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Time to review compensation? — Keep excess benefit transactions in mind

In a tight job market, where nonprofit organizations are competing with for-profit businesses for talent, you may find it necessary to raise your compensation. If so, keep in mind the potential tax penalties that can result if the IRS deems your compensation more than reasonable. Here are some answers to common questions on the topic.

Who’s involved?

Excess benefit transaction (EBT) rules generally apply to “covered organizations,” meaning 501(c)(3) and 501(c)(4) organizations. They don’t, however, apply to private foundations. The rules also involve “disqualified persons,” including:

  • Individuals in a position to exercise substantial influence over your organization’s affairs,
  • Family members of disqualified individuals,
  • Entities in which disqualified individuals have a 35% or greater stake,
  • Individuals able to substantially influence a Section 509(a)(3) supporting organization, and
  • Donors and donor advisors involved in transactions with donor-advised funds (DAFs).

Family members generally include a disqualified person’s parents, siblings and their spouses, children and their spouses, and grandchildren and their spouses. Under proposed regulations, the definition of “donor-advisor” would include personal investment advisors who manage the investment or provide investment advice related to both the DAF assets and the donor’s personal assets.

What’s an EBT?

Generally, an EBT is a transaction with two components:

  1. A covered organization must directly or indirectly provide an economic benefit to a “disqualified person,” and
  2. The value of the benefit must exceed the value of the consideration the nonprofit received in exchange from the disqualified person.

The IRS examines all consideration and benefits exchanged.

What are the potential tax risks?

Although revocation of your tax-exempt status technically is possible, in practice, the sole penalty is “intermediate sanctions,” also known as an excise tax. Disqualified individuals who engage in EBTs face an excise tax of 25% of the excess benefit received. They should make a timely correction to the transaction by, for example, returning the excess benefit. If they don’t, the IRS will impose an additional excise tax of 200% of the excess benefit.

Notably, your nonprofit’s managers also are at risk of a financial penalty. A manager found to have knowingly participated in an EBT might end up on the hook for a 10% tax on the excess benefit up to $20,000, to be paid by the individual.

How can you reduce threats?

The tax regulations provide nonprofits a safeguard known as the “rebuttable presumption of reasonableness.” The compensation you pay disqualified persons is presumed to be reasonable if you satisfy three requirements:

1. Advanced approval from an authorized body. The compensation arrangement should be approved by your board of directors or a board committee composed entirely of individuals who don’t have conflicts of interest.

2. Comparability. The authorized body must obtain and rely on appropriate data on the comparability of the compensation before making its determination. Appropriate data includes compensation paid by similar organizations for comparable positions, the availability of similar services in your geographic area and current compensation surveys compiled by independent firms.

3. Documentation. The authorized body needs to adequately — and concurrently — document the basis for its determination. Documentation must note the transaction’s terms and the date it’s approved; the members of the authorized body present for debate of the transaction and who voted on it; and any actions taken by a member who has a conflict of interest.

The documentation also must include comparability data and how it was obtained. This can be difficult to come up with — but smaller organizations are in luck. Authorized bodies of nonprofits with annual gross receipts of less than $1 million can fulfill the requirement if they have data on compensation paid for similar services by three comparable organizations in the same or similar communities for similar services.

Protect your organization

Rising salaries are a fact of life for many organizations. To avoid penalties, take the time to get reasonable-compensation reviews for your highest-paid employees. We can help you through the review process.

Highlights of the revised Uniform Guidance

Federal agencies were required to adopt the U.S. Office of Management and Budget’s (OMB) latest revised Uniform Guidance (UG) by October 1, 2024. It affects organizations with a fiscal year ending September 30, 2025, and later. The revisions are being welcomed by many nonprofit organizations because the changes aim to help reduce the burden on recipients and subrecipients of federal grants and other financial assistance. Read on to learn about some of the ways OMB is trying to make life easier for nonprofits.

Raise the thresholds

The revised UG increases several important thresholds, such as the threshold for determining if your organization is subject to a single audit of its financial statements and programmatic compliance. The audit requirement now applies only to nonprofits that spend at least $1 million in federal financial assistance in the fiscal year, up from a previous $750,000.

It also amends the Type A/B threshold for entities with total federal expenditures of $34 million or less (an increase from $25 million). For these organizations, the threshold to determine if a program is Type A for purposes of the single audit major program determination rose to $1 million from $750,000. The threshold for Type B programs requiring risk assessment increased to $250,000. Additional changes have been made to the thresholds for organizations with total annual federal expenditures exceeding $34 million.

The thresholds for equipment and unused supplies doubled to $10,000. As a result, you can expense equipment purchased for less than $10,000 — rather than capitalizing it over time — and keep, sell or otherwise dispose of it with no further responsibility to the federal agency. In addition, if unused supplies exceed $10,000 in total aggregate value at the termination or completion of a project or programs (and the supplies aren’t needed for another federal award), you must retain them to use on other activities — or sell them. Either way, you’re required to compensate the federal government for its share.

Increase the de minimis cost rate

The de minimis indirect cost rate has increased from 10% to 15% of Modified Total Direct Costs (MTDC). You may apply for lower rates if desired, but you can’t be required to apply for lower rates, unless mandated by statute. The revised UG makes clear, too, that pass-through entities must accept federally negotiated indirect cost rates for subrecipients. This means that if your nonprofit has negotiated rates with one federal agency, it will receive the same cost rate from all other federal, state and local agencies.

