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 rectify inappropriate benefits to insiders without revoking the organization’s tax-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 a draconian step except in tremendously egregious circumstances. Proposed regulations providing guidance on the rules applicable to excess benefit transactions were issued in 1998. On January 9, 2001 the IRS issued temporary regulations which refine and clarify the previously issued regulations. The temporary regulations, which are in effect for three years from January 10, 2001 through January 9, 2004, 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 temporary regulations address many of the concerns raised by the proposed regulations and provide much-needed guidance to exempt organizations.

Operation of the Provision

In general, an excise tax is imposed on excess benefit transactions occurring on or 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. The temporary regulations outline available safe harbors and the steps necessary for an organization to (1) take advantage of a rebuttable presumption that a transaction is reasonable and (2) correct an excess benefit transaction to avoid imposition of second tier excise taxes. One major departure from the proposed regulations is the IRS’s decision to withhold issuing guidance regarding revenue-sharing arrangements, pending further discussion and study by the IRS and the Treasury Department.

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 (the "look back period") is to ensure that there is no incentive to forgo 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 temporary regulations make no significant departure from the guidance in this area set forth in the proposed regulations.

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 temporary 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 look back period. In general, whether a person is a disqualified person will depend on all the facts and circumstances, but the temporary regulations set forth certain persons considered to have substantial influence by reason of their positions and/or authority in the organization and certain persons deemed not to have substantial influence.

The following individuals are deemed to be disqualified persons:

1. Any individual who serves as a voting member of the governing body of the organization;
2. Any individual or individuals who have the power or responsibilities of the president, chief executive officer, or chief operating officer of the organization;
3. Any individual or individuals who have the power or responsibilities of treasurer or chief financial officer of the organization, provided the person has ultimate responsibility for managing the finances of the organization; and,
4. Any person who has a material financial interest in certain provider-sponsored organizations in which a hospital that is an applicable tax-exempt organization participates.

With regard to the per se disqualified persons described above, the temporary regulations make clear that a person who has the authority of an identified officer or director is classified as a disqualified person, regardless of title.

Three categories of persons are deemed not to be disqualified persons: (1) other organizations described in section 501(c)(3) of the Code, including private foundations; (2) social welfare organizations described in section 501(c)(4) of the Code, but only with regard to other organizations described in section 501(c)(4) of the Code; and (3) 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, by title or authority, an officer or director of the organization and is not a substantial contributor. Currently, employees receiving less than $85,000 per year in compensation will not be disqualified persons as long as they are not a voting board member, an executive, an officer, an employee whose job description includes authority usually vested in an officer, or a substantial contributor. If the chief executive officer were paid less than $85,000 per year, she would nevertheless be a disqualified person. The second category of per se non-disqualified persons was an addition to the categories found in the proposed regulations.

The determination of whether any other person has substantial influence over the organization, and will therefore be classified as a disqualified person, will be based on all relevant facts and circumstances. The temporary 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:

1. The person founded the organization;
2. The person is a substantial contributor, meaning that the person contributed more than $5,000 to the organization and his contribution represented more than two percent of total contributions and bequests received by the organization during its current year and the four preceding taxable years (the temporary regulations specify that only contributions made during this defined time frame must be considered);
3. The person’s compensation is primarily based on revenues derived from activities of the organization that the person controls (the temporary regulations clarify this factor by requiring that the compensation be primarily based on such revenues);
4. The person has or shares authority to control or determine a substantial portion of the organization’s capital expenditures, operating budget, or compensation for employees;
5. The person manages a discrete segment or activity of the organization that represents a substantial portion of the activities, assets, income or expenses of the organization, as compared to the organization as a whole (note that this factor is more specific than the provision in the proposed regulations, which merely identified persons having managerial authority);
6. The person owns a controlling interest in a corporation, partnership, or trust that is a disqualified person; and
7. The person is a non-stock organization controlled directly or indirectly by one or more disqualified persons.

Examples indicate that a radiologist without managerial responsibility affecting either the hospital as a whole or a discrete segment of the hospital is not a disqualified person vis-à-vis the employing hospital, while the cardiologist who heads the cardiology department, which constitutes a significant portion of the hospital’s activities and generates a corresponding portion of its revenues, is a disqualified person.

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

1. The person has taken a bona fide vow of poverty;
2. The person is an independent contractor, such as an attorney, accountant, or investment manager, acting in such capacity;
3. The direct supervisor of the individual is not a disqualified person;
4. The person does not participate in any management decisions affecting the organization as a whole or a discrete segment or activity of the organization that represents a substantial portion of the activities, assets, income or expenses of the organization, as compared to the organization as a whole; and
5. Any preferential treatment received because of the size of an individual’s contribution is also provided to any other donor making a comparable contribution.

