Final Intermediate Sanctions Regulations Issued

In Jan. 21, 2002, the IRS issued final regulations on intermediate sanctions under Sec. 4958.

Background

Congress added Sec. 4958 to the Code in 1996 in an effort to find a middle ground short of exemption revocation for "applicable tax-exempt organizations" (Sec. 501(c)(3) organizations (other than private foundations) and Sec. 501(c)(4) organizations), when insiders (disqualified persons) receive excess economic benefits at the organization's expense. An excess-benefit transaction occurs when the economic benefit provided by such an organization to (or for the use of) a disqualified person exceeds the value that the organization received from the consideration (Sec. 4958(c)(1)(A)).

The statute added a three-tier system of excise taxes:

• A first-tier tax of 25% of the excess-benefit amount imposed on the disqualified person receiving the excess benefit;
• A second-tier tax of 200% of the excess-benefit amount imposed on the disqualified person if the organization does not correct the transaction in a timely manner; and
• An additional tax of 10% of the excess benefit imposed on any organization manager who knowingly participated in the excess-benefit transaction.

Excess-benefit transactions can include compensation arrangements, asset sales, loan arrangements and a variety of other dealings between organizations and insiders.

The Service published proposed regulations in August 1998. After a lengthy comment process, it released temporary regulations in January 2001 (see Tax Clinic, "IRS Issues Intermediate Sanctions Regulations," TTA, March 2002, p. 161.) The temporary regulations went into significant detail in defining applicable tax-exempt organizations, disqualified persons, organization managers and excess-benefit transactions, with extensive guidance on compensation arrangements. The temporary regulations established a rebuttable presumption of reasonableness for both compensatory and noncompensatory arrangements, through a process of governing-body approval, use of comparable data and documentation. If the organization met these requirements for reasonableness, the IRS could rebut the presumption only if it developed sufficient contrary evidence to rebut the probative value of the comparability data on which the organization's governing body relied.

Final Regulations

After reviewing comments on the temporary regulations, the Service made only a few changes to the year-old temporary regulations:

• Organization managers would not be considered to have knowingly participated in an excess-benefit transaction if the governing body originally met the rebuttable presumption-of-reasonableness requirements—even if the transaction was subsequently held to be an excess-benefit transaction.
• In the case of a required correction under Sec. 4958 (repayment of excess benefits), the exempt organization may be out of existence or not a tax-exempt organization at the time of the correction. In such cases, the temporary regulations allowed taxpayers to make correction payments to other exempt organizations not related to the disqualified person. The final regulations add further restrictions when:

—A Sec. 501(c)(3) organization receiving correction amounts has to be publicly supported and in existence for five years before the correction date;

—The disqualified person cannot make or recommend a receiving organization to make grants or distributions; and

—The disqualified person cannot be a disqualified person of the organization receiving the correction amounts.

• The temporary regulations provided that governmental entities are not subject to Sec. 4958. The final regulations clarify that this exception includes Sec. 115 entities. Governmental units or affiliates would not be applicable tax-exempt organizations if they were exempt from (or not subject to) tax without regard to Sec. 501(a), or relieved from filing an annual return under Regs. Sec. 1.6033-2(g)(6).
• By revising one of the examples in the final regulations and the discussion in the regulation's preamble, the Service clarified that management companies with ultimate responsibilities for managing an organization are disqualified persons per se. This removes any question as to whether only individuals can have substantial influence over the organization (and hence be disqualified persons).
• The temporary regulations exempted most Sec. 132 income from Sec. 4958's provisions. The final regulations also disregard expense reimbursements paid under an accountable plan meeting the requirements of Regs. Sec. 1.62-2(c). Thus, Secs. 162 and 274 will determine whether employee expense reimbursements are disregarded for Sec. 4958 purposes.
• The final regulations clarify that general timing rules apply to fixed payments with a substantial risk of forfeiture. Reasonableness is determined at the time the parties enter into a contact to transfer property. Nonfixed payments are governed by a facts-and-circumstances determination.
• Other fairly narrow clarifications were made in the final regulations.

More significant than the changes made in the final regulations is the fact that the IRS did not change its position on some controversial matters.

The temporary regulations added an exclusion from Sec. 4958's provisions for fixed payments to persons pursuant to an initial binding contract, provided that the person was not previously disqualified. The Service received comments urging it to eliminate or modify this important "first bite" exception, but it did not make any changes in the final regulations. Thus, the IRS will not consider a person's first employment contract or other agreement as an excess-benefit transaction, as long as he was not a disqualified person before signing the contract.

Even though the IRS had requested comments on donor-advised funds, it did not include any special provisions in the final regulations on whether fund donors are disqualified persons. The Service will apply general rules in making this determination.

The final regulations continue to reserve a separate section (Regs. Sec. 53.4958-5) on revenue-sharing agreements that are becoming popular with many organizations. The final regulations state simply that the general rules will apply regardless of whether the benefit will be determined by the organization's revenues. The IRS may issue future regulations in this area.

Comments to the contrary not-withstanding, the final regulations would also continue to exclude an organization manager from being considered as knowingly participating in an excess-benefit transaction if that manager relies on a reasoned written opinion from legal counsel, certain accounting firms and specified valuation experts.

Conclusion

With no major changes, these final regulations allow affected organizations and their advisers to continue following the same basic course that they should have set when the Service issued temporary regulations last year.

From R. Michael Sorrells, CPA, Washington, DC