How to comply with the 'Intermediate Sanctions' regulations

Summary:

Federal law and IRS regulations impose severe penalties on individuals who profit unduly from nonprofit organizations. This item explains what to do to avoid questions.

Answer:

The subject of Intermediate Sanctions took on newly serious dimensions in 2004. "We'd like to increase the tension in decision making about compensation in the nonprofit area," Steve T. Miller, director of the IRS's exempt-organizations division, said in an interview with the Wall Street Journal (see http://www.careerjournal.com/salaryhiring/industries/nonprofits/20040601-lublin.html).

These efforts were also described in the testimony IRS Commissioner Mark Everson gave at hearings before the Senate Finance Committee on June 22, 2004:

IRS Tax Exempt Compensation Initiative: This summer, we are launching a comprehensive enforcement project to explore the seemingly high compensation paid to individuals associated with some exempt organizations. This is an aggressive program that will include both traditional examinations and correspondence compliance checks. The purpose of the project is to enhance compliance by learning what practices organizations use to set compensation; learning how organizations report compensation to the IRS and the public; and creating positive tension for organizations as they decide on compensation arrangements. These organizations need to know that their decisions will be reviewed by regulatory authorities. This project also will have educational components.

We will be contacting hundreds of organizations. During the first stage, we will be looking at public charities of various sizes and private foundations. We will be asking these organizations for detailed information and supporting documents on their compensation practices and procedures, and specifically how they set and report compensation for specific executives. Organizations also will be asked for details concerning the independence of the governing body that approved the compensation and details of the duties and responsibilities of these managers with respect to the organization. Other stages will follow, and will include looking at various kinds of insider transactions, such as loans or sales to executives and officers. We also will be looking at organizations that failed to, or did not fully complete, compensation information on Form 990.

This information will help inform the IRS about current practices of self-governance, both best practices and compliance gaps, and will help us focus our examination program to address specific problem areas.

(The testimony is online at http://www.senate.gov/~finance/hearings/testimony/2004test/062204metest.pdf.)

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Lisa Runquist, a Los Angeles attorney, offers an explanation of this complicated subject online at her website -- see http://www.runquist.com/article_intermedsancts.htm

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Barnaby Zall posted this to the cyber-accountability listserve:

Revised Version of Intermediate Sanctions Client Memo

Here is a revised version of my client memo
explaining how to comply with the new Intermediate Sanctions rules.
Permission
is granted for reproduction so long as the reproduction includes the
sentence
"This is only a general overview of a complex new tax law."

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AVOIDING THE EXCESS BENEFITS TRANSACTION TAX

Note: This is only a general overview of a complex new tax law. For
more
information, contact Barnaby Zall at (301) 231-6943.

Summary:
If a tax-exempt organization engages in an "excess benefits transaction"
with
a person who could exercise "influence" over the organization, the
organization's directors and managers, and the influential person could be
subject to a tax of up to 200% of the "excess benefit." Some protection is
available by appropriate Board action and by working with experienced tax-
exempt organization counsel. Every exempt organization must review every
transaction with anyone who might be an influential "disqualified person" to
protect against possible significant tax liability.

Background:
Charitable organizations' assets are supposed to be forever dedicated to
public benefits, not private gain. After a flurry of publicity about persons
exploiting tax- exempt organizations for their own benefit, the Internal
Revenue Service sought new powers from Congress to punish those who engaged
in
misconduct. Previously, the IRS could only penalize the organization for an
individual's wrong-doing.

The new penalties became Section 4958 of the Internal Revenue Code, which
imposes new excise taxes. During development, however, the new penalties
were
expanded and changed. The new penalties are no longer limited to the most
serious misconduct, but apply to virtually every financial transaction with
"insiders." Now every charity (tax-exempt under § 501(c)(3) of the tax code)
or a social advocacy group (tax-exempt under § 501(c)(4) of the tax code)
must
take steps to avoid organizational and personal liability in every financial
transaction.

