Super Lawyers Magazine
by Lisa A. Runquist
February, 2001
Perhaps the most important change in the last 30 years in the area of nonprofit law occurred on July 30, 1996, when the Taxpayer Bill of Rights 2 added section 4958 to the Internal Revenue Code. Section 4958 adds intermediate sanctions as an alternative to revocation of the exempt status of an organization when private persons benefit from transactions with a nonprofit organization. Intermediate sanctions allow the Internal Revenue Service to impose excise taxes (i.e., penalties) on certain persons who improperly benefit from transactions with an exempt organization. Intermediate sanctions penalize the person(s) who benefit from an improper transaction, rather than the organization.
Section 4958 applies to all organizations exempt under section 501(c)(3) other than private foundations, and to those exempt under section 501(c)(4). Because section 4958 represents a major change in nonprofit tax law, it is important that you and your board fully understand what the law is, how it works and what you and your organization can do to limit the possibility of penalties being incurred under the new law.
Proposed regulations for Section 4958 were issued on July 30, 1998. On January 10, 2001, Temporary Regulations were issued, effective for three years until January 9, 2004 (unless final regulations are issued earlier). Because of the number and complexity of comments to the Proposed Regulations received by the IRS from attorneys and other practitioners, as well as the compexity of the area, the Regulations were issued as temporary rather than final and the IRS will review some areas further. Of course, even in the areas that the IRS has not asked for comments, there may be further modifications before the regulations are issued in final form. Unlike proposed regulations, Temporary Regulations are binding during their effective period.
History
Prior to section 4958, if a transaction with an exempt organization resulted in private inurement or private benefit, the only option available to the Service was to revoke the organization’s exemption. Because this is an extreme penalty, most often hurting the beneficiaries of the organization more than the recipient of the improper benefit, the penalty was rarely used. For several years prior to the passage of section 4958 in 1996, attempts were made to provide a less severe penalty. This goal was met in section 4958 with the adoption of what are commonly referred to as intermediate sanctions. Intermediate sanctions may be imposed in lieu of, or in addition to, revocation of an organization’s exempt status.
Although the intermediate sanctions law is retroactive to September 14, 1995, the effective date of the law should not be confused with the effective date of regulations adopted by the Internal Revenue Service to implement the law. Further, the force of the law (Section 4958) is different from the IRS’ interpretation of it (the regulations).
What Organizations Are Covered?
Section 4958 applies to all organizations which are or were described in Section 501(c)(3) or Section 501(c)(4) of the Internal Revenue Code at any time during the last five years, except for private foundations (which are already subject to their own excise tax law), governmental entities that are exempt from taxation without regard to section 501(a), and foreign organizations that receive substantially all of their support from non-US sources.
Because most organizations are required to establish their exempt status with the IRS, an organization is considered “described” in Section 501(c)(3) only if it has made the requisite filing, unless it is exempt from such filing under Section 508 (e.g. churches and small organizations). An organization is considered “described” in Section 501(c)(4) if it has applied for and received exemption from the IRS as such an organization, or has filed for recognition under 501(c)(4) or has filed an annual return as a 501(c)(4) organization, or has otherwise held itself out as being a 501(c)(4) organization, exempt from tax under Section 501(a). The organization is not described in Section 501(c)(3) or (c)(4) during any period for which a final determination or adjudication that the organization is not exempt has been made (so long as the determination or adjudication is not based on private inurement or excess benefit transactions).
What Individuals are Affected?
Intermediate Sanctions may be imposed on any “disqualified person” who receives an excess benefit from a covered organization and on each “organization manager” who approves the excess benefit transaction. Note: Although being a disqualified person is a prerequisite to finding an excess benefit transaction, being a disqualified person does not automatically result in a finding that a transaction involves an excess benefit. If a person is not a disqualified person, then there can be no excess benefit with regard to that person.
Who is a Disqualified Person?
A disqualified person is any person (whether an individual, organization, partnership or unincorporated entity) which, during a five year period beginning after September 13, 1995, and ending on the date of the transaction in question, was in a position to exercise substantial influence over the affairs of an exempt organization.
Where there are affiliated organizations, whether a person has substantial influence must be determined separately for each organization. A person may be a disqualified person for more than one organization.
