As we previously reported, the "Taxpayer Bill of Rights 2" (IRC §4958) adopted three new penalty taxes that might apply when tax-exempts engage in transactions that benefit certain insiders. The taxes are called "intermediate sanctions" because, before §4958 was adopted, the only penalty the IRS could impose on these private inurement transactions was revocation of tax exemption.
The IRS has enormous discretion to impose these three new taxes as punishment any time the IRS thinks you overpaid an insider for a product or service. The regs. offer guidance for boards to achieve a "rebuttable presumption" of reasonableness, but this presumption could be difficult (and costly) to achieve, and is not a "safe harbor" because the IRS can still challenge it. And, although §4958 never uses the word "compensation", the regs. make it clear the IRS will be looking for, and penalizing, unreasonable compensation paid by tax-exempts.
Who is Affected?
The rules affect any organization described in §501(c)(3) or 501(c)(4), at the time of an excess benefit transaction ("EBT") or at any time during the five-year period ending on that date. These include most charitable, educational, and certain civic organizations, museums, apprentice funds (if exempt under (c)(3)), and scholarship and charitable trust funds. Private foundations under §509(a) were already subject to inurement penalties, so these new sanctions do not apply to them.
What is an Excess Benefit Transaction?
An excess benefit transaction is any transaction in which a tax-exempt organization provides an economic benefit to a disqualified person, and the value of the benefit exceeds the value of consideration received by the organization in exchange for the benefit. The excess benefit is generally the excess of the value of the benefit to the disqualified person over the value of the consideration received by the organization. For certain revenue sharing transactions, if they result in inurement, the excess benefit is defined as the entire amount of the transaction, not just the amount exceeding fair value.
Who is a Disqualified Person?
A disqualified person is any person who was in a position to exercise substantial influence over the affairs of the organization at any time during the 5-year period ending on the date of the excess benefit transaction,. A disqualified person also includes any family member of a disqualified person or any entity in which at least 35% of the control or beneficial interest is held by such a person. Family/constructive ownership rules apply.
How Do the New Taxes Work?
Two of the taxes are paid by the disqualified persons who benefit from an excess benefit transaction, and the other tax is paid by organization managers who participate in the transaction knowingly, willfully, and without reasonable cause. A disqualified person who receives an excess benefit from a transaction is liable for a tax equal to 25% of the excess benefit. If the excess benefit is not corrected before the 25% tax is assessed (or deficiency notice mailed), that disqualified person is then liable for a tax of 200% of the excess benefit. If correction and reasonable cause can be demonstrated, the IRS has authority to abate the penalties.
Correction is defined as 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 that in which it would be if the disqualified person had been dealing under the highest fiduciary standards. Correction occurs, for example, if the disqualified person repays the organization an amount of money equal to the excess benefit, plus any additional amount needed to compensate the organization for the loss of the use of the money or other property until the date of correction.
What About the Third Tax?
Each organization manager who participated in the excess benefit transaction, knowing that it was such a transaction, unless such participation was not willful and was due to reasonable cause, is liable for a tax equal to 10% of the excess benefit, not to exceed an aggregate amount of $10,000 with respect to any one excess benefit transaction. An organization manager is any officer, director, or trustee of such organization, or any individual having powers or responsibilities similar to those of officers, directors, or trustees of the organization. Independent contractors, acting in a capacity as attorneys, accountants, and investment managers and advisors, are not officers. Any person who has authority merely to recommend particular administrative or policy decisions, but not to implement them without approval of a superior, is not an officer. An individual who is not an officer, director, or trustee, yet serves on a committee of the governing body of an applicable tax-exempt organization that is invoking the rebuttable presumption of reasonableness (described later) based on the committee's action, however, is an organization manager for purposes of the 10% tax.
If an organization manager, after full disclosure of the factual situation to legal counsel (including in-house counsel) relies on the advice of such counsel expressed in a reasoned written legal opinionthat a transaction is not an excess benefit transaction, that manager's participation in such transaction will ordinarily not be considered knowing or willful, and will ordinarily be considered due to reasonable cause, even if the transaction is subsequently held to be an excess benefit transaction. (But be careful: the regs define what must be in the legal opinion for it to be "reasoned").
