IRS targets excess-benefit transactions.

• Author: Packard, Pamela

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 organization's 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 Service's revocation of an organization's tax-exempt status. It found that the organization's directors had received excess benefits of more than $5 million. Although the Federal government initially expressed an intention to appeal the Tax Court's 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 organization's 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 IRS's Exempt Organizations Division indicated that even though the Service will continue to examine the validity of an organization's 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...