Disqualified Persons. Section 4958 identifies certain persons as having substantial influence as a matter of law; these persons are conclusively presumed to be disqualified persons. In addition, the temporary regulations identify additional categories of persons who have substantial influence, and are thus considered by the IRS to be presumptively disqualified.
Under the statute, the following are disqualified:
a. A family member (spouse, siblings and their spouses, ancestors, children, grandchildren, great grandchildren, and spouses of children, grandchildren and great grandchildren) of a disqualified person. A legally adopted child is a child of said individual.
b. An organization (corporation, partnership, trust or estate) owned 35% or more, directly or indirectly, by a disqualified person or his or her family member(s). This does not include voting rights held only as a director, trustee, or other fiduciary, without any stock, profit or other beneficial interest.
Other persons defined by the temporary regulations as having substantial interest include:
a. Members of the governing board of the organization who are entitled to vote on matters over which the governing body has authority (e.g., directors, elders, trustees, etc.).
b. Executive officers of the organization, such as the president, chief executive officer, and chief operating officer. Regardless of the actual title used, this category includes any individual who has ultimate responsibility for implementing board decisions, or for supervising the management, administration or operation of the organization. This responsibility may rest with more than one individual. Unless a person demonstrates otherwise, any person who has a title of president, chief executive officer or chief operating officer will be considered to have this authority.
c. The treasurer or chief financial officer. This category includes anyone who has or shares ultimate responsibility for managing the organization’s financial assets, regardless of actual title. Again, there may be more than one individual with this responsibility, and any person with the title of treasurer or chief financial officer will be considered to have this ultimate responsibility unless he/she demonstrates otherwise.
d. If a hospital participates in a provider-sponsored organization, any person who has a material financial interest in the organization (e.g., a person involved in a joint venture with the organization).
Not a Disqualified Person. Conversely, there are categories of persons who, under the temporary regulations, are deemed not to have substantial influence. These include:
a. 501(c)(3) organizations.
b. With respect to a 501(c)(4) organization, another organization described in 501(c)(4).
c. Employees who do not fit into one of the categories listed above, provided they are not highly compensated employees (as defined in section 414(q)(1)(B)(i) – compensation in excess of $80,000, as adjusted by the IRS) or substantial contributors (as defined in section 507(d)(2)(A), taking into account only contributions received during the current and the four preceding taxable years).
Facts and Circumstances Test. In all other cases, whether or not an individual or organization is a disqualified person is determined by a facts and circumstances test. The temporary regulations include two lists of facts and circumstances. The first, includes facts and circumstances that tend to show an individual has substantial influence. The second, includes facts and circumstances that tend to show a person does not have substantial influence.
a. Facts and circumstances which tend to show a person has substantial influence include:
1. The person founded the organization.
2. The person is a substantial contributor to the organization (as defined in section 507(d)(2)(A), taking into account only contributions received during the current taxable year and the four preceding taxable years).
3. The person’s compensation is primarily based on revenues derived from an activity of the organization that the person controls (see further discussion about percentage payments, below).
4. The person has or shares authority to control or determine a substantial portion of the organization’s capital expenditures, operating budget, or compensation for employees.5. The person manages a discrete segment or activity of the organization that represents a substantial portion of the organization’s activities, assets, income or expenses, as compared to the organization as a whole. For example, a person who manages one department that contributes significantly to the whole may be a disqualified person.
6. The person owns a controlling interest (measured either by vote or value) in an organization (corporation, partnership, trust) that is a disqualified person.
7. The person is a non-stock organization (such as a social club, homeowners association, etc.) controlled, directly or indirectly, by one or more disqualified persons.
b. Facts and circumstances which tend to show a person has no substantial influence include:
1. The organization is a religious organization and the person has taken a “bona fide” vow of poverty as an employee or agent, or on behalf of the organization.
2. The person is an independent contractor (e.g. an attorney, an accountant, or investment manager or advisor) whose sole relationship to the organization is providing professional advice (without having decision-making authority) with respect to transactions from which the independent contractor will not economically benefit, either directly or indirectly, apart from customary fees received for the professional advice rendered.
3. The direct supervisor of the individual is not a disqualified person.
4. The person does not participate in any management decisions affecting the organization as a whole or a discrete segment or activity of the organization that represents a substantial portion of the organization’s activities, assets, income or expenses, as compared to the organization as a whole.
