Review By: Samuel T. Swansen
Reprinted from Conspectus Current, Spring Issue 2000.
Copyright 2000 by Esperti Peterson Publications, LLC. All rights reserved.
This article is relevant to executives, officers, directors, and all other insiders of tax-exempt public charities, as well as all professionals who advise them. It addresses possibly the most important development for exempt organizations since passage of the Tax Reform Act of 1969.
DISQUALIFIED PERSONS
Under Section 4958, a disqualified person is anyone who, during the five-year period preceding the transaction in question, has acted in a position of "substantial influence" over the organization's affairs. The proposed regulations treat directors, trustees, presidents, CEOs, C00s, CFOS, and treasurers as persons with substantial influence. However, a person's function, not title, controls.
Employees of exempt organizations do not exercise substantial influence if they satisfy a three-part test:
The facts and circumstances test determines whether or not other persons are disqualified persons. Factors indicating that a person has substantial control include:
Someone who controls a significant, but discrete, segment of an organization may also be a disqualified person. The proposed regulations provide as an example the dean of a law school at a major university who has control over sizeable operating and capital budgets. Attribution can also cause disqualification (e.g., through spouses and family members), as can ownership of a partnership, trust, or corporation in which a disqualified person possesses a 35% or greater interest in voting rights, profits, or beneficial interest. Factors indicating that a person is not disqualified include: a vow of poverty by an employee or agent of a religious organization; actions in the capacity of independent advisor, such as attorney or accountant; or contributors who receive treatment no more preferential than other similar contributors.
EXCESS BENEFIT TRANSACTIONS
Disqualified persons who enter into an excess benefit transaction with a public charity risk significant liability for themselves and the charity.
An excess benefit transaction is any transaction in which the value of the benefit the exempt organization provides to, or for the use of, a disqualified person exceeds the benefit the organization receives. This potentially includes any transaction between a disqualified person and an exempt organization, including compensation and acquisition or disposition of property. The old rule of compensation - that it be reasonable - still stands, but the consequences for being wrong are now much more severe. Evidence that the organization intends benefits as compensation must be clear and convincing, for example by including them on a Form W-2 or Form 1099.
The proposed regulations disregard four classes of economic benefits:
Special rules apply to revenue-sharing arrangements with disqualified persons that are based, in whole or in part on the exempt organization's activities (e.g., basing an employee's compensation on a percentage of revenues from a fundraising activity). Under such an agreement the disqualified person must provide benefits that are proportional to the additional compensation.
THE REBUTTABLE PRESUMPTION OF REASONABLENESS
Under the proposed regulations, a charity can establish a rebuttable presumption of reasonableness. To do so, disinterested persons on the governing body or a committee thereof must approve the transaction, based upon "appropriate data" as to comparability. Appropriate data is information that allows the governing body to determine whether the compensation is reasonable or the transaction is for fair market value. (A special rule applies to organizations that receive less than $1 million in annual donations.) To establish the rebuttable presumption, the governing body must also thoroughly document the basis for its decision.
CALCULATING THE EXCISE TAX
If a disqualified person enters into an excess benefit transaction, he or she must pay an excise tax equal to 25% of the excess benefit. If more than one disqualified person receives the benefit, all such recipients are jointly and severally liable for the excise tax. Absent reasonable cause, all managers who knowingly participate in the transaction are jointly and severally liable for an additional excise tax equal to 10% the excess benefit, up to $10,000 each. Managers who receive an excess benefit can be liable for both excise taxes.
There is an additional excise tax equal to 200% of the excess benefit amount if the disqualified person fails to "correct" the problem in a timely fashion.
THE FUTURE OF INTERMEDIATE SANCTIONS
In a recent decision, United Cancer Council v. Comm'r, the Seventh Circuit refused to revoke an organization's exempt status based on a private inurement theory, holding that such a theory applies to insiders only and not to an outside direct-mail fundraiser. In United Cancer Council, the outside fundraiser was paid fees and expenses of $26.5 million out of the $28 million it raised for the charity.) Significantly, the court indicated that the Service's "facts and circumstances" standard was "no standard at all, and makes the tax status of charitable organizations and their donors subject to the whim of the Service." Thereafter, the Service indicated that it would make several changes in the final regulations. The Service also notified its field agents to submit all decisions to impose intermediate sanctions to the National Office for technical advice.
Intermediate sanctions are here to stay, although as a result of United Cancer Council, the final regulations may be more helpful than the proposed regulations. Until Treasury promulgates final regulations, however, exempt organizations should use the proposed regulations as a guide.
At a minimum, exempt organizations should compile fists of all disqualified persons and closely scrutinize any transaction involving these persons. To help establish the rebuttable presumption, the organization should implement procedures regarding interested parties; no interested person should participate in consideration of any potential excess benefit transaction. Moreover, the governing body should establish procedures so that it meticulously documents all deliberations concerning these transactions, particularly the data it considers concerning comparability to similar transactions. The Internet, with Web sites like www.guidestar.com, should assist organizations in compiling this information. The practice tool further details practices and procedures to establish the rebuttable presumption.
Since the Tax Reform Act of 1969, the Service has enforced rules in Section 4941 prohibiting self-dealing in connection with private foundations. The idea was that other than reasonable payments for goods or services, no charitable funds should inure to the benefit of any private individual.
The problem, in the Service's view, was what to do about self-dealing abuses that occurred in public charities. Until the advent of intermediate sanctions, as set forth in Section 4958 and the proposed regulations thereunder, the only real remedy was to revoke the organization's exempt status.
Instead of imposing a prohibition on self-dealing, the proposed regulations force a refund of the excess amount of any excess benefit transaction and impose a penalty. This authorizes the Service to penalize all persons involved in such transactions, without penalizing the charity, while regaining for the charity the excess amount, plus an additional amount for opportunity costs, etc.
While the proposed regulations offer a rebuttable presumption of reasonableness, its requirements may be significantly higher than those necessary to satisfy fiduciary duties under state law. Therefore, boards of directors and persons in positions to exercise influence over public charities must familiarize themselves with these requirements and strictly enforce them in all transactions involving disqualified persons.
All managers and board members of public charities must also familiarize themselves with state law regarding conflicts of interest and fiduciary duties. In certain instances, such law may impose higher standards than Section 4958.
THE LAW
IRC §§ 501(c)(3),
501(c)(4), 507(d)(2), 4958
Prop. Reg. §§
53.4958-1 - 53.4958-7
Notice 99-55,1999-49 I.R.B.
638
United Cancer Council
v. Comm, 165 f 3d 1173 (7th Cir. 1999)
ADDITIONAL REFERENCES
Boisture and Sellers. Treasury Issues the Long- Awaited Proposed Regulations on Intermediate Sanctions, 10 JOURNAL OF TAXATION OF EXEMPT ORGANIZATIONS 99 (Nov./Dec. 1998).
Flannery, Scott and Ting. Intermediate Sanctions Proposed Regs. Highlight Dangers of Excess Benefit Transactions to Exempt Org. Executives, JOURNAL OF ASSET PROTECTION, Jan./Feb. 1999, at 48.
Mancino. A Practical Guide to the Rebuttable Presumption of Reasonabless, 11 JOURNAL OF TAXATION OF EXEMPT ORGANIZATIONS 105 (Nov./Dec. 1999).
Simpson. Tax-Exempt Organizations: Organization, Operation and Reporting Requirements, 870 TAX MGMT. (BNA).