Note, though, that the revised UG changes the exclusion amount for subaward costs in the MTDC computation. It jumps from $25,000 to $50,000. OMB has also indicated that it might permit recipients and subrecipients to use direct labor as the base for the de minimis rate (instead of the MTDC) at some point in the future.

Encourage community engagement

The UG includes several changes that recognize that the communities most in need of assistance often have trouble navigating the complex process of grant application. For example, it eliminates the requirement to use English in notices, applications and reporting. The revised UG also requires federal agencies to improve the official descriptions of their programs (referred to as “Assistance Listings”) in the Federal Program Inventory, a new searchable website with information on the spending associated with all federal assistance programs.

Further, it instructs federal agencies to simplify their Notices of Funding Opportunities. For example, agencies must now provide basic information at the top of a grant announcement and use plain language, not jargon, when describing program requirements.

Leverage opportunities

Although many of the UG’s changes are favorable for nonprofits, the changes may require some adjustments to policies within your organization. We can help you understand the changes and advise on ensuring compliance.

Understanding board-designated net assets

Sometimes donors put restrictions on their donated funds, and in other instances, nonprofit boards place limits on certain assets. Board-designated net assets can prove critical to the survival of programs, projects — or even your organization itself. Let’s take a closer look.

What they are

The term “board-designated net assets” generally refers to funds that haven’t been restricted by donors but are subject to self-imposed limits on their use. They’re typically intended to ensure that funding is available when needed. Board-designated funds also can play a role in fundraising by demonstrating your organization’s commitment to a specific plan or program.

They may be designated for a special, one-off purpose or set aside on an as-needed basis for a specified period of time (for example, covering contingent liabilities that may or may not arise). Unlike net assets with donor restrictions, where only the original donor may remove the restrictions, designated funds can be undesignated at the discretion of your board of directors and therefore are considered to be unrestricted.

In most cases, funds are designated by a board, but, in some organizations, a board assigns this responsibility to management. Ideally, it’s assigned to specific positions (such as chief financial officer) that possess the requisite knowledge and judgment, rather than to specific individuals. In such circumstances, be sure to formally document these delegations. In addition, have your board regularly review actual designations made by management. And, of course, properly document every net asset designation.

When to disclose them

There are benefits to taking the time to properly document board designations. For example, the practice will make it easier to comply with financial reporting requirements in Financial Accounting Standards Board Accounting Standards Update (ASU) 2016-14, Not-for-Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities. ASU 2016-14 requires nonprofits that follow U.S. Generally Accepted Accounting Principles to disclose board-designated net assets and their purposes on their financial statements or in the notes to those statements.

Also bear in mind that designating net assets can affect the amounts in your liquidity and the availability disclosure. Designating a large chunk of cash for a capital project, for example, could reduce your liquidity.

How to manage them

Your organization should adopt formal policies and procedures related to managing board-designated net assets. For example, your policy should require your board to establish objectives for designated net assets. That might include providing an internal line of credit to better manage cash flow and allow financial flexibility. Other objectives could be related to funding future programs or projects, maintaining reserves, or funding an endowment.

Be sure your policy clearly delineates authority. Document whether it’s your board or management that can designate and undesignate funds, and under what circumstances exceptions are allowed.

Finally, describe procedures for monitoring designated net assets, including stating whether funds will be segregated. Procedures are necessary to track expenditures and comply with applicable reporting requirements as well.

Take a closer look

Board-designated net assets have their own obligations and responsibilities. If your organization is considering this option, consult with your CPA to help with the details.

Endowment management 101

If your nonprofit has an endowment, you understand that it’s a major responsibility. For example, organizations must adhere to certain regulations, including when it comes to spending from investment income. For this reason, many nonprofits opt to have a financial professional manage their endowment investments. But even if you have professional guidance, it’s important for both your staff and board members to know the basics of endowment management.

Making prudent decisions

First, it’s important to distinguish endowments from operating reserves. Endowments generally are designed to provide steady income while their core investments grow untouched. That steady income can be a financial safeguard in times of crisis.

A significant portion of most nonprofit endowment assets are restricted funds. Organizations generally must conform to provisions of the Uniform Prudent Management of Institutional Funds Act (UPMIFA). Among other things, UPMIFA allows nonprofits to include appreciation of invested funds as part of what’s “spendable” in addition to realized gains, interest and dividends.

UPMIFA also provides guidance for “prudent” decisions. It suggests that spending more than 7% of an endowment in any one year generally isn’t fiscally responsible; however, not all states have enacted this provision. And UPMIFA specifies procedures for nonprofits to change an endowment’s purpose — useful for those that may be dedicated to obsolete or impractical purposes.

Creating a spending policy

Your spending policy should define how much of your endowment fund’s income can be spent on operations each year. Often, this is defined as a percentage of between 4% and 7% of a rolling average of endowment investments. A rolling average helps even out the ups and downs of market returns and prevents the endowment’s contribution to any one budget year from being significantly lower than contributions to other years.

However, this approach doesn’t address whether your endowment fund will be able to maintain a similar level of funding for future operations. Also, because investment returns usually don’t correspond to the inflation rates that affect your operating budget, your spending policy should be based on more than just recent returns. To factor inflation into your spending policy, you might start with a relatively conservative, inflation-free investment rate of return. Then, adjust it for inflation to arrive at a spending rate you can apply on an annual basis.

Keeping it current

If you haven’t done so recently, now’s the time to review your organization’s endowment spending policy. Economic realities or developments within your nonprofit may have changed since your policy’s inception. Check with your CPA or investment professional to discuss changes to your policy to meet your needs.