5. Any preferential treatment a person receives which is based on the size of the person’s donation, is also offered to all other donors making a comparable contribution as part of a solicitation intended to attract a substantial number of contributions.
Donor Advised Funds. The IRS has not addressed the issue of donor advised funds in the temporary regulations, it did note in its Explanation of disqualified persons, that although donors “cannot properly have legal control over the segregated fund, they nonetheless are in a position to exercise substantial influence over the amount, timing, or recipients of distributions from the fund.” The IRS also requested comments concerning the issues raised by applying the fair market value standard of section 2958 to distributions from a donor advised fund to (or for the use of) the donor or advisor.
Organization Manager. An organization manager who participates in an excess benefit transaction, knowing that it is such a transaction, is liable for penalties unless the participation was not willful, and was due to reasonable cause.
Who is an Organization Manager? An organization manager is any officer, director, trustee, or person having similar powers or responsibilities, regardless of his or her title. A person is an officer if specifically so designated under the articles or bylaws of the organization, or if he or she regularly exercises general authority to make administrative or policy decisions for the organization. If a person only makes recommendations, but cannot implement decisions without approval of a superior, that person is not an officer.
The temporary regulations make it clear that an “independent contractor who acts solely in a capacity as an attorney, accountant, or investment manager or advisor is not an officer.”(1)
An organization manager also includes anyone serving on a committee of the board (or board designee, whether or not a member of the board), if the organization is claiming that the rebuttable presumption of reasonableness (see discussion below) is based on the committee’s (or the designee’s) actions. In other words, if the committee is responsible for determining the reasonableness of a transaction, and this determination is relied upon by the organization, every member of the committee will be considered an organization manager.
When Does an Organization Manager Participate in a Transaction? Participation includes silence or inaction by the organization manager, when the manager is under a duty to speak or act, as well as any affirmative action. Therefore, abstention is considered consent to a transaction. However, if a manager has opposed the transaction in a manner consistent with his/her responsibilities to the organization, the manager will not be considered to have participated in the action.
Knowing Participation. “Knowing” means that the manager 1) has actual knowledge of sufficient facts which indicate, based solely on those facts, the transaction is an excess benefit transaction, 2) is aware that the transaction may violate the law, and 3) negligently fails to make reasonable attempts to ascertain whether the transaction is an excess benefit transaction or is, in fact, aware that it is such a transaction. Although knowing does not mean having reason to know, under the temporary regulations, evidence that a manager has reason to know is relevant to determine whether the manager has actual knowledge. It is up to the IRS to prove that the manager knowingly participated. If an organization manager relies on a reasoned written opinion of an appropriate professional, his or her participation will ordinarily not be considered knowing. See “Opinion of Professional”, below. In addition, an organization manager’s participation is ordinarily not considered knowing if the requirements of the rebuttable presumption of reasonableness are satisfied. See “Rebuttable Presumption of Reasonableness”, below.
Willful Participation. Participation by an organization manager is willful if it is voluntary, conscious and intentional. It is not willful if the manager does not know (see above discussion) that the transaction is an excess benefit transaction.
Due to Reasonable Cause. Participation is due to reasonable cause if the manager exercised responsibility on behalf of the organization with ordinary business care and prudence.
Opinion of Professional
If an organization manager, after full disclosure of all relevant facts to an appropriate professional, relies upon the advice of such professional that a transaction is not an excess benefit transaction, the person’s participation will generally not be considered to be knowing and willful and will be considered due to reasonable cause, even if the transaction is subsequently determined to be an excess benefit transaction. However, to qualify, the advice must be contained in a reasoned written opinion with respect to elements of the transaction within the professional’s expertise. An opinion must apply the specific facts relative to the transaction to the applicable standards and reach a reasoned conclusion. The opinion is not reasoned if it simply recites the facts and expresses a conclusion.
Under the preliminary regulations, reliance was limited to opinions rendered by attorneys. However, the temporary regulations have expanded the professionals on whose written opinions an organization manager may rely to include attorneys, certified public accountants or accounting firms with expertise regarding the relevant tax law matters, and independent valuation experts (appraisers and compensation consultants). Independent valuation experts must hold themselves out to the public as appraisers or compensation consultants, perform the relevant valuations on a regular basis, be qualified to make valuations of the type of property or services involved, and include in their written opinion, a certification that these requirements are met.
