In 1996 Congress enacted section 4958 of the Internal Revenue Code of 1986 (the "Code"), which imposes excise taxes on transactions known as "excess benefit transactions" between disqualified persons (essentially insiders) and certain tax-exempt organizations. The excise taxes are commonly referred to as "intermediate sanctions" because they provide the Internal Revenue Service (the "IRS") with a mechanism to punish inappropriate benefits to insiders without revoking the organization’s exemption. Prior to enactment of these excise taxes, the IRS’s only option was to revoke the organization’s exemption, and it was generally reluctant to take such draconian steps except in tremendously egregious circumstances. On July 30, 1998, the IRS issued the long-awaited proposed regulations providing guidance on the rules applicable to excess benefit transactions. The proposed regulations define applicable terms, provide examples, and most importantly, set forth guidelines that exempt organizations may use to protect themselves and disqualified persons from imposition of the excise taxes. On the whole, the proposed regulations are a fair interpretation of the statute and provide much needed guidance to exempt organizations.

Operation of the Provision

In general, an excise tax is imposed on excess benefit transactions occurring after September 14, 1995. An excess benefit transaction is any transaction in which an economic benefit provided by an applicable tax-exempt organization to, or for the use of, any disqualified person exceeds the value of consideration received by the organization in exchange for the benefit. Thus, an excess benefit transaction occurs whenever the disqualified person benefits at the expense of the exempt organization. This is also commonly known as inurement. There are three potential excise taxes: (1) a tax of 25 percent of the excess benefit may be imposed on the disqualified person receiving the excess benefit; (2) a tax of 200 percent of the excess benefit may be imposed on the disqualified person if the transaction is not, in effect, unwound before the IRS officially assesses the 25 percent tax; and (3) a tax of 10 percent of the excess benefit, up to $10,000 per transaction, may be imposed on organization managers who knowingly participate in the excess benefit transaction. The regulations focus on the definition of "applicable tax-exempt organization", "disqualified person", "organization manager", and "excess benefit transaction" and provide specific guidance with respect to compensation, including revenue sharing compensation arrangements. The legislative history indicates that, in certain situations, an organization could avail itself of a presumption that the transaction is reasonable, and the proposed regulations outline the steps necessary for an organization to take advantage of this rebuttable presumption.

Applicable Tax-Exempt Organization

The excise tax provisions apply to applicable tax-exempt organizations. An applicable tax-exempt organization is any organization that is a public charity described in section 501(c)(3) of the Code or a social welfare organization described in section 501(c)(4) of the Code at any time during a five-year period ending on the date of the excess benefit transaction. An organization is deemed to be a public charity described in section 501(c)(3) of the Code if it had an IRS determination to that effect at any time during the five year period preceding the transaction, and an organization is deemed to be described in section 501(c)(4) of the Code if it attempted to take advantage of any of the provisions applicable to organizations exempt under section 501(c)(4) of the Code, whether or not it had actually received an exemption determination, during the preceding five year period. The reason for the difference in treatment is that organizations are not described in section 501(c)(3) of the Code unless they receive a determination of exemption while organizations are described in section 501(c)(4) of the Code if they meet the definition regardless of whether they apply for a determination of exemption. The purpose of the five-year look-back period is to ensure that there is no incentive to forego an exemption in order to provide an excess benefit. An applicable tax-exempt organization does not include a private foundation described in section 501(c)(3) of the Code because such organizations are subject to the more stringent self-dealing provisions of section 4941 of the Code.

The most anticipated guidance in the proposed regulations was the definition of disqualified person. The excise tax provisions only apply to transactions between a disqualified person and an applicable tax-exempt organization. Thus, if the person is not a disqualified person, the provisions do not come into play at all.

The proposed regulations define a disqualified person as a person who was in a position to exercise substantial influence over the affairs of the organization during the five year period ending on the date of the relevant transaction with the tax-exempt organization. In general, whether a person is a disqualified person will depend on all the facts and circumstances, but the proposed regulations set forth certain persons considered to have substantial influence by reason of their position in the organization and certain persons deemed not to have substantial influence.

