Intermediate Sanctions Under 4958: An Overview of the Proposed Regulaitons
The issuance last year of proposed regulations under §4958 of the Internal
Revenue Code is considered by many to be the most important development in the law of tax-exempt organizations since the Tax Reform Act of 1969. These proposed regulations impose excise taxes, referred to in the charitable community as “intermediate sanctions,” on officers, directors, and other organization insiders who receive excessive economic benefits from public charities and certain other tax-exempt organizations. Although eagerly awaited, the proposed regulations have been widely criticized because they interject the specter of intermediate sanctions into the most routine, day-to-day transactions involving exempt organizations. For this reason, any person who enters into an economic relationship with a charitable organization, be it as an employee, board member, substantial contributor, or otherwise, has little choice but to seek legal advice as to how these proposed regulations may affect that relationship.
Background
Throughout this century, through application of the tax laws, Congress has sought to prevent the exploitation of charitable organizations for personal gain. Fundamental to these laws is the long-standing requirement under the Internal Revenue Code that no part of a tax-exempt organization’s net earnings inure in whole or in part to the benefit of any private shareholder or individual.1 Until fairly recently, the primary vehicle for enforcing this proscription on “private inurement” was the ability of the Internal Revenue Service to revoke an organization’s exemption from federal income taxation. Of course, revoking the organization’s exemption from taxation—a lethal penalty in most cases—often seemed an unjustified punishment, particularly where the facts demonstrated that the organization and its exempt purpose were innocent victims of insider wrongdoing.
Responding to this inequity, Congress in 1996 passed into law §4958 of the Internal Revenue Code, which provided the groundwork for asserting personal liability for excise taxes on individuals who are provided an excess benefit transaction from tax-exempt organizations. Under the statute, if a public charity qualifying under §501(c)(3) (other than a private foundation qualifying under §509(a)), or a social welfare organization qualifying under §501(c)(4), enters into an “excess benefit transaction” with a “disqualified person,” the disqualified person and the organization “managers” who participate in the decision to approve the transaction are subject to personal liability for excise taxes.2 Section 4958 is applicable to all transactions occurring on or after September 14, 1995.
In the legislative history that accompanied §4958, Congress directed Treasury to adopt regulations that would provide guidance with regard to several of the issues raised by the statute. This mandate was fulfilled on July 30, 1998, when the Internal Revenue Service released proposed regulations that govern the imposition of these excise taxes. The proposed regulations provide additional insights as to who is a “disqualified person” or a “manager” under §4958, and also outline the mechanics by which an exempt organization may establish a rebuttable presumption that certain transactions do not provide excess benefits.
Disqualified Persons
A disqualified person generally can be thought of as an insider with respect to an exempt organization. Section 4958(f)(1)(A) uses the following definition: “any person who was, at any time during the 5-year period ending on the date of such transaction, in a position to exercise substantial influence over the affairs of the organization.”
The proposed regulations divide the universe of potential disqualified persons into the following three categories: 1) persons who are deemed to have substantial influence over the affairs of an exempt organization; 2) persons who are deemed not to have such substantial influence; and 3) everyone else. Determining whether or not the latter are disqualified persons requires application of a facts and circumstances test.
Directors and trustees on the governing board of an exempt organization, as well as the organization’s president, chief executive officer, chief operating officer, treasurer, and chief financial officer, all are deemed to have substantial influence over the affairs of the organization for purposes of these rules.3 Official titles are of little moment, however. For example, a person who has or shares responsibility for managing the organization’s financial assets and who has authority to sign checks for the organization is treated as a treasurer or chief financial officer (and thus is disqualified) whether or not that person has been appointed formally to either position.