A former top IRS official described the thinking behind the new rules: "The
[new law] makes clear to trustees, officers, and others that the privilege
of
overseeing or managing a charitable organization is accompanied by
potentially
significant personal tax liabilities." Although for many Americans,
involvement with charitable organizations is more of a responsibility than a
privilege, the IRS has taken this reasoning to heart in implementing the new
law.

The IRS has now proposed new regulations to implement Section 4958. The
regulations are not final, but will govern the IRS's scrutiny of tax-exempt
organizations until final regulations are issued.

Thus, anyone involved in financial transactions with a charity or a social
advocacy group should carefully review all current and planned transactions
with an experienced tax-exempt organization lawyer. Although this review
provides only a "rebuttable presumption" of compliance with the new rules,
the
potential penalties are so severe that most organizations should adopt these
new procedures.

THE GENERAL RULE FOR AVOIDING EXCESS BENEFITS TAX

In order to protect against possible organizational and personal tax
liability, disinterested members of an organization's Board must review,
approve and document every financial transaction between the organization
and
a "disqualified person" to be sure the transaction does not provide an
"excess
benefit" to the disqualified person.

The Prohibition Against Excess Benefit Transactions:
A covered organization may not engage in an Excess Benefit Transaction with
a
disqualified person. Excess benefits may create taxes for the disqualified
person and the organization's managers, and may endanger the organization's
tax exemption. The general rule described above provides some protection
from
taxes and penalties on Excess Benefits Transactions.

Which Tax-Exempt Organizations Are Covered?
Organizations which are exempt from most federal taxation under Internal
Revenue Code Sections 501(c)(3) – charities, including churches, but not
including private foundations – and 501(c)(4) – social welfare advocacy
groups.

Who's A "Disqualified Person?"
"Disqualified person" is a general "catch-all" phrase in the new rules. It
means an officer, director, trustee, highly-compensated or high-level
employee, department or project manager, major donor, or anyone who has been
in a position to exert "substantial influence" over the organization within
the prior five years. For example, the founder may have substantial
influence
over an organization even if not an employee or a member of the Board, and a
department head may have substantial influence over the organization because
she controls an important part of the organization's activities. The
proposed
regulations do not cover middle-level managers or employees, only those
whose
decisions can be implemented without further approval from a higher
official.
The term also covers family members of a disqualified person, and some
employees of corporate "disqualified persons." Thus, the son of the pastor
of
a church who left that position four years before would still be considered
a
"disqualified person."

What's A Financial Transaction?
A financial transaction is any agreement or action involving the assets,
income or property of the organization. This means ANY financial
transaction;
although IRS officials suggested that small violations would be overlooked,
there is no such "de minimis" test in the new regulations. If an individual
should be sent a 1099 or W-2 tax reporting form, that would be a financial
transaction; other financial transactions might include payments too small
for
a 1099 or W-2 reporting form, severance payments, transfers of property, and
use by the disqualified person of corporate opportunities which might
otherwise have been used by the organization. Examples include paying for
directors' "luxury" or spousal expenses for Board meetings, payment of
directors' and officers' liability insurance premiums, and employee or
contractor compensation (especially including compensation for persons who
are
also officers or directors). Revenue-sharing compensation agreements (where
a
person's compensation is based in part on revenue received by the
organization) are restricted by the proposed regulations. Note that the
proposed regulations consider the "value" of the transaction, not its cost;
this could become important, for example, where the organization provides
some
benefit to disqualified persons without cost (such as a spouse's travel
costs,
or a special seat at an event).

What's An "Excess Benefit?"
An excess benefit is one that exceeds Fair Market Value for the benefit
received by the organization, or is not "comparable" to similar benefits
paid
by similar tax-exempt organizations. Fair Market Value is what an ordinary
seller and an ordinary buyer would agree upon as a price; "comparability"
means that the organization can show that it examined similar transactions
by
at least five similar organizations (larger organizations must look at more
than five). Any deviation from FMV or comparability must be documented with
an
explanation of the factors which permit the organization to pay more than
the
"going rate." These "FMV" and comparability tests are in addition (though
similar) to the older "reasonableness" test used to determine "private
inurement" to insiders. The IRS can decide a particular transaction produces
an "excess benefit" even if the organization satisfies the "FMV" and
"comparability" tests.

