IRS Issues Intermediate-Sanctions Regulations

Temporary and proposed regulations under Sec. 4958 (the intermediate-sanctions provisions) permit the IRS to assess excise taxes against disqualified persons who participate in excess-benefit transactions with applicable tax-exempt organizations. The new regulations modify and clarify aspects of the proposed regulations issued in August 1998, and reflect comments the IRS received in writing and at a two-day public hearing held in March 1999.

In lieu of revocation of tax-exempt status, Sec. 4958 imposes sanctions consisting of a two-tier excise tax on disqualified persons who have unduly benefited from dealing with certain exempt organizations. These rules were created as a mechanism to "police" transactions between certain public charities and individuals who have substantial influence over their affairs.

On Jan. 10, 2001, the Service issued temporary regulations interpreting these provisions, which have the same effect as final regulations until Jan. 9, 2004.

Applicability

The regulations apply only to certain Sec. 501(c)(3) or 501(c)(4) organizations. They do not cover:

• A private foundation.
• A governmental entity exempt from (or not subject to) taxation without regard to Sec. 501(a) (Temp. Regs. Sec. 53.4958-2T). This exclusion covers state colleges and universities, state and municipal or county-owned hospitals and other similar organizations.
• Certain foreign organizations.

Disqualified Persons

Sec. 4958 applies only to certain disqualified persons of the organization. In any transaction, a disqualified person is any person in a position to exercise "substantial influence" over the organization's affairs at any time during a five-year period ending on a transaction's date. Thus, a person no longer with an organization at the time an excess-benefit transaction occurs may nevertheless still be considered a disqualified person.

Persons who hold certain powers, responsibilities or interests are among those in a position to exercise substantial influence over the organization's affairs. This would include, for example, voting members of the governing body and persons holding the power of:

• President, chief executive officer or chief operating officer; or
• Treasurer or chief financial officer.

The regulations also cover spouses, certain family members of disqualified persons and entities controlled 35% or more by disqualified persons. Actual powers and responsibilities, rather than title, are considered in making the determination of substantial influence.

Who Is Not a Disqualified Person?

The regulations also clarify which persons are not in positions to exercise substantial influence over an organization's affairs:

• An employee who (1) receives benefits that total less than a specified "highly compensated" amount ($85,000 in 2001) and who does not hold executive or voting powers; (2) is not a family member of a disqualified person; and (3) is not a substantial contributor (see below);
• Sec. 501(c)(3) organizations; and
• Sec. 501(c)(4) organizations, for transactions with other Sec. 501(c)(4) organizations.

Other Persons Subject to a Facts-and-Circumstances Test

Other persons not described can also be disqualified persons, depending on the relevant facts and circumstances that tend to show substantial influence. A person may be a disqualified person with respect to an organization if facts and circumstances show the person:

• Is the organization's founder.
• Is a substantial contributor to the organization (only taking into account contributions to the organization for the most recent five years).
• Is paid compensation primarily based on revenues derived from an organization's activities and the person controls those activities.
• Owns a controlling interest (by vote or value) in an entity that is a disqualified person with respect to the organization.

Facts and circumstances also might tend to show that a person had no substantial influence, such as the person:

• Is an independent contractor whose sole relationship to the organization is providing professional advice (without having decisionmaking authority) for transactions from which he will not economically benefit.
• Does not participate in management decisions affecting the organization.

Sec. 4958 Applies Only to Excess-Benefit Transactions of Disqualified Persons

An excess-benefit transaction is one in which:

• An economic benefit provided by an organization, directly or indirectly, to (or for the use of) any disqualified person; and
• The economic benefit's value provided by the organization exceeds the consideration's value (including the performance of services) received for providing such benefit.

An excess benefit can occur in an exchange of compensation and benefits in return for the services of a disqualified person, or in a sale of property between a disqualified person and an exempt organization.

In determining whether an excess-benefit transaction occurred, the total compensation paid to the organization manager would include (1) certain reimbursements made by the tax-exempt organization of an organization manager's share of the 10% excise tax, (2) the expense of correcting an excess-benefit transaction or (3) the cost of liability insurance. Thus, such payments would not, per se, be deemed to be an excess-benefit transaction, but rather would be evaluated as a part of the organization manager's total compensation package.