What is an Excess Benefit Transaction?
Excess Benefit Defined. Generally, an “excess benefit transaction” occurs anytime a disqualified person receives an economic benefit from an exempt organization which exceeds the value (not the cost) of the benefit provided to the organization by the disqualified person. All benefits from the organization to the disqualified person are taken into account, including every transaction which benefits a disqualified person, whether the benefit is direct or indirect, and whether the benefit is provided directly by the exempt organization or through an organization controlled by the exempt organization. Similarly, all benefits from the disqualified person to the organization are also taken into account. For example, when a pension plan benefit vests, the services performed for the years leading up to the year of vesting may be considered in determining reasonableness.
The excess benefit is the difference between the value of what is received by the organization and the value of what is given by the organization to the disqualified person.
With a transaction involving property, the fair market value (e.g. what would be paid between a willing buyer and a willing seller, neither being under compulsion to enter into the transaction, and both having knowledge of the relevant facts) must be examined to determine if an excess benefit has been received. [Question: what if the organization must sell, and the disqualified person offers the best price?]
Reasonable Compensation. Probably the single most likely area for an excess benefit transaction involves compensation arrangements with officers, directors, and key suppliers. Any disqualified person who receives a salary in excess of reasonable compensation may be subject to penalties and operation managers participating in the approval and payment thereof may also be subject to penalties.
What is Reasonable Compensation? Compensation is reasonable if the amount paid would ordinarily be paid for like services, by like enterprises, under like circumstances. Section 162 standards apply in determining what is reasonable, taking into account most benefits. The fact that a state or local legislative or agency body or court has authorized or approved a compensation package is not dispositive of whether the compensation is reasonable
a. Certain benefits will not be considered in determining excess benefits. These include:
1. Nontaxable fringe benefits (excluded from income under § 132), except certain liability insurance premiums, payments or reimbursements by the organization(2)
2. Economic benefits provided to a volunteer if such benefits are normally provided to the general public in exchange for a membership fee of $75 or less per year.
3. Economic benefits provided solely on account of payment of a membership fee or of a deductible contribution if a) any non-disqualified person paying such fee or making a contribution above a specific amount is given the option of receiving substantially the same economic benefit; and b) the disqualified person and a significant number of non-disqualified persons, in fact, make a payment or contribution of at least the specified amount.
4. Economic benefits provided to a disqualified person solely as a member of a charitable class.
5. Economic benefits to a governmental unit, if the transfer is made exclusively for public purposes.
b. In determining the value of compensation for purposes of section 4958, all items of compensation must be considered, including:
1. All forms of cash and noncash compensation including salary, fees, bonuses, severance payments, and deferred and noncash compensation at the time it vests or is not subject to substantial forfeiture (see Effective Dates, below).
2. Unless excludable as a de minimus fringe benefit, the payment of certain liability insurance premiums for, or payments or reimbursement by the organization not excludable under a.1, of this section (see footnote #2).
3. All other benefits, whether or not included in gross income for income tax purposes, including but not necessarily limited to medical, dental, and life insurance, severance pay, disability benefits, expense allowances, reimbursements, and forgiveness of interest on loans. A determination of whether an item is included in gross income should be made without regard to whether the item must be taken into account in determining reasonableness of compensation for purpose of intermediate sanctions.
Must be Treated As Compensation. Any benefit received by a disqualified person must be in exchange for some type of service or other benefit provided to the organization by the disqualified person, and the organization must treat it as such. Otherwise, it is treated as an excess benefit, without further consideration, and without regard to any claim of reasonableness of the total compensation package.
An economic benefit will not be treated as payment for the performance of services rendered by the disqualified person unless the organization providing the benefit clearly indicates its intent to treat it as such when the benefit is paid. Except for nontaxable benefits, an exempt organization will be treated as clearly indicating its intent to provide an economic benefit as compensation for services only if the organization provides written substantiation that is contemporaneous with the transfer of the economic benefit. If an economic benefit is reported by the organization (on a Form W-2, 1099 or 990) or by the disqualified person (on Form1040) before any IRS examination is begun, this will satisfy the requirement. There may be other written contemporaneous evidence used to demonstrate this intent, such as an executed and approved written employment contract. If the failure to report was due to reasonable cause (i.e. the exempt organization can establish that there were significant mitigating factors, or that the failure arose from events beyond its control) and the organization otherwise acted in a responsible manner, the organization will be treated as having clearly indicated its intent. If there has not been the requisite withholding or reporting and the failure to report was not due to reasonable cause, then the economic benefit will be considered an excess benefit transaction.