An employee of an exempt organization is deemed not to have substantial influence over the affairs of the exempt organization if 1) the total economic benefits received by that employee, directly or indirectly, are less than the amount of compensation referenced for a highly compensated employee under §414(q) (currently $80,000); 2) the employee is not a person who is deemed to have substantial influence under the rules set forth above; and 3) the employee is not a substantial contributor to the organization under §507(d)(2).4
All other persons may be disqualified based on a facts and circumstances test. Under the proposed regulations, the following circumstances tend to show that a person has substantial influence over an exempt organization: 1) the person is a founder of the organization; 2) the person is a substantial contributor to the organization; 3) the person receives compensation from the organization based on revenues of activities controlled by that person; 4) the person has the authority to control or determine a significant portion of the organization’s capital expenditures, operating budget, or compensation for employees; 5) the person has managerial authority or is a key advisor to a person with managerial authority; or 6) the person owns a controlling interest in an entity that is a disqualified person.5 The following circumstances, on the other hand, tend to show that a person is not a disqualified person: 1) the person has taken a bona fide vow of poverty as an employee or agent of a religious organization; 2) the person is an independent contractor such as an attorney or accountant, provided that person acts in that capacity; and 3) if the person is a contributor, the person receives only such preferential treatment as is available to any other donor making a comparable contribution as part of a solicitation designed to attract a substantial number of contributions.6
The proposed regulations also state that persons with managerial control over discrete segments of organizations may exercise substantial influence over the affairs of the entire organization,7 and several examples of this segmenting approach are provided. One example considers the facts and circumstances surrounding the dean of the college of law at a large tax-exempt university. The college of law is a major source of revenue for the university and is important to the university’s reputation for excellent teaching and high quality faculty scholarship. The reputation of the college of law is relied upon to attract students and contributions from alumni and foundations. The dean, whose compensation is greater than the amount giving rise to highly compensated status under §414(q), plays a key role in faculty hiring and has authority to control or determine a significant portion of the university’s capital expenditures and operating budget. Because of the importance of the college of law to this large university and the dean’s managerial control over that segment of the university, the dean is a disqualified person with respect to the university.8
Persons also can be deemed to be disqualified by way of attribution. A disqualified person’s spouse, siblings and their spouses, ancestors, children, grandchildren, great-grandchildren, and the spouses of children, grandchildren, and great-grandchildren, also are disqualified persons. In addition, any corporation, partnership, or trust in which a disqualified person has a 35 percent or more voting, profits, or beneficial interest is by attribution a disqualified person.
Excess Benefit Transactions
An excess benefit transaction can include almost any financial transaction between an exempt organization and a disqualified person, including but not limited to, the payment of salary, benefits, or deferred compensation, or the sale or exchange of property. To be excessive, the value of the benefit provided by the exempt organization (either directly or indirectly) to or for the use of a disqualified person must exceed the value of the consideration (including the performance of services) received by the organization for providing the benefit.9
Compensation is the most common financial transaction that may be found to constitute an excess benefit transaction. Under the proposed regulations, compensation must be reasonable under all circumstances, meaning it must be in an amount that ordinarily would be paid for like services by like enterprises under like circumstances.10 For these purposes, compensation includes all forms of cash and noncash compensation, earned and vested deferred compensation, premiums paid for liability or any other insurance coverage, and other welfare benefits such as medical and dental plans, life insurance, severance pay, and disability benefits.
However, an economic benefit is not treated as compensation for services rendered unless the exempt organization provides clear and convincing evidence that it intended to treat the benefits as compensation for services when they were paid. If the organization reports the economic benefit as compensation on a Form W-2 or Form 1099 or on the organization’s Form 990, then it will be deemed to be clear and convincing evidence that the payments were intended as compensation, although the return must be filed before the commencement of an examination by the Internal Revenue Service. Alternatively, the recipient of the benefit may satisfy the clear and convincing evidence requirement by reporting the benefit on his or her individual income tax return for the year in which the benefit is received.11
Four categories of economic benefits are disregarded for purposes of the intermediate sanctions. First, reimbursements of reasonable expenses of attending meetings of the governing body, so long as they do not constitute “luxury” or spousal travel, are not counted. Second, economic benefits provided to a disqualified person solely as a member of, or volunteer for, the organization are not considered as excess benefits if the benefit is provided to members of the public in exchange for a membership fee of $75 or less. Third, economic benefits provided to a disqualified person solely as a member of a charitable class are disregarded. Fourth, payments of premiums for liability insurance providing coverage for the excise taxes imposed by the proposed regulations, or indemnification of a disqualified person for such taxes, is not treated as an excess benefit if the premium or indemnification is treated as compensation to the disqualified person when paid and the total compensation is reasonable.12
A special set of transactions—revenue sharing agreements—have their own special rules. These transactions provide economic benefits to disqualified persons based in whole or in part on the revenues of an activity of the organization. Examples of revenue sharing agreements include compensation paid to investment managers based on the increase in the value of the organization’s investments, compensation paid to an employee of an exempt organization in the form of a percentage of royalties on a patent developed by that employee, the payment of a percentage of revenues as compensation for managing an exempt organization’s gaming activities, or the payment of a third party fundraiser based on a percentage of the contributions generated by that fundraiser’s efforts. These arrangements may be considered excess benefit transactions (whether or not they are found to provide excess benefits) if a disqualified person can receive additional financial benefits without providing “proportional” benefits that contribute to the organization’s accomplishment of its exempt purpose.13 If the economic benefit received is provided as compensation for services, the relationship between the size of the benefit provided and the quality and quantity of services provided, and the compensated party’s ability to control the activities generating the revenue, will be among the facts and circumstances relevant to determining whether the arrangement provides an excess benefit.