One significant addition in the temporary regulations is the "initial contract safe harbor." A person will not be considered to be a disqualified person when the factors which would lead to that classification arose as the result of a binding written contract between the organization and a person who was not a disqualified person immediately prior to entering into the contract. Therefore, even if payment under the contract would otherwise constitute an excess benefit transaction, the intermediate sanctions would not apply because the person receiving the excess benefit would not be a disqualified person. The theory behind this safe harbor is that the person was not in a position to exert substantial influence over the organization at the time the contract with the excess benefit transaction was made. The following rules apply to the initial contract safe harbor:

1. The payment under the contract must be fixed, through either a specified amount or formula, meaning that the contract may not allow for subsequent discretion to be exercised when calculating the amount of a payment or deciding when to make payment; and 
2. If the contract is later materially modified, or if the person fails to substantially perform his contractual obligations during any given term, the safe harbor no longer applies and the excess benefit must be evaluated under the intermediate sanctions rules.

So, for example, if a person who is not a disqualified person enters into a contract with a university to serve as President of the university for a five-year term at a salary that exceeds the threshold for highly compensated employees and which will increase according to the Consumer Price Index each year, no excess benefit transaction analysis is necessary because the transaction calls for a fixed payment that falls under the initial contract safe harbor.

It must be emphasized that regardless of whether a particular transaction is subject to excise tax under the intermediate sanctions as an excess benefit transaction, existing principles and rules may be implicated, such as the limitation on private benefit. For example, transactions that are not subject to the excise benefit taxes because of the initial contract exception may nonetheless, under certain circumstances, jeopardize the organization’s tax-exempt status.

Organization Manager

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 she 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. The temporary regulations clarify that an opinion of counsel can be from an attorney, a CPA or an accounting firm, or certain independent valuation experts (public appraisers or compensation consultants).

An organization manager can likewise escape imposition of the excise tax if she relies on the fact that the requirements giving rise to a rebuttable presumption of reasonableness are satisfied with regard to the transaction. The elements necessary to establish a rebuttable presumption are discussed in detail below.

Excess Benefit 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. With regard to an amount not fixed in the contract, reasonableness is determined based upon all facts and circumstances up to, and including, the date the payment in issue is made. 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 temporary regulations make clear that an excess benefit may be provided indirectly through a controlled entity or intermediary of a tax-exempt organization. For purposes of an indirect excess benefit transaction, a controlled entity is one in which the organization has more than a 50 percent interest (by vote, value or board control, depending on the type of entity).

In contrast, an intermediary is any person, including an individual or a taxable or tax-exempt business, having no other necessary relationship to the exempt organization, who participates in a transaction with one or more disqualified persons of the organization. Any economic benefit provided by an intermediary to a disqualified person will be an excess benefit transaction if:

1. The organization provides an economic benefit to the intermediary with the oral or written understanding that the intermediary will provide economic benefits to the disqualified person; and
2. The intermediary provides the benefit to the disqualified person without having a significant business or exempt purpose of its own to support the transaction.

So, for example, a research lab having no previous relation to a tax-exempt organization may receive a research grant from the organization and, after conducting a reasonable search, may independently hire a researcher who is a disqualified person with regard to the organization. Such a scenario will not result in an indirect excess benefit because (1) the lab has a significant purpose of its own in hiring the disqualified person, and (2) there is no oral or written understanding between the organization and the lab that the lab will hire the disqualified person or otherwise provide him with economic benefits as a result of the grant.

The reasonableness of any fixed payment is determined at the time the parties enter into the contract. If the compensation or benefit is subject to subsequent discretion, such as a bonus to be based on performance, then the reasonableness of the payment may only be assessed after the amount has been determined.

The temporary regulations offer the following example: A disqualified person enters into a new employment contract with an organization. The contract provides for a specified amount of salary, contributions to a qualified pension plan, and a discretionary bonus to be determined by the Board of the organization. The specified amount of salary and benefits constitute fixed benefits and therefore the reasonableness of those economic benefits can be evaluated as of the day the contract is made. However, because the bonus payment is not a fixed payment, the determination of whether any bonus awarded to the disqualified person is an excess benefit cannot be made until the amount or a formula for calculating the amount has been specified.

The temporary regulations specify that embezzled money can count toward a determination of whether an individual has received an excess benefit. Basically, the guidance provides that an organization does not have to approve a transfer of funds or assets in order for that transfer to result in an excess benefit to the disqualified person.

Certain economic benefits are disregarded for purposes of determining whether there is an excess benefit. Fringe benefits that are generally excluded from gross income under section 132 of the Code are disregarded for purposes of determining whether excess benefit exists, with the exception of liability insurance payments. By paralleling existing rules in the Code regarding what is considered income, the temporary regulations encompass the more specific provision of the proposed regulations which stated that the payment of reasonable expenses for members of the governing body to attend meetings of the governing body are not economic benefits for purposes of excess benefit determination, but that luxury travel and spousal travel are.