The following individuals are deemed to be disqualified persons:

There are two categories of persons that are deemed not to be disqualified persons: (1) other public charities described in section 501(c)(3) of the Code, and (2) employees who are not classified as highly compensated employees under the Code in the year in which the benefit occurs, provided the employee is not specifically listed above as an officer or director and is not a substantial contributor. Currently, employees receiving less than $80,000 per year in compensation will not be disqualified persons as long as they are not a voting board member, an executive, or a substantial contributor. If the chief executive officer were paid less than $80,000 per year, she would nonetheless be a disqualified person.

The determination of whether any other person has substantial influence over the organization, and will therefore be classified as disqualified persons, will be based on all relevant facts and circumstances. The proposed regulations list certain factors indicating that an individual is a disqualified person and certain factors indicating that he is not. Factors indicating that a person has substantial influence over the organization include the following:

Thus, any department head of an organization is likely to be a disqualified person under the facts and circumstances test. Examples indicate that a radiologist without managerial responsibility is not a disqualified person vis-à-vis the employing hospital while the cardiologist who heads the cardiology department is a disqualified person.

The following factors tend to show that a person does not have significant influence over the organization:

The proposed regulations clarify who will be treated as a disqualified person without providing many surprises. One interesting aspect of the proposed regulations, however, is that a person may apparently be a disqualified person for purposes of the excise tax even though the relationship with the organization arises as a result of the excess benefit transaction. Thus, a person being employed as the president of a university or a hospital, for example, may be a disqualified person with respect to the first contract negotiations he has with the employer.

An organization manager who knowingly participates in an excess benefit transaction may be subject to an excise tax. An organization manager for this purpose is any officer, director, or trustee of an organization or any person having similar powers or responsibilities. A person will be deemed to be an officer if she is specifically so designated in any of the governing documents of the organization or if she regularly makes general administrative or policy decisions. A manager participates in the decision if she is silent or inactive with respect to the decision but not if she opposes the approval of the transaction. In general, an organization manager participates knowingly if he has actual knowledge of sufficient facts to indicate an excess benefit. If organization managers receive a reasoned written opinion of counsel that a transaction is not an excess benefit transaction, the managers will not be subject to the excise tax even if the transaction is later determined to be an excess benefit transaction. These rules generally follow the rules applicable to managers of private foundations with respect to self-dealing transactions.

An excess benefit transaction occurs if the fair market value of the benefit provided to the disqualified person exceeds the fair market value of the consideration, including the performance of services, received by the tax-exempt organization. Thus, the sale of property by a disqualified person to a tax-exempt organization would be an excess benefit transaction if the organization pays more than fair market value. For this purpose, fair market value is the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell. The payment of compensation in excess of reasonable compensation is also an excess benefit transaction. The proposed regulations make it clear that an excess benefit may be provided indirectly through a for-profit subsidiary. Thus, if a for-profit subsidiary of an organization were to pay more than reasonable compensation to a disqualified person of the exempt parent, the transaction would be an excess benefit transaction subject to the excise tax.

Certain economic benefits are disregarded for purposes of determining whether there is an excess benefit. For example, the payment of reasonable expenses for members of the governing body to attend meetings of the governing body, excluding luxury travel and spousal travel, is not an excess benefit transaction. In addition, the payment of insurance premiums or an indemnification payment with respect to the intermediate sanction excise taxes is not an excess benefit transaction as long as the amount of the premium or the indemnification payment, when added to all other compensation, results in reasonable compensation for services rendered. As a practical matter, the insurance premiums would likely be acceptable, but the indemnification payment, if large, would not be. Thus, there is probably incentive to purchase insurance to protect disqualified persons and managers with respect to the excise tax.

