Final IRS Intermediate Sanctions Regulations: Few Surprises
The Internal Revenue Service ("IRS") issued final intermediate sanctions regulations on January 23, 2002. The new regulations, which replace temporary regulations issued in 2001, contain few surprises and reflect only minor changes from last year's temporary rules. Like the temporary regulations before them, the final regulations fail to provide any guidance concerning "revenue sharing" transactions.
BackgroundCongress enacted "intermediate sanctions" in 1996 as Section 4958 of the Internal Revenue Code ("Code"). The provisions were intended to penalize persons who use their influence over tax-exempt organizations in order to derive an impermissible benefit from an organization. Under prior law, the only remedy for such transactions was revocation of the organization's tax exemption. The 1996 legislation provides an "intermediate" means of addressing improper transactions by penalizing both the persons who benefit from such transactions and those organization managers who approve them.
The intermediate sanctions provisions impose excise taxes on certain persons who engage in "excess benefit" transactions with nonprofit organizations that are exempt from tax under Code Sections 501(c)(3) and 501(c)(4). 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. Organization managers who knowingly participate 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.
The IRS initially issued proposed regulations under Section 4958 in 1998, to a rather critical reception. The proposed regulations were withdrawn in 2001 when the temporary regulations were issued, incorporating significant changes. The final regulations issued in January 2002 closely follow the temporary regulations.
Management Company as "Disqualified Person"
Certain persons are per se disqualified persons under the intermediate sanctions rules, while in other cases facts and circumstances determine whether a person has sufficient influence over an organization to be a disqualified person. The temporary regulations provided that voting members of an organization's governing body, its president, CEO, COO, treasurer and CFO are per se disqualified persons. Members of their families, as well as organizations more then 35% controlled by such persons are also disqualified persons.
The final regulations add another category to the per se disqualified list: an exempt organization's management company. An example in the final regulations concludes that a for-profit hospital management company that is given broad discretion to manage day to day operations and has ultimate responsibility for supervising management is a disqualified person. The example also confirms that the definition of a disqualified person is not limited to individuals.
Rebuttable Presumption of Reasonableness
Perhaps the most significant element of all three versions of the intermediate sanctions regulations is a procedure under which organizations can create a rebuttable presumption that a transaction is reasonable, and therefore not subject to intermediate sanctions. By following the procedure, an organization can provide a meaningful level of protection to both its organization managers and any disqualified person involved in the transaction.
The final regulations, like the earlier versions, provide that an organization may create the presumption if it:
(i) has the transaction approved by an independent board or board committee without the disqualified person participating;
(ii) relies on "appropriate comparability data" that documents the arms' length nature of the transaction, such as a compensation survey or appraisal; and
(iii) documents the approval in writing, such as through board minutes.
The final regulations, like the temporary ones, clarify that a board may satisfy the approval requirement by authorizing an individual, such as a CEO, to act on its behalf, to the extent permitted by state law. The board must specify the procedures for the individual to use in approving compensation arrangements or property transfers.
Tax on Organization Managers
The temporary regulations provided that an organization manager's participation in an excess benefit transaction was not "knowing," and therefore did not give rise to sanctions, if the manager relied on the fact that the organization had satisfied the rebuttable presumption of reasonableness. The final regulations are more lenient, providing that a manager's participation is not "knowing" if the organization satisfied the rebuttable presumption procedure, without addressing the subjective question of the manager's reliance.
Initial Transaction Exception
Like the temporary regulations, the final regulations contain an initial transaction exception to the intermediate sanctions rules. Specifically, intermediate sanctions do not apply to payments made under an initial contract with a party who was not previously a disqualified person, but who may become one under the contract. This is a key issue for an organization that is negotiating an employment or management contract with a new CEO or management company with which it has no prior relationship. 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.
Code Section 4958 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. Like the temporary regulations before them, the final regulations fail to provide any guidance concerning such "revenue sharing" arrangements.
This does not mean that revenue sharing transactions fall outside the intermediate sanctions rules, however. Until regulations are issued that specifically address revenue sharing, 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 in excess of the value that the disqualified person provides in exchange.
Revocation in Addition to Sanctions
The question remains when the IRS will revoke an organization's exempt status in addition to imposing intermediate sanctions. The final regulations do not shed any light on this issue. The IRS has indicated that it will at some point publish guidance on the factors that it will consider. Until then, the IRS will consider all relevant facts and circumstances. <
The final regulations are effective January 23, 2002.