Establishing a
Rebuttable Presumption
The proposed regulations provide a mechanism by which the governing board of an exempt organization can establish a rebuttable presumption that a particular financial transaction does not result in the payment of an excess benefit. The presumption arises if the following conditions are satisfied: 1) the governing body of the organization or a committee thereof consisting solely of disinteresting members approves the transaction; 2) the approving group or committee obtains and relies upon “appropriate data” as to the “comparability” of the transaction to similar transactions involving similarly situated organizations; and 3) the governing body adequately documents the basis for its decision to approve the transaction.14
With regard to the second requirement, the proposed regulations state that a governing body or committee has “appropriate data as to comparability” if, given the knowledge and expertise of its members, it has information sufficient to determine whether a compensation arrangement will result in the payment of reasonable compensation or that a transaction will be for fair market value.15 In this regard, relevant information would include compensation levels paid by similarly situated organizations for functionally comparable positions, the availability of similar services in the geographic area of the exempt organization, independent compensation surveys compiled by independent firms, actual written offers from similar institutions competing for the services of the disqualified person, and independent appraisals of the value of property that the applicable organization intends to purchase from or sell to the disqualified person. However, for organizations with receipts of less than $1 million, the governing body is considered to have “appropriate data as to comparability” if it has data on compensation paid by five comparable organizations in the same or similar communities for similar services.
Calculating the
Excise Tax Liability
The excise tax imposed on a disqualified person receiving an excess benefit is equal to 25 percent of the portion of the benefit that is determined to be excessive. If more than one disqualified person is liable for the tax, all of the disqualified persons are jointly and severally liable.
In addition to the 25 percent excise tax, separate excise taxes also are imposed on any manager of a charitable organization who knowingly participates in an excess benefit transaction, unless that participation was not willful and was due to reasonable cause.16 Excise taxes imposed on managers are equal to 10 percent of the excess benefit, up to a maximum of $10,000 per transaction. Each person who is a manager is jointly and severally liable for the excise taxes payable by the managers with respect to an excess benefit transaction. Managers who receive an excess benefit can be liable for both the 25 percent and the 10 percent/$10,000 excise taxes.
For purposes of the 10 percent/$10,000 excise tax, a manager is a director, officer, or trustee of an exempt organization, or any individual having the powers normally associated with such positions. Individuals acting merely as independent contractors to an exempt organization, including the organization’s attorneys, accountants, investment managers, or other advisors, normally are not managers for purposes of the 10 percent/$10,000 excise tax.
In order to be personally liable for the 10 percent/$10,000 excise tax, a manager must knowingly participate in an excess benefit transaction. Knowingly participating in an excess benefit transaction is found where 1) the manager had actual knowledge of facts supporting the characterization of a transaction as excessive, 2) the manager was aware that the transaction could be treated as an excess benefit transaction under the intermediate sanctions, and 3) the manager negligently failed to make reasonable attempts to ascertain if the transaction was an excess benefit transaction.17 Participating in a transaction can include silence or inaction where the manager is under a duty to speak or act.18 However, if the manager opposes the transaction in a manner consistent with the fulfillment of the manager’s responsibilities to the organization, that person’s actions will not constitute participation for these purposes.
If the managers of an exempt organization fully disclose to legal counsel (which may include in-house counsel) the factual situation surrounding the proposed transaction, and if they rely on a reasoned written legal opinion by such counsel that the transaction will not constitute an excess benefit transaction, the 10 percent/$10,000 excise tax will not be imposed, even if the transaction later is found to be an excess benefit transaction.19 To be reasoned for purposes of the proposed regulations, the written legal opinion must not merely recite facts and express an opinion, but must address the facts and applicable law.
Additional Excise Tax
for Failure to Correct
If the excess benefit transaction is not “corrected” within the time required under the proposed regulations, the disqualified person is liable for an additional excise tax of 200 percent of the amount determined to be excessive.20 Correcting an excess benefit transaction means more than simply returning the excess benefit, but also may require the payment of an additional amount to compensate the organization for the loss of the use of money or other property, or other steps necessary to make the organization whole. To avoid the payment of excise taxes through a correction of an excess benefit transaction, the disqualified person must correct the transaction within the earlier of 1) the date of mailing of a notice of deficiency and 2) the date on which the initial excise tax is assessed by the Internal Revenue Service.