Percentage Payments. Some nonprofit organizations use revenue-sharing methods to pay for certain services. For example, a fundraiser might agree to conduct a fundraising event in exchange for a percentage of the overall revenues generated. Such arrangements have always been disfavored by the IRS.
The proposed regulations issued in 1998 provided that, unlike other compensation arrangements, a revenue-sharing transaction may constitute an excess benefit transaction even if the economic benefit does not exceed the fair market value of the consideration provided in return if, at any point, it permits a disqualified person to receive additional compensation without providing proportional benefits that contribute to the organization’s accomplishment of its exempt purpose.(3) In other words, the benefit can increase only in proportion to the actual services being rendered. The proposed regulations also provided that if an excess benefit is found in a transaction where the economic benefit is based on revenues, the excess benefit consists of the entire economic benefit provided in such a transaction. This means that if the proposed regulations were to be adopted as final, and any of the compensation was determined to be an excess benefit, all compensation received by the disqualified person would be treated as an excess benefit, and not just that portion that exceeds the fair market value of the consideration/services provided.
Because of the extensive controversy over this position, and the many, often conflicting suggestions made to resolve the issue, the IRS has reserved a section in the new temporary regulations to cover revenue-sharing transactions, and will continue to consider this area further. The IRS has also noted that any revised regulations issued in the future on this matter will be issued again in proposed form, and will become effective only after being published in final form. In the meantime, these transactions will be evaluated under the general rules defining excess benefit transactions.
The only item of guidance contained in the temporary regulations concerning this type of transaction is that the fact that a bonus or revenue-sharing arrangement is subject to a cap will be a relevant factor in determining the reasonableness of compensation. For example, an agreement to pay 20% of the income received, up to a total of $50,000, will more likely be found to be reasonable than will an agreement simply to pay 20% of the income.
Indirect Economic Benefit. The temporary regulations provide that a transaction that would be an excess benefit if the exempt organization engaged in it directly will still be an excess benefit transaction if it is accomplished indirectly through either of the following ways:
a. Through a Controlled Entity: If the exempt organization owns more than a 50% interest in an organization (or controls at least 50% of the directors of a non-stock organization) that organization will be a controlled entity. If it is a controlled entity, then economic benefits provided will be treated as though they were provided by the exempt organization.
b. Through an Intermediary: An intermediary is any person (including another tax-exempt entity) that participates in a transaction with a disqualified person of the exempt organization. Economic benefits provided by the intermediary will be treated as being provided by the exempt organization when 1) the exempt organization provides an economic benefit to the intermediary, and 2) in connection with receipt of the benefit by the intermediary, there is evidence of an oral or written agreement or understanding that the intermediary will provide benefits to or for the use of the disqualified person, or the intermediary provides benefits to or for the use of the disqualified person without a significant business or exempt purpose of its own.
What happens if an excess benefit is paid to a disqualified person?
What is the penalty?
Correction: Return of Benefit Plus Interest. The cost of receiving an excess benefit is severe. In all cases, the excess benefit must be corrected. Correction requires the excess benefit to be undone to the extent possible, and the taking of any additional steps necessary to restore the organization to a financial position not worse than where it would be if the disqualified person had dealt under the highest fiduciary standards.
The correction amount equals the sum of the excess benefit, plus interest on the excess benefit a rate that equals or exceeds the applicable Federal rate, compounded annually. The period from the date the excess benefit transaction occurred to the date of correction determines whether to use the Federal short-term rate, mid-term rate, or long-term rate.
Repayment of Correction Amount. An excess benefit is corrected only by the disqualified person making a payment in cash or cash equivalents, excluding payment by a promissory note, equal to the correction amount. The disqualified person may not engage in a series of transactions to attempt to circumvent this section. Notwithstanding this requirement, if the excess benefit transaction results, in whole or in part from the vesting of benefits under a nonqualified deferred compensation plan, then to the extent the benefits have not yet been distributed, the disqualified person may correct the portion of the excess benefit resulting from the undistributed deferred compensation by relinquishing any right to receive the benefits (including earnings thereon).