Who Are Disinterested Members of An Organization's Board?
Persons who do not have a conflict of interest in a particular transaction
are "disinterested." Persons who are not part of or do not benefit from the
financial transaction and are not family members of those who are part of or
who benefit from the financial transaction generally do not have a conflict
of
interest. A person who is a "disqualified person" to the organization
generally (i.e., a person who could exert substantial influence over the
organization) may be "disinterested" in a particular transaction. Thus, only
Board members who do not have a conflict of interest in a particular
transaction should review, consider and approve the transaction (and the
organization's minutes should describe any person who "recused" themselves
from considering a particular transaction). If state law permits, a
committee
of the board may act for the whole Board, or the Board may appoint a
committee
of disinterested persons to act on its behalf (those persons may become
subject to the "organizational managers' tax" described below).

What Does "Review, Approve and Document" Mean?
The disinterested members of the Board (or committee) must consider the
financial transaction (after full disclosure of the details) in advance to
determine whether the terms provide an "excess benefit" (see below). In
other
words, the disinterested members must receive a full report on the proposed
transaction, must determine whether the transaction is at "fair market
value"
or otherwise provides a better than fair market value for the organization,
and must determine whether other "comparable" organizations would enter into
the proposed transaction the same way. If the Board thinks the transaction
does not provide an "excess benefit," it must vote to approve the
transaction
(and any dissenting vote or abstention from voting must be recorded in the
minutes). The Board must also describe its reasons for approving or
rejecting
the transaction in a report or complete statement in the minutes. If the
transaction is not at fair market value, or is not comparable to what
similar
organizations might enter into, the Board must also record in the minutes
the
differences and its reasons for entering into the transaction despite the
difference.

What If An Organization Engaged In An "Excess Benefit
Transaction?"
The organization must disclose the Excess Benefit Transaction to the IRS.
Individuals must file Form 4720 to report the imposition of an Excess
Benefits
Tax. Failure to file a complete disclosure form can trigger tax penalties.

The excess benefit also may trigger three taxes. First, the disqualified
person may have to pay a 25% tax on the excess benefit. Second, if the
excess
benefit is not "corrected" (paid back or reversed) before the IRS assesses
the
first tax, the disqualified person is slapped with an additional tax of 200%
of the excess benefit. Third, "managers" of the organization (which includes
officers, directors, trustees, or persons wielding similar powers, including
committees of the Board who approved the transaction) are subject to a 10%
tax
on the excess benefit, up to $10,000 for each Excess Benefit Transaction, if
the managers "knowingly" approved the transaction. These taxes are joint and
several (full tax imposed on each individual involved).

The proposed regulations say that the IRS may waive taxes and penalties on
an
organization which "corrects" an Excess Benefit Transaction before an audit
uncovers the transaction.

Isn't There Some Way to Forestall These Taxes?
The general rule above describes a "safe harbor" mechanism to protect the
organization and those involved with it from tax liability. The "safe
harbor"
comes from disinterested Board disclosure, review and documentation. The
three
required steps are: full advance disclosure of the facts of a transaction to
a
disinterested Board or committee; consideration of Fair Market Value and
comparability; and documentation of the decision and the underlying facts.
There are other ways to review and approve transactions with disqualified
persons and the IRS has pledged to keep an open mind. The "safe harbor,"
however, can be ignored by the IRS if the auditing agent believes
circumstances indicate that the transaction was still an Excess Benefit
Transaction despite the organization's efforts.

There is another "safe harbor" for organization managers: if an
organization
obtains a "reasoned opinion of counsel" (which means a particular type of
memo
from a qualified tax-exempt organization lawyer), the managers' conduct
won't
be considered "knowingly" approving an excess benefit (so no managers' tax
imposed).

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Posted 1/20/2000 -- PB