This article is meant as an overview to intermediate sanctions and who is a disqualified person under that excise tax regime. Readers should be aware that this is meant as a “Disqualified Persons: 101” level discussion. There are many nuances in the application of these rules, for example, for entities with complex structures, supporting organizations, or donor advised funds that are not discussed in this article.
As many of us are all too aware, the price of the benefits resulting from holding tax exempt status is that organizations are subject to significant scrutiny and regulation of their activities. As a part of that oversight, those managing a tax exempt organization are likely to be familiar with the need to pay special attention to transactions with insiders. What you may not be familiar with is the level of special attention you need to pay to transactions with insiders which may violate the limitations on private inurement and private benefit. Those limitations are enforced through the intermediate sanctions excise tax regime and require understanding (or knowing when to reach out for assistance in understanding) a specific definition of “disqualified persons.” 
Prior to 1996, the only sanction available to the IRS for organizations who engaged in private inurement was revocation. However, in 1996 the intermediate sanctions rules were enacted to provide an “intermediate” option between doing nothing and revocation of exempt status. These rules allow the IRS to impose an excise tax on insiders who improperly benefit from a transaction with a §501(c)(3) public charity or §501(c)(4) social welfare organization . Improper benefit is also known as an excess benefit and is understood to mean the disqualified person transacting with the organization received a better than fair market value result from that transaction. Disqualified persons who engage in an excess benefit are subject to an initial 25% tax on the excess benefit. If the excess benefit isn’t corrected promptly enough, then the penalty increases to 200%. Organizational managers that knowingly approved an excess benefit are subject to a 10% tax on the benefit.
Because the penalties are significant and fairly unforgiving, It is important for organizations to understand who (people and entities) are disqualified persons with respect to their organization. If organizations are engaging in transactions with certain disqualified persons, then the intermediate sanctions rules come into play.
When we are considering who is a disqualified person, we are concerned about people that may have had the opportunity to use the organization to their own advantage. This includes people that were in a position of substantial influence or control over an organization at the time of a transaction, or at any time in the five years prior to the transaction. Certain people are disqualified persons by definition:
In true IRS fashion, the above is not a complete explanation of who may be a disqualified person. Even if someone is not a disqualified person by definition, s/he can still be considered a disqualified person based on other factors. Factors tending to indicate that someone has substantial influence (and thus a disqualified person) include : founder of the organization; the person receiving revenue-based compensation from the organization; and the person has control over a significant portion of the organization’s operations, budget, etc. Factors that tend to indicate a person does not have substantial influence over an organization include: the person has taken a bona fide vow of poverty; s/he is a contractor solely providing professional advice and without decision-making authority (like a lawyer or a CPA); the direct supervisor of the person is not a disqualified person; and any benefits s/he receives as a result of a donation is the same as offered to other donors giving comparable amounts. There is unfortunately no clear formula to compare the above factors and other factors relevant to whether someone has substantial influence, and so the determination should always be made with care.
The intermediate sanction excise tax regime and the penalties it imposes in situations in when there is an excess benefit transaction are not meant to completely prevent organizations from entering into transactions with insiders. Instead, the purpose is to make sure that those transactions are fair to the organization and that funds are properly devoted to charitable and social welfare purposes. Therefore, it is important to understand who those people (or entities) are so the organization knows it needs to slow down and ensure the transaction is proper before proceeding.
1. Managers of certain public charities need to be aware that there is a different definition of “disqualified persons” that applies with regard to the public support test. The disqualified person definition in that context is the same as the definition in the private foundation context under the self-dealing rules.
2. Or §501(c)(29) organizations.
3. Or, substantial contributors, defined as those that gave the greater of $5,000 or 2% of the total contributions received by the organization in a taxable year.
4. A family member includes: spouse; brothers and sisters; spouses of brothers or sisters, ancestors, children, grandchildren, great grandchildren, and spouses of children, grandchildren and great grandchildren.
5. Note that there rules that require that the interests of certain family members be combined.
Emily Robertson has spent much of her career working in and around nonprofit organizations. In 2011, she started Robertson Law Office, LLC, through which she helps nonprofits with tax, business, and employment law issues. She volunteers for various organizations, including as a board member of the Charities Review Council. Emily is adjunct faculty for Hamline University in their Masters in Nonprofit Management program, and is a frequent speaker on governance and other issues related to nonprofit organizations. Outside of the nonprofit world, she attempts to be handy around the house and ride a motorcycle as much as possible. Emily was recently named a “2014 Up & Coming Attorney” by Minnesota Lawyer.