If specific property was transferred in the excess benefit transaction and the exempt organization agrees, the disqualified person may make a payment by returning the property. The payment will be considered to be the lesser of i) the fair market value of the property on the date the property is returned to the organization, or ii) the fair market value of the property on the date the excess benefit transaction occurred. If the payment is less than the correction amount, the disqualified person must make an additional cash payment. If the payment exceeds the correction amount, the organization may make a cash payment to the disqualified person equal to the difference. The disqualified person may not participate in the exempt organization’s decision as to whether or not to accept the return of specific property.
Excise Penalties. In addition to correction, the penalty on the disqualified person is an amount equal to 25% of the excess benefit. If the monies are not returned “within the taxable period”, an additional tax equal to 200% of the excess benefit may be imposed. If more than one disqualified person is liable for the tax, all are jointly and severally liable.
The taxable period is the period beginning on the date the excess benefit transaction occurs and ending on the earlier of the date the notice of deficiency is mailed or the 25% penalty is assessed. However, if the excess benefit is corrected within 90 days after the mailing of the notice of deficiency, the 200% penalty shall either not be assessed or shall be abated. If less than the full correction amount is paid, the 200% penalty will be imposed only on the unpaid portion.
Tax on Organization Manager. A tax equal to 10% (up to $10,000 per transaction) of the excess benefit may also be imposed on each organization manager who participates in the transaction, knowing that it is an excess benefit transaction, unless the participation is not willful and is due to reasonable cause. The $10,000 is an aggregate figure; all organization managers participating in the transaction are jointly and severally liable.
If the disqualified person receiving the excess benefit is also an organization manager, the 25%, the 200%, and the 10% tax can all be imposed on said person.
No Need To Terminate Contract. If the contract under which the excess benefit has occurred has not been completed, termination of the employment or independent contractor relationship between the organization and the disqualified person is not required. However, the terms of compensation may need to be modified to avoid future excess benefit transactions.
Correction in Case of No Longer Existing Organization. If the exempt organization no longer exists, the disqualified person must still correct the excess benefit transaction by paying the correction amount to another qualified organization, provided that organization is not related to the disqualified person. With a 501(c)(3) organization, the funds must be paid to another 501(c)(3), in accordance with the dissolution clause of the organizational documents of the exempt organization. With a 501(c)(4) organization, the correction amount must be paid to a successor 501(c)(4) organization or, if there is no successor, to another 501(c)(3) or (c)(4) organization.
Rebuttable Presumption of Reasonableness
In determining reasonable compensation, although Section 4958 does not contain the same, the legislative history indicated that Congress intended that there be a rebuttable presumption of reasonableness, or a “safe harbor.” Under the safe harbor, compensation is presumed to be reasonable, and a property transfer is presumed to be at fair market value if (1) the compensation arrangement or terms of transfer are approved, in advance, by an authorized body of the exempt organization, composed entirely of individuals without a conflict of interest, (2) the board or committee obtained and relied upon appropriate data as to comparability in making its determination; and (3) the board or committee adequately documented the basis for its determination, concurrently with making the decision. The disqualified person/organization manager normally has the burden of proving that the compensation was reasonable. However, if the three criteria above are met, the burden of proof shifts to the IRS and the IRS must prove that the compensation was unreasonable. The IRS may rebut the presumption by furnishing sufficient contrary evidence to show that the compensation was not reasonable, or that the transfer was not at fair market value.
Approval by Authorized Body. In order to be considered disinterested, the authorized body, which is made up of the board of directors, a committee of the board if authorized by state law, or to the extent permitted by local law, other parties to whom the board has delegated this duty, must not include anyone with a conflict of interest with regard to the transaction.
A person will not be considered included if the person attends only to answer questions and otherwise recuses himself or herself from the meeting and is not present during the debate and voting on the transaction or compensation arrangement.
A conflict of interest is present if a member is the disqualified person, is related to the disqualified person, economically benefits from the transaction, is in an employment relationship subject to the direction or control of the disqualified person, receives compensation or other payment subject to approval by the disqualified person, has a material financial interest affected by the transaction, or approves a transaction providing economic benefits to a disqualified person, who in turn has approved or will approve a transaction providing economic benefits to the member.
