Understanding Intermediate Sanctions Rules; Legal; IRS Disciplining of Tax-Exempt Organizations
For many years the Internal Revenue Service had only one main weapon to enforce the various rules and requirements applicable to organizations exempt from federal income tax: revoking tax-exempt status. But the IRS found many situations in which revocation of exemption was too dire a penalty for relatively minor transgressions of exempt organizations. Therefore, the IRS sought a penalty--intermediate sanctions--positioned somewhere between no penalty at all and revocation of exemption. As part of the 1996 Taxpayer Bill of Rights 2, Congress enacted an intermediate sanctions rule imposing penalties on excess benefit transactions by some types of tax-exempt organizations. On January 23, 2002, the final regulations implementing the law were issued. The law and regulations apply to all organizations exempt from taxation under Section 501(c)(3), other than private foundations, and under Section 501 (c)(4).
Jerald A. Jacobs
In this article, Lauren W. Bright explains the ramifications of the intermediate sanctions rules. Intermediate sanctions regulations impose penalties on what the Internal Revenue Service (IRS) considers excess-benefit transactions of most 501(c)(3)and all 501(c)(4) organizations. Understanding the regulations will help leaders of these organizations avoid such penalties.
Intermediate sanctions may be imposed by the IRS on any "disqualified person" who receives an "excess benefit" from a "covered organization." In the even that an excess benefit, such as unreasonably high compensation, is paid to a disqualified person, the excess benefit must be corrected to the extent possible and any necessary additional steps must be taken to restore the organization to a financial position no worse than it would have been had the excess-benefit transaction not occurred. The intermediate sanctions rules generally apply to excess-benefit transactions occurring on or after September 14, 1995. However,the rules do not apply to written contracts in effect as of September 13, 1995,as long as the contract remains binding and there are no material changes in the agreement.
Defining a disqualified person
Under the law, 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 a five-year period ending on the date of the transaction in question. Specifically, this would include officers, directors, and executive employees of tax-exempt organizations, or a family member of a disqualified person.
In addition, an organization's manager, defined as "any officer, director,or trustee of an organization (or any individual having powers or responsibilities similar to those of officers, directors, or trustees of the organization)," who knowingly participates in an excess-benefit transaction, may also be subject to financial penalties. For purposes of demonstrating knowing participation, a manager must have actual knowledge of facts indicating that the transaction is an excess-benefit transaction, must be aware that the transaction may violate the law, or must negligently fail to ascertain whether the transaction is an excess-benefit transaction. Participation includes silence or inaction, when the manager is under a duty to speak or act, as well as any affirmative actions that may be taken. An organizational manager's actions may not, however, be deemed knowing if the manager relied on the advice of legal counsel, certified public accountants, or other professionals with relevant expertise.
Independent contractors such as legal counsel or a certified public accountant are not deemed to have substantial influence over an organization if the contractor's sole relationship to the organization is to provide professional advice and the contractor does not have control over the organization's decisions. This presumes, however, that the contractor receives no compensation from the organization other than normal and customary fees.
Clarifying excess-benefit transactions
An excess-benefit transaction is defined in the law to mean any 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 value of the economic benefit provided exceeds the value of the consideration received for providing such benefit." In short, the excess benefit is the difference in value of that received by the organization and that given by the organization to the disqualified person. All benefits from the organization to the disqualified person must be considered, regardless of whether the benefit was directly or indirectly received.
The most common area of potential excess-benefit transactions is that of compensation arrangements with directors, officers, managers, or vendors. Under general principles of corporate law, directors and officers are prohibited from making monetary profit from a nonprofit corporation as a result of their positions. However, unless provided in statute or corporate bylaws, directors and officers are not legally prohibited from receiving reasonable compensation for services provided. This means that the payment must relate to, and be no more than, the fair market value of the services being rendered.
Determining reasonable compensation
The facts and circumstances test is generally the basis for determination of reasonable compensation. Under the test, the IRS will review the totality of circumstances to determine whether a compensation plan was created to serve the interests of private individuals. In addition, the IRS will review the structure of the salary or compensation plan to determine whether the payment reflects fair market value or competitive market price. The IRS has identified three criteria that, if met, provide a presumption that compensation is reasonable. Under this safe harbor rule, compensation is presumed to be reasonable if it meets the three criteria.
1. No conflict of interest. The compensation arrangement must be approved in advance by an authorized governing body of the exempt organization, which is composed entirely of individuals who do not have a conflict of interest with regard to the transaction.
2. Appropriate data as to comparability. The authorized body must have obtained and relied on appropriate data as to comparability prior to making its determination. Relevant information might include compensation levels paid by similar organizations for comparable positions, the availability of similar services in the geographic area, and examples of offers from similar organizations competing for the services of the disqualified person. An organization with gross revenues of less than $ 1 million will be deemed to have appropriate information f it obtains compensation data from three comparable organizations.
3. Appropriate documentation of the determination. Concurrent with making the determination, the authorized body must adequately document the basis for its decision. The written or electronic records of the authorized body must state the terms and date of approval of the transaction, the members of the authorized body present during the discussion on the transaction, a record of the vote, the comparability data used, and notation of how the body treated any individual with a conflict of interest in the transaction.
Given the significant amount of attention focused on this issue, it is prudent for tax-exempt organizations affected by the intermediate sanction provisions to carefully analyze and evaluate all compensation proposals and arrangements and make every attempt to conform to IRS rules .
Lauren W. Bright is an attorney and Jerald A. Jacobs is a partner in the Nonprofit Organizations Practice at the law firm of Shaw Pittman, Washington,D.C. Jacobs edits this column and is general counsel to ASAE.