Exemption from federal income tax carries significant responsibilities and restrictions, especially regarding transactions with related parties, also known as “insiders.” Leaders must understand these rules to protect both their mission and their organization’s tax-exempt status.
At the heart of the IRS’s oversight of insider transactions are prohibitions against private inurement and excess benefit transactions. These rules make sure the organization’s resources are devoted to its exempt mission and not diverted for the personal benefit of insiders or other private individuals.
What Are Insider Transactions?
Insider transactions are financial relationships or exchanges between a tax-exempt organization and individuals (or entities) with significant influence over the organization’s affairs.
The IRS does not completely prohibit all transactions between an organization and insiders. Rather, the law prohibits transactions that improperly benefit insiders at the expense of the organization or its exempt purpose. IRS
Two core doctrines underlie IRS scrutiny of insider transactions:
- Inurement and Private Benefit: Tax-exempt organizations may not operate in a way that directly enriches insiders or provides more than incidental benefit to private persons. Impermissible inurement can jeopardize tax-exempt status.
- Excess Benefit Transactions: Internal Revenue Code Section 4958 imposes excise taxes on certain transactions that confer a benefit exceeding fair value to insiders, called “excess benefit transactions.”
Understanding these concepts is essential for good governance and compliance.
Who Is an “Insider”?
The IRS uses the term “disqualified person” to define insiders subject to the excess benefit transaction rules. A disqualified person is someone who was in a position to exercise substantial influence over the organization at any time during the five-year period preceding the transaction. IRS
Disqualified persons commonly include:
- Officers, directors, and trustees
- Key employees with authority over budgets or policy
- Major donors with significant influence
- Family members of disqualified persons
- Businesses or entities controlled by disqualified persons
Titles alone are not determinative. Someone without a formal role may still be considered a disqualified person if they effectively control or influence organizational decisions. Leaders should therefore think broadly about who may qualify as an insider.
The critical factor is influence, not title alone.
What Is an Excess Benefit Transaction?
An excess benefit transaction occurs when an organization provides an economic benefit to a disqualified person and the value of that benefit exceeds the value of the consideration (including services) received in return.
Common examples include:
· Compensation that is unreasonable or above market norms
· Loans to insiders with favorable terms or no repayment expectations
· Sales or leases of property at below-market rates
· Severance or deferred compensation packages that lack justification
The IRS evaluates these transactions by comparing the value transferred to the insider with the value received by the organization. If the insider receives more than fair market value, the difference is considered an excess benefit.
Reporting Transactions with Insiders
All transactions with insiders, whether or not there is private benefit or excess benefit, must be reported on Schedule L of form 990. This allows the IRS and the public to gain visibility into these transactions. Schedule L includes five parts:
· Part I – Excess Benefit Transactions
· Part II – Loans to and/ or From Interested Persons
· Part III – Grants or Assistance Benefitting Interest Persons
· Part IV – Business Transactions Involving Interest Persons
· Part V – Supplemental Information
Part IV of Form 990 asks a series of questions (lies 38a-40b) about transactions with insiders. Form 990 filers that answer yes to any of those questions must complete and file the applicable parts of Schedule L. Form 990-EZ filers that answer yes to Form 990-EZ, lines 38a or 40b must also complete Schedule L.
If there has been an excess benefit transaction, the organization may also need to file form 4720 – Return of Certain Excise Taxes on Charities and Other Persons under Chapters 41 and 42 of the Internal Revenue Code, to report the penalties for the improper insider transaction.
Penalties for Improper Insider Transactions (Intermediate Sanctions)
When an excess benefit transaction occurs, the IRS may impose excise taxes rather than immediately revoking exemption.
The penalties include:
- A 25% excise tax on the disqualified person receiving the excess benefit,
- An additional 200% excise tax if the excess benefit is not corrected within the allowed period, and
- A 10% excise tax (up to a statutory cap) on organization managers who knowingly approved the transaction.
These penalties can be financially significant and personally burdensome for both insiders and board members. Correction of the excess benefit (plus interest) is required to avoid escalating penalties.
Correction and Avoidance of Excess Benefit Transactions
If an excess benefit transaction occurs, it can be corrected by placing the organization back in the financial position it would have been in had the transaction been arm’s-length. Corrections often involve repayment of excess benefits plus interest. This will avoid more severe penalties and preserve tax exemption. If the transaction is corrected before the close of the tax year in which it occurred, no disclosure is required.
IRS rules also allow a “rebuttable presumption of reasonableness” when approving certain transactions, which can protect organizations from a finding of excess benefit if specific safeguards are met:
- A committee composed entirely of independent individuals approves the transaction,
- The committee relies on appropriate data (e.g., comparability data), and
- The committee documents the basis for its decision contemporaneously.
Meeting these criteria shifts the burden of proof to the IRS to demonstrate that the transaction was unreasonable.
Best Practices to Avoid Insider Transaction Issues
Strong governance is the best defense against insider transaction issues. Leaders should ensure that their organizations implement and consistently follow best practices, including:
- Conflict-of-Interest Policies: Require disclosure of personal or financial interests and recusal when conflicts arise.
- Independent Review: Use independent board members or committees for compensation and major financial decisions.
- Fair Market Valuations: Obtain and document objective data supporting transaction terms.
- Clear Documentation: Maintain detailed meeting minutes and approval records.
- Ongoing Board Education: Train board members and executives on fiduciary duties and IRS rules.
These practices not only reduce risk of IRS sanctions but also reinforce public trust.
When Insider Transactions Risk Exempt Status
While intermediate sanctions apply to many excess benefit situations, repeated or systemic insider benefit abuses may signal that the organization is operated for private interests rather than public benefit. In such cases, the IRS may revoke the organization’s tax-exempt status under the operational test or private inurement doctrines.
Organizations should take this risk seriously. A pattern of insider enrichment, inadequate oversight, or failure to document arms-length processes undermines public trust and IRS confidence.
Conclusion
Transactions with insiders are among the most scrutinized areas of nonprofit governance. For leaders of tax-exempt organizations, implementing strong policies, maintaining documentation, and regularly training board members are critical to avoiding excess benefit issues. With a clear understanding of IRS rules and a proactive compliance culture, organizations can safeguard their tax-exempt status while fulfilling their missions.
If your organization has complex insider transactions or anticipates them, feel free to contact our Compliance Lead, Rebecca Christiansen at rchristiansen@evergreenalliancecpa.com