Unreasonable Compensation Is A Diversion Of Funds

October 22, 2015       The NonProfit Times      

In the Governing Body and Management section of the annual federal Form 990, managers at tax-exempt organizations are asked to address the following question: Did the organization become aware during the year of a significant diversion of the organization’s assets?

The Internal Revenue Service (IRS) defines a “significant diversion of assets” as embezzlement, theft, fraud or other improper use of funds exceeding the lesser of 5 percent of the organization’s current annual gross receipts, 5 percent of the organization’s total assets at the end of the year, or $250,000.

The Washington Post published an October 2013 report, “Inside the Hidden World of Thefts, Scams and Phantom Purchases at the Nation’s Nonprofits,” that showed “more than 1,000” tax-exempt organizations where the response was “yes” to the aforementioned question, based on returns filed from 2008 to 2012. Additionally, disclosures of required details were lacking on the returns with respect to the significant diversion.

Reporting a significant diversion requires transparency, which includes explaining the nature of the diversion, dollar amounts and property involved, along with any corrective actions the organization takes to address the matter. The IRS is concerned that there are so many reports of a significant diversion that fail to provide the required transparency.

The occurrence of a significant diversion and failing to provide the required transparency are indications that an organization might have inadequate internal controls over financial accountability and poor governance. The IRS has made it clear that good governance is essential to ensure that exempt-purpose assets are used exclusively for charitable purposes.

Significant diversions can go undetected if there are inadequate internal controls or if there are insufficient procedures in place to monitor internal controls over financial reporting and the safeguarding of assets.

Be Proactive

A significant diversion is less likely to occur if nonprofit managers have good internal controls of assets. Most nonprofit organization are audited annually to comply with funding source or state charity registration requirements, and the annual audit should include feedback to management and the board identifying opportunities to proactively strengthen internal controls and improve efficiency of accounting policies and procedures.

Nonprofit leaders should always ask their auditors to put management comments in writing, even when it is not required, as this motivates corrective action.

Accurate, timely internal reporting also helps an organization achieve its mission by providing crucial information necessary for strategic decision making. Nonprofit managers should ask the auditors how they document their understanding of the organization’s internal controls. Do they:

* Test controls across different types of transaction categories;

* Perform substantive analytics;

* Discuss with management, employees and board members how the organization prevents, detects and deters fraud;

* Perform risk analysis;

* Review the organization’s documented accounting policies and procedures; and,

* Communicate internal control deficiencies and make recommendations regardless of whether the internal control deficiencies are a significant deficiency or a material weakness?

Excess benefit transactions occur when a manager, officer, director, trustee or someone who is in a position to exercise substantial influence over the affairs of the organization, collectively defined as a “disqualified person,” receives unreasonable compensation.

Other common examples of excess benefit transactions include the sale of the organization’s property to a disqualified person for less than the fair market value, the sale of a disqualified person’s property to the organization for more than the fair market value, expense reimbursements without submitting an expense report and supporting documentation, and payment of personal expenses.

To qualify as tax-exempt under the Internal Revenue Code, “no part of the organization’s net earnings can inure (accrue) to the benefit of any private shareholder or individual.” Inurement is defined as occurring whenever a disqualified person receives funds or property from a tax-exempt organization in return for which the disqualified person gives insufficient consideration in exchange.

Occurrence of any form of unreasonable compensation to a disqualified person is a diversion of funds from the exempt purpose and is deemed an excess benefit transaction. The excess benefit transaction also has the potential to be classified as a significant diversion if it meets the IRS definition. Failure by management and the board of the tax-exempt organization to prevent excess benefits can also ultimately result in loss of tax-exempt status.

The organization violates the statutory prohibition against inurement if excess benefit transactions are occurring. The IRS imposes statutory excise taxes on the value of the excess benefit: A 25-percent excise tax is imposed on the disqualified person; a 10-percent excise tax is imposed on any participating manager; but, no excise tax is imposed on the organization.

However, if managers do not take appropriate corrective action to prevent excess benefits transactions from continuing to occur, the IRS can revoke the organization’s tax-exempt status.

The best protection for avoiding substantial diversion is to implement and monitor sufficient internal controls and enforce accountability by the management team and the board.


Sarah G. Avery, CPA, is a director at Friedman LLP in East Hanover, N.J. She is a member of the New Jersey Society of Certified Public Accountants. Her email is savery@friedmanllp.com