Intermediate sanctions under [sections] 4958: an overview of the proposed regulations.

• Author: Taylor, J. Eric
• Position: IRC section 4958; IRS regulations

Exempt organization insiders may be liable for excise taxes if they receive excess financial benefits from the organizations they serve.

The issuance last year of proposed regulations under [sections]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 [sections] 501(c)(3) (other than a private foundation qualifying under [sections] 509(a)), or a social welfare organization qualifying under [sections] 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 [sections] 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 [sections] 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...