Nonprofit Law/severance pay
QUESTION: The 501(c)3 I am a board member of is planning to dissolve sometimes this year due to the founder/president's retirement. He is the only paid employee and has worked for very low wages for over 30 years. Upon dissolution we are required to distribute our assets to other non-profits, but the board would like to make sure the founder, now in his 70s, has some compensation for his hard work over the years. He has no retirement plan and the organization has always operated on a shoestring. Is there a way to accomplish this without running afoul of IRS regs? Can you also cite the IRS pub that discusses this kind of issue? Thank you very much.
ANSWER: It is against IRS regulations for a 501(c)3 organization to give
"severance pay" or any substantial gift to an outgoing employee
unless it is required by a long-standing employment contract. Such
payments would be a prohibited use of funds as the funds would not
be used for the benefit of the organization or pursuant to the
exempt purposes of the organization and, even worse, may be
considered by the IRS to be a distribution similar to a profit
distribution to an insider. Of course, 501(c)(3) organizations,
right in Internal Revenue Code §501(c)(3) are prohibited from
giving private inurement. That code section is at:
and it has, in part, that the 501(c)(3) organization must be
"operated exclusively for religious, charitable, scientific,
testing for public safety, literary, or educational purposes ...
no part of the net earnings of which inures to the benefit of any
private shareholder or individual". That is the main issue that
needs to be addressed, as a 501(c)(3) organization is supposed
to use its assets for charitable, educational or religious
In fact, the IRS defines a severance payment in the instructions to
the Form 990 (which is the annual form used by exempt organizations
to report their activities to the IRS) as "payment made if the
right to the payment is contingent solely upon the person's
severance from service in specified circumstance, such as upon an
involuntary separation of service.... Treat as a severance payment
any payment to a listed person in satisfaction or settlement of a
claim for wrongful termination or demotion."
A severance payment is allowed to be given to someone going out
the door if there was something of equal value given to the
employer by the employee, such as the agreement to terminate an
existing employment contract.
Attorney at Law
P.S. This response is intended to be a general statement of law, should not be relied upon as legal advice and does not create an attorney/client relationship. For me to consider your individual situation and how the law applies, I would need to gather more information.
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QUESTION: Thank you very much for that information.
Would it be legal to increase the president's pay for this, the last year of the organization's existence? I'm talking a substantial increase, say, 50%. The current annual salary is $30,000. Or might this be construed as subverting the regulations?
You are welcome.
That appears to be highly suspect. Why don't you have a private collection for that person?
The IRS often uses a "Substance over Form" doctrine.
The concept of the substance over form doctrine is that the tax
results of an arrangement are better determined based on the
underlying substance rather than an evaluation of the mere formal
steps by which the arrangement was undertaken. For instance, two
transactions that achieve the same underlying result should not be
taxed differently simply because they are achieved through
different legal steps. As the Supreme Court stated some years ago
in Minnesota Tea Co. v. Helvering, 302 U.S. 609, 58 S. Ct. 393, 82
L. Ed. 474 (1938), "A given result at the end of a straight path is
not made a different result because reached by following a devious
path." 302 U.S. at 613, 58 S. Ct. at 394.
Added in 2010, section 7701(o) of the Internal Revenue Code
defined another doctrine, the economic substance doctrine, as the
common law doctrine under which certain tax benefits are not
allowable if the transaction does not have economic substance or
lacks a business purpose and states that "[t]he determination of
whether the economic substance doctrine is relevant to a
transaction shall be made in the same manner as if [the
legislation] had never been enacted." The statute further states
that "[i]n the case of any transaction to which the economic
substance doctrine is relevant, such transaction shall be treated
as having economic substance only if-(A) the transaction changes in
a meaningful way (apart from Federal income tax effects) the
taxpayer's economic position, and (B) the taxpayer has a
substantial purpose (apart from Federal income tax effects) for
entering into such transaction." That code section is available at
A 2010 Act added section 6662(b)(6), which imposes a strict
liability penalty of 20 percent (40 percent for undisclosed
transactions) of any underpayment attributable to the disallowance
of claimed tax benefits by reason of the application of the
economic substance doctrine or failing to meet the requirements of
any similar rule of law.