The payment of compensation may result in an excess benefit transaction if the compensation is not reasonable. Under the proposed regulations, compensation is reasonable if it is an amount that would ordinarily be paid for like services by like enterprises, including for-profit businesses, under like circumstances. Compensation for this purpose includes all items of compensation, including salary, fees, bonuses, severance payments, vested and earned deferred compensation, insurance premiums, indemnification payments, and all other benefits, whether included in taxable income or not, such as medical insurance premiums and educational benefits.

An economic benefit will not be treated as compensation for services rendered unless the organization clearly indicates its intent to treat the payment as compensation. For example, if an exempt organization pays more than fair market value for property sold by a disqualified person employee, it may not later claim that the excess over fair market value is compensation for services on the theory that, when the excess is added to other compensation, the total would be reasonable. An indication that the payment is intended as compensation would include reporting on Forms W-2, 1099 or 990 or a statement in an employment agreement. This is intended to preclude the provision of benefits which are not reported as compensation until the IRS questions the acceptability of such payments, at which time the organization argues that the payments would have been reasonable compensation in any event.

The proposed regulations permit revenue sharing arrangements between disqualified persons and applicable tax-exempt organizations under certain circumstances. If a revenue sharing arrangement is not acceptable, however, the entire amount of the payment, not just the excess over fair market value for services rendered, is deemed to be an excess benefit subject to the excise tax. This applies to revenue sharing arrangements occurring after the date of publication of the final regulations. Prior to that date, the excess benefit will be only the amount in excess of fair market value.

Whether a revenue sharing arrangement is acceptable depends on the facts and circumstances. The proposed regulations provide that an arrangement will not be acceptable if the organization permits a disqualified person to receive additional compensation without providing proportional benefits that contribute to the organization’s accomplishment of its exempt purposes. Relevant facts include the size of the benefit provided and the ability of the party receiving compensation to control the activities generating the revenues on which the compensation is based. The examples indicate that a share of net revenue would not be acceptable, but that a university could compensate an investment manager based on a percentage of the growth in value of the investment portfolio under his management.

The proposed regulations provide a procedure that enables a tax-exempt organization to establish a rebuttable presumption that a transaction is reasonable and is therefore not an excess benefit transaction. The IRS may rebut the presumption only in unusual situations. A compensation arrangement is presumed to be reasonable and a transfer of property, a right to use property, or any other benefit is presumed to be at fair market value, if three conditions are satisfied:

With respect to the first requirement, an individual is not included on an organization’s governing body if the person meets with the governing body only to answer questions and otherwise recuses herself from the meeting, that is, she is not present during debate and voting on the transaction or compensation arrangement. Thus, if the chief executive officer is on the board of directors and the organization desires to take advantage of the rebuttable presumption of reasonableness with respect to her compensation, the chief executive officer must excuse herself completely from the directors meeting during the discussion and vote on hers compensation.

Certain individuals having a conflict of interest, in addition to the disqualified person, must also recuse themselves from the discussion and vote with respect to the transaction benefiting the disqualified person. Those individuals having a conflict of interest include the following:

With respect to the second requirement under the rebuttable presumption procedures, a governing body or committee has appropriate data on comparability if it has information sufficient to determine whether a compensation arrangement will result in payment of reasonable compensation or a transaction will be for fair market value. Relevant information includes the following:

There is a special rule for small organizations. If an organization has annual gross receipts of less than $1 million, it satisfies the comparable data requirement if it has data on compensation paid by five comparable organizations in the same or similar community for similar services.

To satisfy the third requirement for the rebuttable presumption, the minutes of the meeting approving the compensation or transaction must be adequate and concurrent. To be adequate, the documentation must include the following:

Documents are concurrent is they are prepared by the next meeting of the governing body or committee occurring after the final decision.

If the three requirements are satisfied, the exempt organization will establish a rebuttable presumption that the transaction is not an excess benefit transaction. Given the potential excise taxes, applicable tax-exempt organizations should consider instituting the procedures for any transaction, including compensation arrangements, involving a disqualified person.