Appropriate Data as to Comparability. An authorized body has appropriate data as to comparability if, given the knowledge and expertise of its members, it has information sufficient to determine that the compensation is reasonable or the property transfer is at fair market value. Relevant information might include compensation levels paid by similar organizations (both taxable and nontaxable) for functionally comparable positions, the availability of similar services in the geographic area, current compensation surveys compiled by independent firms, and actual written offers from similar institutions competing for the services of the disqualified person. For property, relevant information might include current independent appraisals of the property to be transferred, and offers received as part of an open and competitive bidding process.
For organizations with annual gross receipts (including contributions) of less than $1 million (calculated based on the average of the 3 prior taxable years), it is sufficient that the governing body acquires and relies upon data of compensation paid by three comparable organizations, in the same or similar communities, for similar services. No inference is intended with respect to whether circumstances falling outside this safe harbor will meet the requirement with respect to the collection of appropriate data. For example, there may not be 3 comparable organizations providing similar services, and the board may select another method to meet the objective data requirement. If the exempt organization controls or is controlled by another entity, the gross receipts of both entities must be aggregated to determine if this special rule is applicable.
Note: Although obtaining this comparable data allows the organization to rely on a presumption that a transaction is reasonable, the failure to obtain the data does not, in itself, imply that the transaction is unreasonable. In addition, the organization may compile its own data rather than obtain an independent survey.
Documentation. Adequate documentation requires that the written or electronic records of the authorized body state: 1) the terms of a transaction and the date it was approved; 2) the members of the authorized body present during the debate on the transaction, and those who voted; 3) the comparability data relied upon, and how the data was obtained; and 4) any actions taken with respect to consideration of the transaction by members of the authorized body who had a conflict of interest. If the authorized body determines that reasonable compensation/fair market value is actually higher or lower than the comparables obtained, the basis for this determination must be recorded.
To be documented concurrently, records of the meeting must be prepared before the later of the next meeting of the authorized body, or 60 days after the final action or actions of the authorized body with regard to this decision are taken. Records must be reviewed and approved by the authorized body as being reasonable, accurate and complete within a reasonable time period after they are prepared.
The fact that a transaction between the exempt organization and a disqualified person has not met the safe harbor requirements and therefore is not subject to the presumption that the compensation is reasonable, does not create an inference that the transaction is an excess benefit transaction, nor does it exempt or relieve any person from compliance with any federal or state law that imposes any higher obligation, duty, responsibility, or other standard of conduct with respect to the operation or administration of the exempt organization.
Effective Dates
Date of Occurrence. An excess benefit transaction occurs on the date the disqualified person receives the economic benefit for Federal income tax purposes. If the contract provides for a series of payments over a taxable year, any excess benefit transaction resulting from the payments will be deemed to occur on the last day of the taxable year (or the date of the last payment, if only for part of the year). With qualified pension, profit-sharing or stock bonus plan benefits, the transaction occurs on the date the benefit vests. With a transaction involving substantial risk of forfeiture, the transaction occurs on the date there is no longer any substantial risk of forfeiture.
Effective Date of Law. The effective date of the intermediate sanctions is retroactive to September 14, 1995. The Act will not apply to written contracts in effect as of September 13, 1995, so long as the contract remains binding and there is no material change to the contract. If a contract may be terminated or cancelled by the organization without the disqualified person’s consent and without substantial penalty, it is not considered binding as of the earliest date the termination or cancellation would be effective. A material change includes extension or renewal of the contract, or a “more than incidental” change to any payment thereunder.
Initial Contract – When Intermediate Sanctions Apply. An initial contract is a binding, written contract between the exempt organization and a person who was not a disqualified person immediately prior to entering into the contract. Intermediate sanctions do not apply to any fixed payment (as defined below) pursuant to this initial contract, unless the person fails to substantially perform his or her obligations under the contract.
A fixed payment is defined in the temporary regulations as the amount of cash or property specified in the contract or determined by a fixed formula specified in the contract, in exchange for the provision of specified services or property. A fixed formula may incorporate an amount that depends upon future specified events or contingencies, provided that no person exercises discretion when calculating the amount or deciding whether to make a payment. Contributions to a qualified pension plan or nondiscriminatory employee benefit program are treated as fixed payments.