The Future of
Intermediate Sanctions
Although it appears that intermediate sanctions are here to stay, the implementation of the final regulations, if not their final content, no doubt will be affected by the opinion handed down by the Seventh Circuit earlier this year in United Cancer Council v. Comm. , 165 F.3d 1173 (7th Cir. 1999). There, an exempt organization teetering on the brink of bankruptcy contracted with a third party fundraiser to solicit contributions by large scale direct mailings. As a result of the fundraiser’s efforts, $28.8 million was raised, although under the terms of the contract, the fundraiser was reimbursed $26.5 million for expenses. The facts confirm that the terms of the contract were more favorable to the fundraiser than are the terms of the average fundraising contract.
The Internal Revenue Service revoked the exemption of the organization and claimed, among other things, that the net earnings of the organization had inured to the benefit of a private shareholder or individual—its third party fundraising firm. The Tax Court upheld the revocation of exemption on private inurement grounds, but the Seventh Circuit reversed, noting that the term “private shareholder or individual” under §501(c)(3) was interpreted by courts to mean an insider of the organization. Although it suggested that the organization may have been imprudent in entering into such a one-sided contract, the Seventh Circuit court found no sense in which the one-sided contract had transformed the fundraiser into an organization insider. On that basis, the court determined that there was no private inurement.
As the heir to §501(c)(3)’s “organization insider,” §4958’s “disqualified person” also should be viewed in light of the Seventh Circuit’s decision in United Cancer Council. More relevant to the intermediate sanctions generally, however, were the court’s dramatic comments regarding the government’s response to a question from the bench during oral argument concerning the applicable standard of review for decisions in this area of the law. The government’s response was that the applicable standard was the “facts and circumstances of each case,” a position that, interestingly enough, appears throughout the proposed regulations under §4958. According to the Seventh Circuit, a facts and circumstances standard “is no standard at all, and makes the tax status of charitable organizations and their donors a matter of the whim of the IRS.”21
It may be that these comments resonated with the Internal Revenue Service, which subsequent to the United Cancer Council decision indicated in published reports that several changes will be made in the intermediate sanctions regulations before they become final. In addition, the National Office of the Internal Revenue Service recently published memoranda issued to its field agents notifying them that all decisions to impose intermediate sanctions must first be submitted to the national office for technical advice.
Still, the proposed regulations may be relied upon in their current form until final regulations are issued. Until then, exempt organizations will have little choice but to implement stringent policies to avoid the imposition of intermediate sanctions. At a minimum, these organizations will be forced to inventory their disqualified persons and managers for purposes of §4958. The governing boards of these organizations also will need to develop meticulous record-keeping procedures in order to preserve for the record all of their deliberations concerning the approval of compensation and other potential excess benefit transactions and the materials on which their decisions are based. All of this will command additional resources from organization executives and administrators, who should now view every potential employee or financial transaction through the lens of the intermediate sanctions. For better or for worse, intermediate sanctions will become a familiar participant in the day to day operations of exempt organizations.
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1 I.R.C. §501(c)(3).
2 I.R.C. §4958.
3 Prop. Reg. §53.4958-3(c).
4 Prop. Reg. §53.4958-3(d)(2).
5 Prop. Reg. §53.4958-3(e)(2).
6 Prop. Reg. §53.4958-3(e)(3).
7 Prop. Reg. §53.4958-3(e)(1).
8 Prop. Reg. §53.4958-3(f), Example 6.
9 Prop. Reg. §53.4958-4(a)(1).
10 Prop. Reg. §53.4958-4(b)(3).
11 Prop. Reg. §53.4958-(4)(c)(2)(ii).
12 Prop. Reg. §53.4958-4(a)(3) and -4(a)(4).
13 Prop. Reg. §53.4958-5(a).
14 Prop. Reg. §53.4958-6.
15 Prop. Reg. §53.4958-6(d)(2).
16 Prop. Reg. §53.4958-1(d).
17 Prop. Reg. §53.4958-1(d)(4).
18 Prop. Reg. §53.4958-1(d)(3).
19 Prop. Reg. §53.4958-1(d)(7).
20 Prop. Reg. §53.4958-1(a)(2).
21 United Cancer Council, 165 F.3d at 1179.
J. Eric Taylor is an associate with Trenam, Kemker, Scharf, Barkin, Frye, O’Neill & Mullis, P.A., Tampa. He graduated from the University of Florida with a B.S. in 1987 and J.D. degree with honors in 1990. Mr. Taylor is a member of the Tax and Real Property, Probate and Trust Law sections of the Bar and is admitted to practice in Florida and North Carolina.
This column is submitted on behalf of the Tax Section, David E. Bowers, chair, and Michael D. Miller and Lester B. Law, editors.
