Intermediate Sanctions: IRS Issues New Temporary Regulations
In a surprise move, the IRS on January 10, 2001 issued temporary, rather than final regulations to replace proposed intermediate sanctions regulations issued in 1998. The regulations' temporary form invites further comments and perhaps revisions before the rules are finalized.
The new regulations provide many new helpful examples, but fail to address revenue sharing arrangements, leaving exempt organizations with no guidance in this challenging area. In their most significant change from the proposed rules, the temporary regulations provide a special exception for initial transactions.
Congress added the intermediate sanctions rules to the Internal Revenue Code in 1996 to impose excise taxes on certain persons who engage in "excess benefit" transactions with Section 501(c)(3) and Section 501(c)(4) organizations. The taxes apply to individuals and entities who are "disqualified persons" with respect to an organization, and also to organization managers such as directors, trustees and officers. The rules do not apply to transactions with Section 501(c)(3) organizations that are private foundations, which are instead subject to even stricter rules against self-dealing.
A disqualified person who benefits from an excess benefit transaction is subject to an initial tax of 25% of the excess benefit. An additional tax of 200% of the excess benefit applies if the disqualified person does not "correct" the transaction by restoring any excess benefit to the organization. An organization manager who knowingly participates in an excess benefit transaction, e.g., by approving it, may be liable for a tax of 10% of the excess benefit, to a maximum of $10,000.
Initial Transaction Exception
Can intermediate sanctions apply when a person is contracting with an organization for the first time, and is not otherwise a disqualified person? The question whether there is an initial transaction exception to the intermediate sanctions rules --the so-called "one free bite" rule -- has been hotly debated since their enactment. This is a key issue for a charity that is negotiating an employment contract with a new CEO or executive director, or a hospital that is recruiting a new physician to its staff. The proposed regulations provided no initial transaction exception. The new temporary regulations, in a major reversal, provide that intermediate sanctions do not apply to an initial transaction. The change reflects the Court of Appeals decision in the United Cancer Council case, which was decided after the proposed regulations were released.
The new temporary regulations, in a major reversal, provide that intermediate sanctions do not apply to an initial transaction.
The exception covers only payments that are fixed, whether by amount or by formula, at the time of the initial contract. Any bonus payments under an initial contract that require discretion by the organization at a later date may still give rise to an excess benefit.
The Internal Revenue Code provides that transactions in which a disqualified person's compensation is determined on the basis of the organization's revenues will constitute an excess benefit transaction, to the extent provided in regulations. The proposed regulations provided only sketchy guidance. The temporary regulations, which supercede the proposed regulations, specifically reserve the issue and provide no guidance at all on revenue sharing transactions. Any regulations issued in this area in the future will be in proposed form to allow for comment.
This does not mean that revenue sharing transactions fall outside the intermediate sanctions rules for the time being, however. Until regulations are issued in this area, such transactions will be evaluated under the general excess benefit transaction rules. Revenue sharing transactions may therefore give rise to excise taxes if they result in a disqualified person receiving economic benefits from the exempt organization that exceed the value that the disqualified person provides in exchange.
Indirect Excess Benefit Transactions
An economic benefit that a disqualified person receives from an organization's for-profit subsidiary may be an excess benefit. The temporary regulations provide that all benefits provided to and from a disqualified person by an exempt organization and any entity controlled by it are taken into account for purposes of the excess benefit analysis. For example, if a Section 501(c)(3) organization and its for-profit subsidiary both pay compensation to a disqualified person, the value of the services that the person provides to the two organizations must be at least equal to the aggregated compensation from them in order to avoid an excess benefit situation. This rule will have significant implications for multi-entity systems.
An organization may also be treated as providing an indirect benefit through an intermediary that it does not control where 1) the organization provides an economic benefit to the intermediary, 2) the intermediary provides economic benefits to a disqualified person, and 3) there is evidence of an oral or written understanding that the intermediary will transfer property to the disqualified person, or the intermediary lacks a significant purpose of its own to make the transfer.
In defining a "disqualified person," the temporary regulations largely track the proposed regulations, but provide many more examples. The temporary regulations retain the concept that certain persons, such as voting members of an organization's governing body, presidents, chief executive officers, chief operating officers, treasurers and CFOs are per se disqualified persons. Members of their families, as well as organizations at least 35% controlled by such persons, are also disqualified persons. In other cases, all facts and circumstances determine whether a person has sufficient influence over an organization to be classified as a disqualified person.