Similarly as to a written contract effective September 13, 1995, if the contract may be terminated or cancelled by the organization without the other party’s consent and without substantial penalty to the organization, it will be treated as a new contract as of the earliest date that any such term or cancellation, if made, would be effective. If the parties make a material change to the contract, it is treated as a new contract as of the date the material change is effective, and if the party is a disqualified person at the time the contract is treated as a new contract, it may constitute an excess benefit transaction.
Any non-fixed payments pursuant to an initial contract (e.g. an arrangement where discretion in payment is exercised) is not covered by the exception and must be evaluated to determine whether it constitutes an excess benefit transaction. In making this determination, all payments and consideration exchanged, including fixed payments made pursuant to an initial contract, are taken into account.
Determination of Reasonableness of Other Contracts/Payments. For all contracts other than initial contracts, reasonableness of a fixed payment (as defined above) is determined based on the facts and circumstances existing as of the date the parties enter into the contract. However, if there is substantial non-performance, reasonableness is determined based on all facts and circumstances from the date of entering into the contract up to the date of payment. If a payment is not a fixed payment under a contract, then the determination must be made, based on all facts and circumstances, up to and including circumstances as of the date of payment. However, the organization cannot argue that the compensation is reasonable, based on facts and circumstances existing at the time a contract is questioned.
Again, if a written binding contract may be terminated or cancelled by the organization without the other party’s consent and without substantial penalty to the organization, it will be treated as a new contract as of the earliest date that any such termination or cancellation, if made, would be effective. And if the parties make a material change to the contract, it is treated as a new contract as of the date the material change is effective.
Date for Rebuttable Presumption. For a fixed payment, the requirements for the rebuttable presumption of reasonableness must be satisfied prior to the effective date of the contract. If this is done, the rebuttable presumption applies to all payments made or transactions completed in accordance with the contract.
If the payment is not a fixed payment, the organization can rely on the rebuttable presumption described below only after the exact amount of the payment is determined or a fixed formula is specified, and the requirements for the presumption are subsequently satisfied.
If a contract contains a nonfixed payment subject to a specified cap, the authorized body may establish a rebuttable presumption at the time the contract is entered into if: i) prior to approving the contract, appropriate comparability data indicating that a fixed payment to the disqualified person of up to a certain amount would be reasonable compensation; ii) the maximum amount payable (both fixed and nonfixed) will not exceed this total; and iii) the other requirements to establish a rebuttable presumption of reasonableness are satisfied.
Revocation may still occur
The intermediate sanctions law does not affect the substantive standards for tax exemption under section 501(c)(3) or (c)(4). Therefore, even if a transaction is not an excess benefit transaction under the intermediate sanctions laws, it may still be found to be illegal. The ability of the IRS to revoke the exempt status of an organization that engages in private inurement or private benefit has not been modified. Intermediate sanctions simply provide another weapon in the arsenal of the IRS. The IRS may use either or both weapons.
Application to churches
The intermediate sanctions law applies to churches. It should be noted, however, that section 7611, which controls the process for initiating and conducting a church audit, also applies to any inquiry into whether an excess benefit transaction has occurred between a church and a disqualified person. If there is a reasonable belief that a section 4958 tax is due from a disqualified person, this will satisfy the reasonable belief requirement needed to initiate a church audit.
Conclusion
Intermediate sanctions is a major change in the law and is likely to have a significant impact on how the IRS will respond to situations where they believe insiders of nonprofit organizations have received excess benefits. Although we have tried to give basic information about the law in this memo, please note that it is a complicated area, and there may be additional relevant material applicable to your situation. Because of the adverse consequences that may occur, if you have any questions at all about how this applies to you or your organization, please do not hesitate to contact our office to assist you in your review.
1. Reg. § 53.4958-1T(d)(2)(i)(B).
2. Unless it is excludable as a de minimis fringe benefit, a payment of liability insurance premiums for or the payment or reimbursement by the organization will be included in compensation if said payment or reimbursement is: (i) of any penalty, tax or expense of correction owed as a result of an excess benefit payment, or (ii) is of unreasonable expenses incurred in a civil judicial or civil administrative proceeding arising out of the person’s performance of services on behalf of the exempt organization, or (iii) is an expense resulting from the person’s willful and unreasonable act or failure to act. Reg. § 53.4958-4T(b)(1)(ii)(B)(2).
3. Reg. Section 53.4958-5(a).
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Copyright © 2009 Lisa A. Runquist, Attorney at Law
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