Reasonable Compensation Can Still Result in Intermediate Sanctions
Reasonable Compensation Can Still Result In Intermediate Sanctions
By Tim Snavely, CPA & Troy Lindsey, CPA
If a tax-exempt organization pays for a disqualified person’s personal expenses, e.g., a vacation or the personal use of a car, and it doesn’t substantiate the benefit was paid as consideration for services, the payment may be an automatic excess benefit transaction and subject to penalties.
Such penalties result from intermediate sanctions. A disqualified person includes an officer, director or such other person in a position to exercise control over the tax-exempt organization.
IRS Rules For Expressing Intent
The IRS says even if the benefit was reasonable (and total compensation would be reasonable if the benefit had been taken into account) the receipt of the benefit without documentation that it was for services can be automatically subject to intermediate sanctions.
The IRS’s enforcement position was published in its FY 2004 continuing professional education text and indicates an economic benefit received from a tax-exempt organization is considered compensation for services performed for the organization only if it “clearly indicated its intent to so treat such benefit.”
The industry has generally held that this intent can be satisfied by including the benefit as compensation on Form W-2 for an employee or on Form 1099 for a board member or other non-employee. In addition, intent is expressed if the disqualified person reports the item as income on his/her tax return for the year.
There are a number of expense types to consider when reviewing these issues, including:
- Spousal travel
- Personal use of assets, such as automobiles and cell phones
- Club memberships
- Business-related travel
Document Personal Expenses
Whether an expense is personal or business depends on the particular facts. A benefit, such as the business use of a car, may be disregarded as an item of compensation because it’s a working condition fringe benefit; however, personal use is not disregarded.
If neither the individual nor the organization reports the personal use as compensation, the benefit will be an automatic excess benefit transaction.
If an individual has use of a business vehicle, keep auto logs to document business vs. personal use, e.g., commuting to work, family trips, etc. If personal use is reported as compensation for services, then that benefit, along with other included compensation, will be aggregated to determine if compensation is reasonable.
Substantiating Expenses
One of the many areas subject to enhanced IRS scrutiny during examinations is the substantiation of the business purpose for expenses incurred by employees:
- To adequately substantiate travel away from home, an employee must establish the amount, time, place and business purpose of each expenditure.
- To adequately substantiate entertainment, an employee must establish the amount, time, place, business purpose and business relationship of the people he/she entertains, including sufficient information to establish the business relationship between the employee and the guest.
While asking employees to substantiate the business purpose and to also collect other required documentation may not seem difficult in theory, actually getting employees to follow these rules can be difficult and cumbersome.
Let’s face it; compared to for-profit organizations, standards for compliance are much greater for tax-exempt entities. For-profits only face a payroll risk with noncompliance, but tax-exempts risk that and intermediate sanctions.
Example
In addition to a $375,000 annual salary, assume a tax-exempt organization provides a key executive the personal use of a car and a country-club membership. The fair market value of the salary, car and country-club membership is $400,000, an amount determined reasonable for this individual’s services.
Also, assume this executive incurs travel and entertainment expenses of $20,000 for business purposes, expenses not adequately documented under IRS standards. The W-2 issued for the year reflects only the $375,000 of salary. Form 990 also reflects only the $375,000 of taxable compensation.
Under IRS audit guidelines, the unreported $25,000 of taxable personal benefits, and the $20,000 of unsubstantiated travel and entertainment expenses would constitute automatic excess benefit transactions subject to a 25 percent penalty with an additional 200 percent penalty if the excess benefits are not corrected, e.g., repaid to the organization within a reasonable time.
There also is a 10 percent penalty imposed on any organization manager (potentially to include board members) who knowingly participates in the excess benefit transaction.
Review Reporting Practices
Automatic excess benefit rules raise the stakes for various transactions and substantiation procedures of all tax-exempt organizations, including those in the health care industry.
Therefore, review compensation reporting practices, including the taxable fringe benefits and expense documentation your organization reports (or does not report) on Forms 990, W-2 and 1099. Remember, the risk of intermediate sanction penalties exists even when overall compensation is reasonable.
This article is reprinted with permission of BKD, LLP from its Health Care News newsletter, May 2006.
Tim Snavely (tsnavely@bkd.com) is a partner and Troy Lindsey (tlindsey@bkd.com) is a senior in the
