at issue. A person having the title of “officer, director, or trustee” does not automatically have the status of a disqualified person.
[xl] A tax-exempt organization cannot avoid the private inurement proscription by causing a controlled entity to engage in an excess benefit transaction. Thus, for example, if a tax-exempt organization causes its taxable subsidiary to pay excessive compensation to an individual who is a disqualified person with respect to the parent organization, such transaction would be an excess benefit transaction.
[xli] Reg. Sec 53.4958-4.
[xlii] An economic benefit is not treated as consideration for the performance of services unless the organization providing the benefit clearly indicates its intent to treat the benefit as compensation when the benefit is paid. An organization is treated as clearly indicating its intent to provide an economic benefit as compensation for services only if the organization provides written substantiation that is contemporaneous with the transfer of the economic benefit at issue. If an organization fails to provide this contemporaneous substantiation, any services provided by the disqualified person will not be treated as provided in consideration for the economic benefit for purposes of determining the reasonableness of the transaction. Reg. Sec 53.4958-4(c).
[xliii] Existing tax-law standards (see sec. 162) apply in determining reasonableness of compensation and fair market value. Reg. Sec 53.4958-4(b)(1)(ii).
[xliv] H.R. 104-506, at 56. Ways and Means Committee. Taxpayer Bill of Rights 2.
[xlv] Under IRC Sec. 162.
[xlvi] And also probably to promote good governance by providing a specific process for boards of directors to follow.
[xlvii] Reg. Sec. 53.4958-6.
[xlviii] For example, the IRS could establish that the compensation data relied upon by the parties was not for functionally comparable positions or that the disqualified person, in fact, did not substantially perform the responsibilities of such position.
[xlix] IRC Sec. 4958(a).
[l] Correction must be made on or prior to the earlier of (1) the
date of mailing of a notice of deficiency under section 6212 with
respect to the first-tier penalty excise tax imposed on the
disqualified person, or (2) the date on which such tax is assessed.
[li] When did that happen? It sucks getting old, doesn’t it?
[lii] Apologies to the late great Stephen Sondheim.
[liii] A disqualified person.
[liv] Reg. Sec. 1.501(c)(3)-1.
[lv] Some larger organizations have been accused, in some circles, of taking advantage of their tax-preferred status to generate what critics have characterized as large profits, a not-insignificant portion of which find their way, or so these critics assert, into the hands of the organizations’ key executives in the form of generous compensation packages.
[lvi] Instead of, say, furthering the charitable mission. It should be noted that these expenditures are not necessarily mutually exclusive. For example, https://form1023.org/nonprofit-ceo-salaries-executive-directors-compensations; https://qz.com/gateway/these-are-the-10-highest-paid-nonprofit-ceos-1851719031; https://nonprofitquarterly.org/million-dollar-compensation-nonprofit-ceos/; https://blog.charitywatch.org/2026-update-nonprofit-compensation-packages-of-1-million-or-more/ ,
[lvii] That’s right. The members of these boards elect themselves and their successors. It is rare for a larger charity to have “members” in a legal, “corporate law” sense– i.e., the counterparts to shareholders in a business organization – with voting rights, including the right to elect or remove directors. Rather, these charities depend upon honest, well-intentioned individuals to ensure that their charitable mission is carried out. Many of these individuals – the directors of the organization – are drawn from the business community. Of course, the Attorney General of the State in which a charity is organized also plays an important role in ensuring that the charity and those who operate it stay the course.
[lviii] IRC Sec. 162(m).
[lix] IRC Sec. 280G(b)(5).
[lx] It is certainly possible for an excise tax to be imposed on the executive and board under say, the excess benefit rules, when the compensation is found to be unreasonable, and for the newer excise tax to be imposed on the charitable organization when the compensation is greater than $1 million.
[lxi] Interestingly, the Act made no distinction between public charities and private foundations. In contrast, the comparable limitations for business organizations do not apply to “small business corporations” or certain non-publicly traded corporations.
[lxii] https://www.sciencedirect.com/science/article/abs/pii/S0882611009000261.
[lxiii] There is a comparable exception for physicians.