Tax Matters: New Payroll Tax Credit and Intermediate Sanctions

A few weeks ago I wrote about protecting the tax-exempt status of your nonprofit organization. As promised therein, this post covers intermediate sanctions; however, before I broach that topic, I wanted to pass along a quick tax note.

Earlier this month, President Obama signed the Hiring to Restore Employment Act (or the HIRE Act). One key provision allows most nonprofit and some for-profit organizations to keep their share of the 6.2% payroll tax on certain new hires of certain individuals for the rest of 2010. The new hire must NOT: (1) have worked more than 40 hours in the previous 60 days; (2) replace an existing employee (unless the former employee left voluntarily or for cause); and (3) be related to owners or managers of the hiring organization. Additionally, if the employer is a nonprofit, the new employee must perform work that furthers the employer’s tax-exempt purpose. The Act also includes other provisions such as a new hire retention credit.  Please check the IRS website for additional details if you think your organization or business could benefit from the HIRE Act. 

Now, back to the subject at hand. The sanctions are called "intermediate" because they generally don’t threaten the tax-exempt status of a nonprofit. They were developed because the IRS wanted a system more flexible than the all-or-nothing decision to revoke or not revoke tax-exempt status of questionable organizations. 

Essentially, intermediate sanctions penalize "disqualified persons" from entering into "excess benefit transactions" with tax-exempt organizations. The Internal Revenue Code defines a "disqualified person" as someone who was in a position to exercise substantial influence over the dealings of the organization at any time during the five year period ending on the date of the transaction in question. These are generally the directors, officers, key employees, founders, substantial contributors and employees with compensation based on revenue. Family members of "disqualified persons" also tend to be deemed "disqualified". 

There are two types of "excess benefit transactions". The first occurs when a benefit is provided directly or indirectly by an organization and the value of that benefit exceeds the value of consideration, including services, received by the organization in return. In other words, the "disqualified persons" are getting more than they paid for. The second are revenue sharing transactions with a disqualified person that violates the prohibition on private inurement (as discussed in my previous blog post). 

The penalties for intermediate sanctions can be quite stiff. Initially there is a 25% excise tax applied to the disqualified person. Such penalty will jump to 200% if the transaction is not corrected before an IRS audit. If there is more than one disqualified person in an excess benefit transaction, all are jointly and severally liable. There is an additional tax equal to 10% of the excess benefit imposed on any managers of the organization who knowingly participated in or failed to stop the excess benefit transaction, but there is an exception if the participation is not willful.  

Because of all they do for their respective positions, "disqualified persons" are the lifeblood of the organizations they are involved with. Thus, it is important to protect them and make sure they are aware of the potential for intermediate sanctions.