Excess Benefit Transactions and Their Impact on Not-for-Profits

READ ARTICLES FROM 2016 INTERNATIONAL FRAUD AWARNESS WEEK

 

Charitable organizations are generally associated with altruistic and benevolent intentions. Certainly, the vast majority of not-for-profit (“NFP”) entities are conceived with a charitable mission, such as helping those in need. However, the philanthropic nature of NFPs does not prohibit these entities from being susceptible to fraud, waste and abuse.

Despite the benevolent intent and purpose of NFPs, limited funding, strained resources, underpaid and overworked staff, weak internal controls and employees or fiduciaries who may have earned misplaced trust create an environment that is ideal for potential fraud, waste and abuse.

Statistical data published by the Association of Certified Fraud Examiners shows that fraud committed at NFPs have consistently been approximately 10% of all reported frauds for the past four years.¹  The cost associated with fraud is also significant as the median fraud loss for NFPs increased 20% from 2010 to 2014.²

The impact of fraud on NFPs extends well beyond the loss incurred from the fraud itself.  Far more detrimental is the associated effect on the organization’s reputation. Revelation of fraud can destroy public trust in an organization, resulting in loss of donations, which is the lifeblood of the organization.

The prerequisites for starting a charitable organization are somewhat onerous. The organization must be legally structured as a corporation or a trust, apply to the IRS for exempt status, demonstrate that it has a program to accomplish charitable intentions, demonstrate that it has the ability to generate appropriate donations and/or other funding, and register with the appropriate state authorities. Notwithstanding these procedures, in some cases, there may be a general lack of knowledge regarding the applicable laws and regulations that must be complied with if the NFP is to remain in good standing. It is important that the founders of the organization and boards of directors are educated regarding their fiduciary duties, responsibilities and potential liability under various statutes including the Internal Revenue Code. One of the regulations that can jeopardize exempt status is the prohibition against private benefits (the NFP is not considered a charity unless it serves a public rather than a private interest) or private inurement (no part of the NFP’s earnings inure for the benefit of a private individual, including insiders). A potential pitfall within the NFP world relating to waste and abuse are excess benefit transactions.

Defining Excess Benefit Transactions  

An excess benefit transaction, or EBT, is a transaction in which an economic benefit is provided by an applicable NFP, directly or indirectly, to or for the use of any disqualified person, and the value of the economic benefit exceeds the value of the consideration (including the performance of services) received for providing such benefit.³

A disqualified person, as defined under IRS Code Section 4958, is any person who was, at any time during the 5-year period ending on the date of any EBT, in a position to exercise substantial influence over the affairs of the organization.⁴ Disqualified persons can include voting members of an organization’s board of directors, officers of the organization, certain family members of persons in a position to exercise substantial influence of the organization’s affairs and any entity in which a disqualified person holds a 35% interest.

Considering the Impact of EBTs in the Context of Fraud, Waste and Abuse

Instances of fraud that involve disqualified persons would almost always be considered EBTs, as there is little or no value received by the entity in exchange for the funds disbursed in connection with the fraud.

However, some transactions occur that do not rise to a level which constitutes fraud, but which may be considered EBTs. These types of transactions can be just as detrimental to a charitable organization as a fraud. Types of transactions that may be considered EBTs are transactions with a disqualified person or a related party to a disqualified person including unjustifiable compensation arrangements, expense reimbursements, loans, purchases and/or sales of equipment and leasing agreements. Such transactions should be reviewed to ensure that the economic benefit to the organization is equal to amount paid by the organization. Such transactions should always be at market value.

In addition to transactions directly between the organization and a disqualified person, transactions with third parties should also be reviewed to ensure that it is the organization, and not a disqualified person, that is receiving the primary benefit of such transactions. Examples might be excessive entertainment expenses, automobile expenses, travel expenses, car and limousine services and credit card payments. These types of transactions can be more difficult to identify as EBTs. When reviewing such transactions it is imperative to ask, “Did this transaction benefit the organization or someone else?”

Examples of Possible EBTs and How to Identify EBTs  

Assume that a celebrity, who is also a board member, is paid a $150,000 performance fee to appear at an event for a NFP organization. In addition, the NFP pays travel costs for the celebrity board member and his family members. As this is a transaction between the NFP and a disqualified person, it has the potential to be an EBT. A review of the transaction should include a determination of whether the celebrity board member is able to command a $150,000 performance fee in other venues. If the celebrity is regularly paid $75,000 for performance fees this transaction would result in an EBT of $75,000. The travel fees for the board member’s family would also be considered an EBT if the family members are not a necessary part of the performance. In such a case, the disqualified persons (the family members) are receiving the benefit instead of the organization.

Another common example of an EBT is car service charges. Like their for-profit counterparts, NFP organizations typically have car service accounts, to be used for business purposes. An example of a board member or officer of the NFP using the NFPs car service account to get to and from the airport for a personal trip or for the benefit of his or her spouse running personal errand are examples of EBTs, since the disqualified persons received the benefits of the transactions, rather than the organization.

Payroll is another source of potential EBTs. Sometimes relatives of a disqualified person might be employees of the organization and therefore such employment relationships should be evaluated in a manner that measures the role of the employee and their contribution to the organization against their compensation. Does the employee perform a vital function? Is he or she working regular hours? Does the employee interact with other employees within the organization?  If this related person stopped working for the organization would the organization look to refill the position held?

The Impact of EBTs  

Monetary penalties resulting from EBTs can be significant. The first step to correcting an EBT is to undo the benefit to the extent possible, and take any additional measures necessary to place the organization in the same financial position it was in before the EBT.⁵  In most cases, the disqualified person would repay the amount of the EBT, plus interest, to the organization. In addition the disqualified person may be liable for an excise tax of 25% of the EBT.⁶  Failure to correct and report an EBT on a timely basis can lead to an additional tax of 200% of the EBT amount.⁷   Additionally, other individuals at the organization can be penalized for EBTs. A 10% excise tax can be levied against an organization’s manager who knowingly participated in an EBT.⁸  Egregious examples of excess benefit transactions can even put the organization’s tax-exempt status in jeopardy.

In addition to the monetary penalties for the disqualified persons engaged in EBTs, the NFP organization must also disclose the existence of EBTs on its tax filings on Form 990. Such disclosure can potentially damage the entity’s reputation and have a negative impact on fundraising efforts.

EBTs are something everyone in the NFP world needs to be aware of, including founders, employees, board members, officers and auditors. Transactions with insiders and other disqualified persons should always be reviewed with an air of professional skepticism. The risk of failing to do so is far too great.

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1  Association of Certified Fraud Examiners “Report to the Nations on Occupational Fraud and Abuse” p. 24.
2  Ibid.  Median fraud loss reported at $90,000 in 2010 and $108,000 in 2014
3  Internal Revenue Code §4958 (c) (1) (A)
4  Internal Revenue Code §4958 (f) (1) (A)
5  Internal Revenue Code §4958 (6)
6  Internal Revenue Code §4958 (a) (1)
7  Internal Revenue Code §4958 (b)
8  Internal Revenue Code §4958 (a) (2)

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FRAUD WEEK ARTICLES

• Preventative and Detective Fraud Controls in Accounting Software
• Fraud in the Workplace
• Do You Know Your Employee
• Important Considerations when Conducting an Effective Fraud Risk Assessment
• Expense Reimbursement Fraud
• Recognizing Vendor Fraud
• Occupational Fraud Prevention in Construction
• Excess Benefit Transactions and Their Impact on Not-for-Profit
• Health Care Fraud 
• Ponzi Schemes
• Occupational Fraud and Abuse Statistics