The temporary regulations provide that the fact that a person manages a discrete segment or activity of an organization that represents a substantial portion of the organization's activities tends to indicate that the person is a disqualified person. This is an important factor for individuals or corporate managers who have management responsibility for a significant department or division of a charity.
Rebuttable Presumption of Reasonableness
The proposed regulations set out a procedure under which organizations can create a rebuttable presumption that a transaction was reasonable. By following those procedures, an organization can protect both its organization managers and any disqualified person involved in the transaction from excise tax. In order to invoke the presumption, the organization must:
(i) have the transaction approved by an independent board or board committee without the disqualified person participating;
(ii) rely on "appropriate comparability data" that documents the arms' length nature of the transaction, such as a compensation survey or appraisal; and
(iii) document the transaction in writing, such as through board minutes.
The temporary regulations make it clear that a board may satisfy the approval requirement by authorizing another person, such as a CEO, to act on its behalf where the board specifies the procedures to be used in approving compensation arrangements or property transfers.
The proposed regulations implied that large organizations were required to engage costly compensation consultants to create custom surveys in order to create appropriate compar-ability data to meet the rebuttable presumption. The temporary regulations clarify that a large organization may compile its own comparability data.
Small organizations, with annual gross receipts of not over $1 million, received a special safe harbor under the proposed regulations. In the case of employment relationships, small organizations could obtain compensation comparables from five similarly situated organizations and rely on that data. The temporary regulations make compliance easier by reducing the number of required comparables to three.
Directors and Officers Insurance
The temporary regulations resolve an ambiguity in the proposed regulations regarding the status of D&O liability insurance premiums that include intermediate sanctions coverage. An organization's payment of D&O premiums for its directors and officers will generally constitute a "working condition fringe benefit" to the individuals, with the result that it is not taxable income to them. Both the proposed regulations and the temporary regulations provide that working condition fringe benefits are not generally treated as a benefit to a disqualified person for purposes of determining whether the person has received an excess benefit. In the case of the additional premium attributable to intermediate sanctions coverage, however, the proposed regulations required the cost to be included in the excess benefit calculation. In addition, they seemed to require that the organization affirmatively treat such premiums as compensation to its directors and officers, such as by issuing a Form W-2 or 1099, in order to avoid excess benefit characterization.
The temporary regulations similarly require that the additional premium amount attributable to intermediate sanctions coverage be included for purposes of the excess benefit analysis. They then go on to clarify that the organization need not treat such premiums as compensation to the directors and officers in order to justify such payments as reasonable compensation for services, rather than excess benefit.
Organizations accordingly need not report such insurance premiums on Form W-2 or 1099.
Directors' Travel Expenses
The proposed regulations identified certain benefits that would be disregarded in determining whether a disqualified person received an excess benefit, including reimbursement for reasonable expenses of attending board meetings. "Luxury" travel and the expenses of a spouse's travel would not be disregarded, however.
Under the new rules, working condition fringe benefits are generally disregarded in determining whether there is an excess benefit. This should encompass reimbursement of expenses for board members' travel, so long as the travel is not "lavish or extravagant" under the standard that applies to business expense deductions. That standard is generally regarded as rather lenient. Organizations are not required to issue Form W-2 or 1099 for such payments, which are not taxable to the board member.
Expenses for spousal travel generally will not constitute working condition fringe benefits. Organizations should document reimbursement for spousal travel as compensation to the board member on Form W-2 or 1099. Any such amount will be included for purposes of determining whether the board member has received an excess benefit.
Organization Manager Penalties
The proposed regulations allowed organization managers to protect themselves from the 10% excise tax by relying on a written, reasoned opinion of legal counsel that a transaction was reasonable. The temporary regulations expand this rule to encompass opinions of CPAs, accounting firms, and independent valuation experts.
Public hospitals and other governmental entities that have obtained Section 501(c)(3) or 501(c)(4) status are not subject to the intermediate sanctions rules, under a clarifying provision in the temporary regulations.
The temporary regulations are in effect from January 10, 2001, until their expiration on January 9, 2004. The IRS expects to issue the regulations in final form prior to their expiration.
For more information about these intermediate sanctions contact LaVerne Woods or your usual DWT attorney.