If more than one disqualified person benefits from the same transaction, all the benefitting disqualified persons are jointly and severally liable for the taxes on that transaction. Where an organization manager also receives an excess benefit from an excess benefit transaction, the manager may be liable for both taxes.
The proposed regulations provide that the taxes imposed on excess benefit transactions apply to transactions occurring on or after September 14, 1995, unless it is pursuant to a written contract that was binding on September 13, 1995, and at all times thereafter before the transaction occurred. Amendments, modifications, and extensions will probably be treated as a new contract entered into as of the date of the material modification.
Compensation: High Risk Area?
The new law seems custom made for attacking compensation paid to employees of tax-exempt organizations. The regs. specify that compensation is reasonable only if the amount would ordinarily be paid for like services by like enterprises under like circumstances. The fact that a State or local legislative or agency body, or a court, has authorized or approved a particular compensation package is not determinative of the reasonableness of compensation paid for purposes of the EBT taxes. Compensation includes all items of compensation provided for the performance of services, including salary, fees, bonuses, and severance payments, and all forms of deferred compensation that is earned and vested, whether or not funded, and whether or not paid under a qualified plan under section 401(a). Compensation includes the amount of premiums paid for liability or other insurance coverage, including coverage for EBT taxes, all other benefits, whether or not included in income for tax purposes, including payments to welfare benefit plans, and both taxable and nontaxable fringe benefits (other than working condition and de minimis fringe benefits), including expense allowances; and any economic benefit provided by the tax-exempt organization directly or indirectly through another entity, owned, controlled by or affiliated with the tax-exempt organization, whether such other entity is taxable or tax-exempt.
The regs. make reporting of these benefits critical. None of these economic benefits will be treated as consideration for the performance of services unless the organization clearly indicates its intent to treat the benefit as compensation when the benefit is paid, generally by timely reporting of the economic benefit as compensation on original or amended federal tax information returns (e.g., Form W-2 or 1099, or Form 990). Reporting/evidence of intent is also accomplished if the recipient reports the benefit as income on his Form 1040. If an organization fails to report such benefit, or otherwise fails to provide clear and convincing evidence that it intended the benefit to be compensation for services, any services provided by the disqualified person will not be treated as provided in consideration for the economic benefit. [This seems very nasty: if you fail to file an information return, you are automatically exposed to the three EBT taxes?]
Rebuttable presumption that transaction is not an excess benefit transaction
The proposed regulations provide that a transaction/compensation arrangement is presumed to be reasonable, and at fair market value, if three conditions are satisfied. The three conditions are as follows: (1) the compensation arrangement are approved by the organization's governing body or a committee of the governing body composed entirely of individuals who do not have a conflict of interest; (2) the governing body, or committee thereof, obtained and relied upon appropriate data as to comparability prior to making its determination; and (3) the governing body or committee adequately documented the basis for its determination concurrently with making that determination.
The presumption of reasonableness may be rebutted by additional information showing that the compensation was not reasonable or was not at fair market value.
The proposed regulations provide that a governing body has appropriate data on comparability (condition #2) 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 a transaction will be for fair market value. Relevant information includes, but is not limited to, compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions; the availability of similar services in the geographic area of the applicable tax-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 tax-exempt organization intends to purchase from, or sell or provide to the disqualified person. For organizations with annual gross receipts of less than $1 million, the governing body will be 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.
To be documented adequately (condition #3), the records of the governing body must note the terms of the transaction that was approved and the date it was approved; the members of the governing body who were present during debate on the transaction and those who voted on it; the comparability data obtained and relied upon by the committee and how the data was obtained; and the actions taken with respect to consideration of the transaction by anyone who is otherwise a member of the governing body but who had a conflict of interest with respect to the transaction. If the governing body determines that reasonable compensation for a specific arrangement or fair market value in a specific transaction is higher or lower than the range of comparable data obtained, the governing body must record the basis for its determination.
Excess Benefit Transactions: Examples
