IRS Targets Excess-Benefit Transactions

Enactment of Sec. 4958 was perhaps the most important change in Federal income tax law for tax-exempt organizations in the past 30 years. It gives the IRS a way to curtail excess-benefit abuses by public charities and social welfare organizations, through an assessment of intermediate sanctions against various organization insiders.

Excess benefits comprise compensation packages, loans, unreported benefits and transfers of property and other transactions with insiders or related parties. If the Service determines that a not-for-profit organization confers an excess benefit, it can assess and impose the following intermediate sanctions:

• A penalty on the recipient equal to 25% of the excess benefit.

• A 200% penalty on the recipient if the taxpayer does not return the amounts deemed excessive.

• A 10% penalty on the organizations manager (even a noncompensated board member) who approved the transaction.

Interpretation of Sec. 4958

In Caracci, 118 TC 379 (2002), the Tax Court upheld an imposition of intermediate sanctions for excess-benefit transactions, but overturned the Services revocation of an organizations tax-exempt status. It found that the organizations directors had received excess benefits of more than $5 million. Although the Federal government initially expressed an intention to appeal the Tax Courts decision on the revocation issue, it ultimately withdrew its notice of appeal. The taxpayer, however, continues to contest the claims that the transfer of assets of three exempt Mississippi home healthcare agencies gave rise to this level of excess benefits.

How the IRS Will Proceed

Caracci gives a fairly clear indication that the IRS will revoke an organizations nonprofit status only in the most egregious cases of private inurement. Regardless, Sec. 4958 still gives the Service plenty of punitive power without destroying an organization that has a valid and important exempt purpose.

Although Caracci was the first case tried under Sec. 4958, other similar battles will probably be fought in the courts. On Jan. 22, 2003, Leonard J. Henzke of the IRSs Exempt Organizations Division indicated that even though the Service will continue to examine the validity of an organizations exempt status, it will also conduct a second type of examination aimed specifically at disqualified persons and excess benefits.

The IRS is also considering a voluntary compliance initiative, which would permit excess-benefit violators to correct their transactions before an IRS audit, if they do so within 30 days of discovering the excess-benefit transaction. Such corrections may support an organizations request for abatement of the 25% penalty.

The establishment of a rebuttable presumption of reasonableness for transactions may be viewed as acting with due diligence. This rebuttable presumption consists of three criteria: (1) obtaining advance approval of the organizations board, (2) placing reliance on appropriate data and (3) having adequate documentation, as detailed in Regs. Sec. 53.4958-6.

The Service stresses the duty of the board of directors, or its delegate, to work with a compensation analyst and to negotiate compensation with an organizations top officials. It is important for boards to understand that all transactions (not just compensation) with disqualified persons will be subject to IRS scrutiny.

Recent findings by IRS agents have been addressed through the use of technical advice memoranda (TAMs). For example, TAM 200243057 describes the excess benefits received by a used car salesman who created a tax-exempt entity to receive vehicle donations. The Service discovered significant violations, including excessive compensation, undocumented loan transactions and unsubstantiated rental payments.

Another example, TAM 200244028, raised issues about an organizations consulting and noncompete agreement with its CEO and his spouse. The Service described three steps to establish the rebuttable presumption of reasonableness and whether this organization had met the presumption. It concluded that the organization had satisfied only two of the three required steps; accordingly, it did not meet the rebuttable presumption.

Conclusion

Given recent public IRS comment and stepped-up activity in this area, it is critical that all boards review their transactions with insiders. Some organizations may have conferred excess benefits on insiders without even realizing it. Many organizations may wish to adopt the proper procedures and documentation needed to establish a rebuttable presumption of reasonableness.

From Geralyn R. Hurd, Chicago, IL