Compensation as an Excess Benefit Transaction

The payment of compensation may result in an excess benefit transaction if the compensation is not reasonable. Under the temporary 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. Note that if insurance premiums or indemnification payments qualify as de minimus fringe benefits, they may be excluded from total compensation. Additional factors in determining reasonableness of compensation include the rate at which any deferred compensation accrues and whether a bonus or revenue-sharing plan is subject to a cap (if the bonus or revenue-sharing plan is subject to a cap, the reasonableness of the total compensation can be evaluated by including the maximum possible amount of the bonus or revenue-sharing payment).

An economic benefit will not be treated as compensation for services rendered unless the organization clearly indicates that it intends to treat the payment as such by providing a written substantiation that the services to the organization are contemporaneous with the transfer of the benefits at issue. An indication that the payment is intended as compensation would include reporting by the organization on Forms W-2, 1099 or 990 (either in an initial filing or on an amended filing, provided that amendment takes place prior to any IRS examination of the year in question), reporting by the employee on a Form 1040, or an appropriate statement contained in an employee 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. 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.

The temporary regulations provide an exception to the substantiation requirement. Non-taxable benefits such as employer-provided health benefits, contributions to qualified pension plans, and profit sharing do not require written substantiation that they are being transferred in exchange for services to the organization. There is an assumption that the benefits are part of a comprehensive employee compensation program. However, these non-taxable benefits must still be taken into account in determining the reasonableness of the disqualified person’s total compensation.

Guidance regarding revenue-sharing transactions, which was briefly discussed in the proposed transactions, is not included in the temporary regulations. The IRS has stated that proposed regulations addressing revenue-sharing transactions will be issued separately after the IRS and Treasury Department have considered relevant issues further. Until such proposed regulations are issued, the temporary regulations provide that any revenue-sharing transaction will be evaluated under the general provisions as they apply to all excess benefit transactions.

Correcting an Excess Benefit Transaction

An excess benefit transaction is corrected by undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the tax-exempt organization in the same financial position it enjoyed prior to the excess benefit transaction. The correction amount with respect to an excess benefit transaction equals the sum of the excess benefit plus any interest on the excess benefit, as calculated according to the applicable Federal rate ("AFR"). An excess benefit may be remedied in several ways:Correction may be made through cash or cash equivalents, excluding payment by a promissory note;

1. If the excess benefit has resulted from the vesting of benefits provided under a nonqualified deferred compensation plan, then to the extent that such benefits have not yet been distributed, the disqualified person may correct the portion of the excess benefit by relinquishing any right to receive such benefits; or
2. If the tax-exempt organization agrees (absent the vote or input of the disqualified person), correction may be made by returning the specific property transferred in the excess benefit transaction, in which case the value of the specific property will be the lesser of (i) the fair market value of the property determined on the date it is returned to the organization, or (ii) the fair market value of the property on the date the excess transaction occurred.

If the correction amount is not met by the relinquishment of vested benefits or the return of specific property, the disqualified person must make an additional cash payment to the organization equal to the difference.

Rebuttable Presumption of Reasonableness

The temporary regulations provide a procedure that enables a tax-exempt organization, or its controlled or affiliated entity, 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 that is fixed under the contract (not subject to subsequent discretion) 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 met:

1. The compensation arrangement or terms of the transfer are approved in advance by the organization’s governing body or a committee of the governing body composed entirely of individuals who do not have a conflict or interest with respect to the arrangement or the transfer;
2. The governing body or committee obtained and relied upon appropriate data as to comparability prior to making its determination; and
3. The governing body or committee adequately documented the basis for its determination concurrently with making that determination.

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 her 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:

1. Persons related to any disqualified person receiving an economic benefit, that is, spouses, siblings, spouses of siblings, children, grandchildren, great grandchildren, spouses of children, grandchildren, and great grandchildren, and certain 35 percent-owned entities;
2. An employee under the supervision of the disqualified person receiving an economic benefit;
3. A person receiving compensation or other payment subject to the approval of the disqualified person receiving an economic benefit;
4. A person having a material financial interest affected by the compensation arrangement or transaction; or
5. A person who had or will have a transaction to be approved by the disqualified person receiving an economic benefit.

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:

1. Compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions;
2. The availability of similar services in the geographic area of the organization;
3. Compensation surveys compiled by independent firms;
4. Actual written offers from similar institutions competing for the services of the disqualified person;
5. Independent appraisals of the value of the property involved in the transaction;
6. Offers received as an open and competitive bidding process for the property involved in the transaction.

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 three comparable organizations in the same or similar community for similar services. The temporary regulations reduce the number of comparable organizations for which a small organization must obtain data from five to three.

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 record, which may be written or electronic, must include the following:

1. The terms of the transaction or arrangement that was approved and the date it was approved;
2. The members of the governing body or committee who were present during the debate on the transaction or arrangement that was approved and those who voted on it;
3. The comparability data obtained and relied on by the governing body or committee and how the data was obtained;
4. The actions taken with respect to consideration of the transaction or arrangement by anyone who is otherwise a member of the governing body or committee but who had a conflict of interest with respect to the transaction or arrangement; and
5. If th