The transfer of economic benefits to a governmental entity for exclusively public purposes is disregarded for purposes of the intermediate-sanctions rules.

Compensation Provided by Tax-Exempt Organization Must Be Reasonable

Reasonable compensation is the value that would ordinarily be paid for like services by like enterprises under like circumstances. In determining reasonableness, all compensation items that an organization provides in exchange for the performance of services are taken into account in determining the value of compensation, such as:

• All forms of cash and noncash compensation (including salary, fees, bonuses, severance payments and deferred and noncash compensation);
• The payment of certain liability insurance premiums;
• Taxable and nontaxable fringe benefits (except fringe benefits described in Sec. 132); and
• Forgone interest on loans.

Organization managers may now rely on the opinion of any qualified professional (i.e., CPAs or accounting firms with relevant tax expertise, compensation-valuation specialists, attorneys, including in-house counsel, etc.) when seeking to substantiate whether a transaction is reasonable or at arm's-length (i.e., at fair market value (FMV)). This advice-of-counsel safe harbor presumes that the organization manager provides the qualified professional with all of the relevant information about the transaction.

Written Intent Required to Treat Benefits as Compensation

An economic benefit is not consideration for the performance of services, unless the organization providing the benefit clearly indicates its intent to treat the benefit as compensation when it is paid.

An organization is treated as clearly indicating its intent to provide an economic benefit as compensation for services only if the organization provides written substantiation deemed contemporaneous with the transfer of the economic benefits under consideration. The following is a list of ways to provide contemporaneous written substantiation of intent to provide an economic benefit as compensation:

• The organization enters into a signed written employment contract;
• The organization reports the benefit as compensation on an original Form W-2, Form 1099 or Form 990, or on an amended form, filed prior to the start of an IRS examination; or
• The disqualified person reports the benefit as income on his original Form 1040, or on an amended form, filed prior to the start of an IRS examination.

Employer-provided health benefits and contributions paid to qualified plans under Sec. 401(a) are compensation for the performance of services.

Caution: Under the regulations, the reimbursement of personal expenses is an excess-benefit transaction without regard to the reasonableness of total compensation. Accordingly, every organization subject to these rules should take care to review its expense-reimbursement policies to ensure that they conform to the "accountable plan" rules.

Special Exception for Initial Contracts

Sec. 4958 does not apply to any "fixed payment" made to a person pursuant to an initial contract. This would potentially exclude, for example, all initial contracts with new, previously unrelated officers and contractors; see United Cancer Council Inc., 165 F3d 1173 (7th Cir. 1999), rev'g and remd'g 109 TC 326 (1997).

However, if an initial contract has a variable-compensation component (e.g., a discretionary bonus), the initial-contract exception would not apply to this component. Further, if a material modification is made to the contract, or if a person fails to perform substantially under the contract subsequent to its initial issuance, the initial-contract safe harbor would no longer apply.

Organizations Can Create a Rebuttable Presumption of Reasonableness

Payments under a compensation arrangement would be presumed reasonable and the property transfer (or right to use property) would be presumed at FMV, if the following three conditions were met:

• The transaction is approved by an authorized body of the organization (or an entity it controls) composed of individuals who do not have a conflict of interest concerning the transaction;
• Prior to making its determination, the authorized body obtained and relied on appropriate data as to comparability. (There is a special safe harbor for small organizations; if the organization has gross receipts of less than $1 million, appropriate comparability data would include data on compensation paid by three comparable organizations in the same or similar communities for similar services.); and
• The authorized body adequately documents the basis for its determination concurrently with making it.

Organizations Not Establishing Presumption Can Still Comply

In some cases, an organization may find it impossible or impracticable to fully implement each step of the rebuttable-presumption process. In such cases, the organization should try to implement as many steps as possible (in whole or in part) to substantiate the reasonableness of benefits in as timely and complete a manner as possible. If an organization does not satisfy the requirements of the rebuttable presumption of reasonableness, a facts-and-circumstances approach would be followed, using established rules for determining compensation reasonableness and benefit deductions in a manner similar to the established procedures for Sec. 162 business expenses.

