Planning strategies to avoid intermediate sanctions.

• Author: Richtermeyer, Sandra B.

EXECUTIVE SUMMARY

* Disqualified persons, such as officers, directors and trustees who exercise substantial influence over an exempt organization, are subject to a substantial excise tax when they receive an excess benefit from it.

* Excess benefit transactions include unreasonable compensation, asset purchases for more than FMV and other private inurement transactions.

* Tax advisers can help exempt organizations avoid excess benefit sanctions by reviewing compensatory arrangements and financial transactions with disqualified persons.

Tax advisers can help tax-exempt clients minimize the risk of triggering 5ec. 4958 sanctions on excess benefit transactions. This article identifies these transactions, explains the potential excise tax liability and discusses strategies for avoiding or reducing sanctions.

A substantial excise tax can be imposed under Sec. 4958 when officers, directors, trustees and other persons exercising influence over a tax-exempt entity receive an excess benefit from the organization. Detailed guidance on the grounds and liability for such sanctions is provided in regulations. (1) This article reviews the current rules on excess benefit transactions, the potential excise tax liability arising from these transactions and strategies for minimizing the risks of sanctions.

Background

Prior to the Taxpayer Bill of Rights 2 (TBOR2), revocation of exempt status was the only tool the IRS had to punish Sec. 501(c)(3) or (4) tax-exempt organizations that paid disqualified persons unreasonable compensation, or more than fair market value (FMV) for an economic benefit. When the IRS identified such situations--known as private inurement--it was faced with two extreme choices: (1) chastise the organization and ignore the indiscretion or (2) rescind the nonprofit's exempt status. (2) Thus, chief executive officers (CEOs), chief financial officers (CFOs), managers or board members who received such excess benefits potentially jeopardized the organization's exempt status.

Recognizing the potential inequity of punishing an entire organization for the transgressions of one or just a few persons, Congress struck a compromise in the TBOR2 by creating an excise tax in Sec. 4958 that could be imposed on offending persons of influence in nonprofit organizations. It also reduced the threat of excess benefit transactions triggering revocation of the organization's exempt status, unless such benefits are carelessly blatant. This legislation is often referred to as "intermediate sanctions," because the sanctions are a choice between inaction by the IRS and revocation of exempt status. It has considerable relevance for exempt entities concerned with proper governance, as well as for tax professionals with exempt clients. (3)

Intermediate Sanctions--Overview

Sec. 4958 and Regs. Sec. 53.4958 are the primary authority on intermediate sanctions. Guidance is also derived from cases, although most pertain to old (pre-1996) law. (4) In general, according to the Committee Reports, the Sec. 4958 excise penalty tax will be the only sanction imposed on an exempt transaction if the indiscretion is not so significant that it brings into question whether the organization is still charitable in its focus and mission. (5)

Excess Benefit Transactions

Sec. 4958(c)(1)(A) defines an excess benefit transaction as:

[A]ny transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person, if the benefit's value exceeds the value of the consideration (including the performance of services) received for providing such benefit.

The three broad types of excess benefit transactions are (1) unreasonable compensation payments; (2) organizational purchases of assets from the disqualified person for more than their FMV; and (3) payments to a disqualified person that violate private inurement, such as certain revenue-sharing transactions. (6)

Disqualified Persons

Sec. 4958(f)(1)(A) defines disqualified persons generally as insiders (e.g., officers, employees, directors or trustees) who "exercise substantial influence" and control over an exempt organization. These persons are insiders who can potentially deal with the organization on a non-arm's-length basis because of their substantial influence, allowing them to reap "excess benefits" normally not possible for persons without such stature.

Under Regs. Sec. 53.4958-3(c), a person is deemed to exercise substantial influence if he or she is a (1) voting member of the governing body; (2) president, CEO or chief operating officer; (3) treasurer or CFO; or (4) person with material financial interests in a provider-sponsored organization. According to Kegs. Sec. 53.4958-3(e), the facts and circumstances may also suggest substantial influence if the person (1) founded the organization; (2) is a substantial contributor; (3) is compensated based primarily on organization revenues; (4) has or shares authority to control capital expenditures; (5) manages a discrete segment of the organization that represents a substantial portion of its activities, assets, income or expenses; (6) owns a controlling interest in the entity; or (7) is a nonstock organization controlled by disqualified persons.

Members of a disqualified person's family are also disqualified under Sec. 4958(f)(1)(B) and Regs. Sec. 49583(b). A person's family is limited to (1) a spouse, (2) brothers and sisters and their spouses, (3) ancestors, (4) children and their spouses and (5) grandchildren and great-grandchildren and their spouses. Finally, 35%-controlled entities of disqualified persons are also disqualified, under Sec. 4958(f)(1)(C). Further, anyone who has met any of these definitions at any time during the five years preceding the excess benefit transaction is disqualified.

Conversely, the following have no substantial influence: (1) Sec. 501(c) (3) organizations, (2) certain Sec. 501(c)(4) organizations or (3) employees who are not persons of influence listed above and are not highly compensated as described in Sec. 414(q) (providing an income threshold of $95,000 in 2005). (7)

Valuing Disqualified Person's Compensation

To determine whether excess benefits relate to a disqualified person, it is necessary to establish the compensation's FMV under Regs. Sec. 53.49584(b)(1)(ii). Traditional Sec. 162 standards apply, which typically involve compensation comparisons with persons who perform analogous functions for similar organizations. According to Regs. Sec. 53.4958-6(c)(2), compensation can be compared to current surveys compiled by independent firms and/or actual written offers from similar institutions for the disqualified person in question. If property transfers are involved, the property's FMV can be compared to current independent appraisals, as well as offers received as part of a competitive bidding process.

Insider compensation packages that involve a cap enhance the presumption of reasonableness, while authorization or approval by state or local legislative agencies or courts is not effective. (8) For example, an administrator of an exempt organization was deemed to receive private inurement because compensation was determined on a percentage basis, was not linked to business goals and had no ceiling. (9) Further, Regs. Sec. 53.4958-6(a)-(c) outline a rebuttable presumption that compensation arrangements with insiders are...