Excess Benefit Transactions: Tax Court Clarifies Definition of “Disqualified Persons”

Excess benefit transactions, where economic benefits provided to so-called “disqualified persons” are greater than the value of what was received by the nonprofit organization, can lead to hefty excise taxes for those individuals, as well as reputational damage to organizations themselves. And the definition of “disqualified persons” may be much broader than you realize.

In a recent ruling, the U.S. Tax Court rejected the notion that only people with a formal affiliation with an organization can be disqualified persons. Rather than focusing on narrow definitions, the court considered the substance of the relationship with the nonprofit.

Rotten relationship

The taxpayer in the case was a Pennsylvania state senator from 1978 to 2008. In 2009, he was convicted of federal corruption charges, including wire and mail fraud. One of his victims was an organization that three of his staff members incorporated in 1991, at his direction, which was later granted tax-exempt status. Two of the staff members served as officers, and one as executive director, at various times, but all while still employed by the senator.

The senator was never an officer or employee. However, he used his position as chair of a senate appropriations committee to obtain funding for the organization, including at least $15 million in public grants and a comparable amount from private sources. In addition, he testified at his criminal trial that he approved most significant projects and directed many major expenditures. He also admitted to receiving numerous “perks and gifts” from the nonprofit, such as tools worth $43,000, a bulldozer used exclusively on his farm and the use of various vehicles. The nonprofit paid for foreign travel, the services of a private investigator and cell phone service for his chauffeurs and daughter.

In May 2013, the IRS determined the senator was liable for excise taxes under Internal Revenue Code Section 4958. That section imposes a tax on disqualified persons involved in excess benefit transactions with a charity. The former senator contended that he wasn’t a disqualified person with regard to the nonprofit.

Relevant factors

Under federal tax law, a disqualified person is someone who, during a five-year look-back period, was in a position to exercise “substantial influence” over an organization’s affairs. Certain individuals are automatically deemed to be in such a position, including voting board members, presidents, CEOs, COOs and CFOs. Certain family members of disqualified persons also are considered disqualified.

A disqualified person is a person who, during a five-year lookback period, was in a position to exercise “substantial influence” over the organization’s affairs.

As the court noted, though, those aren’t the only parties who exert substantial influence over an organization. The applicable tax regulation enumerates seven nonexclusive factors that tend to show a person has substantial influence under a “facts and circumstances” test. The court found several of these went against the senator.

For example, the first factor is whether the person founded the organization. The senator testified that he “created” the nonprofit. It was incorporated at his direction by his staff members, two of whom listed his senate office as their address. The senator’s assertion that he didn’t form the entity because the staff members were the literal incorporators, the court said, was a “hypertechnical argument that ignored the substance of what occurred.”

The senator also satisfied the second factor — he was a “substantial contributor.” Someone can qualify as a substantial contributor if the person’s annual contributions represent as little as 2% of total contributions. Although the senator didn’t appear to donate directly, he was responsible for raising virtually all the organization’s funding.

Finding substantial influence

The clearest indicator that the senator was in a position to exercise substantial influence, though, was that he in fact exercised such influence repeatedly over a period of many years. The trial court in the criminal case found that the benefits he extracted from the organization caused it to suffer a cumulative loss of more than $1.1 million. The Tax Court found he couldn’t have achieved this without wielding substantial influence.



Two months after ruling in this case (above), the U.S. Tax Court released its decision in another “disqualified person” dispute. In that case, the determination that the individual was a disqualified person was more clear-cut, but the case illustrates the danger of not promptly addressing excess benefit transactions when the IRS flags them.

The taxpayer was married to the nonprofit’s founder and president. In 2015, the IRS opened an examination into the organization. Among other things, it determined the taxpayer received unreported excess benefit transactions of $130,000 (including $15,000 in health insurance), which were used to cover the family’s personal expenses.

The court held that the health insurance benefits didn’t constitute an excess benefit but found the taxpayer owed a first-tier tax of $28,750 (25% of the $115,000 excess benefits). She also was liable for a second-tier tax of $230,000 (200% of the excess benefits) because she failed to correct the excess benefit transaction in a timely manner after IRS notification.


You can always reach out to Sechler Morgan CPAs with your questions at answers@azcpa.com.