Excess Benefit Usually Occurs on the Date the Disqualified Person Receives the Benefit

For Federal income tax purposes, an excess-benefit transaction would occur on the date the disqualified person receives the economic benefit from the organization. However, when a single contractual arrangement provides for a series of compensation payments or other payments to a disqualified person during the disqualified person's tax year, any excess-benefit transaction with respect to these payments would occur on the last day of that year.

For a property transfer subject to a substantial risk of forfeitures, or for rights to future compensation or property, the transaction occurs on the date the property (or the rights to future compensation or property) is not subject to a substantial risk of forfeiture. If a disqualified person elects under Sec. 83(b) to include an amount in gross income in the tax year of transfer, for Federal income tax purposes, the excess-benefit transaction would occur on the date the disqualified person receives the economic benefit.

Excise Taxes Under Sec. 4958

Tax on disqualified persons. An excise tax equal to 25% of the excess benefit is imposed on each excess-benefit transaction between an organization and a disqualified person. The disqualified person who benefited from the transaction is liable for the tax. If the 25% tax is imposed and the excess-benefit transaction is not corrected within the tax period, an additional excise tax equal to 200% of the excess benefit would be imposed.

To avoid the 200% tax, a disqualified person must correct the excess-benefit transaction during a specified tax period. This 200% tax may be abated if the transaction is corrected subsequently during a 90-day correction period.

Tax on organization managers. An excise tax equal to 10% of the excess benefit may be imposed on an organization manager participating in an excess-benefit transaction between an organization and a disqualified person. This tax, which may not exceed $10,000 for any single transaction, would be imposed only if the 25% tax is imposed and the manager knowingly participated in the transaction, willfully and without reasonable cause.

The regulations expand the safe harbor in the proposed rules on an organization manager's reliance on counsel's advice. A manager's participation in an excess benefit transaction "will not ordinarily" be considered "knowing" if the manager relies on a reasoned, written opinion by legal counsel, a CPA or independent valuation expert. Additionally, under the temporary regulations, a manager's participation in a transaction would not be considered "knowing" if the manager relies on the fact that the requirements giving rise to the rebuttable presumption of reasonableness are satisfied.

Correcting the Excess Benefit

A disqualified person corrects an excess-benefit transaction by undoing the excess benefit to the extent possible and taking any additional measures necessary to place the organization in a financial position not worse than it would have been had the disqualified person dealt under the highest fiduciary standards. The regulations provide a detailed description of how this may be done. The regulations contain five new examples that illustrate how to correct an excess-benefit transaction. Corrections must be made within the specified tax period.

Revenue-Sharing Transactions Are Subject to the Same Rules

The proposed regulations had special provisions for revenue-sharing transactions that covered "any transaction in which the amount of any economic benefit provided to or for the use of a disqualified person is determined in whole or in part by the revenues of one or more activities of the organization." The temporary regulations reserve action on this provision and state that currently, the temporary regulations' general rules will apply.

Sec. 4958 Does Not Replace Revocation

Sec. 4958 does not affect the substantive standards for tax exemption under Sec. 501(c)(3) or (4), including the requirements that an organization organize and operate exclusively for exempt purposes, and that no part of its net earnings benefit any private shareholder or individual. The legislative history and the IRS have indicated that, in most instances, the imposition of intermediate sanctions will be in lieu of revocation. However, under the regulations, both the imposition of an excise tax under the intermediate sanctions and the revocation of tax-exempt status may be applicable, at least when prohibited private inurement occurs.

Effective Dates

The temporary regulations are effective on Jan. 10, 2001, and will cease to apply on Jan. 9, 2004. (The Code provisions apply to excess-benefit transactions on or after Sept. 14, 1995.)

By Jane E. Hopkins, CPA, and Thomas M. Mayer, CPA, Minneapolis, MN