Greenberg Traurig Alert
Managers of Charities May Be Subject to New Excise Tax
By Harry J. Friedman, Greenberg Traurig, Miami
View or download the PDF version of this Alert here.
On July 30, 1998, the IRS issued proposed treasury regulations that provide long
awaited guidance in connection with Intermediate Sanctions. The proposed regulations
answer a number of questions about the application of Intermediate Sanctions, the persons
to whom Intermediate Sanctions will apply and the types of transactions that will be
subject to Intermediate Sanctions.
The Taxpayer Bill of Rights 2, enacted in 1996, authorized the IRS to impose excise
taxes on certain individuals and managers of public charities and civic organizations that
engage in "excess benefit transactions" with such organizations. These rules are
commonly referred to as "Intermediate Sanctions." Intermediate Sanctions were
sought by the IRS to provide authority to penalize persons improperly benefiting from
transactions with public charities and civic organizations without resorting to the
draconian, and infrequently administered penalty of revocation of the organizations
tax exempt status. The Internal Revenue Code defines the persons subject to Intermediate
Sanctions, described as "disqualified persons," as persons who have substantial
influence over the affairs of the organization. An "excess benefit transaction"
is a transaction in which an economic benefit provided by the exempt organization to or
for the use of a disqualified person exceeds the value of the consideration received by
the organization in exchange for the benefit or certain revenue sharing agreements - for
example, compensation paid to the president of a university that exceeds the value of the
services provided. The Code provides that certain kinds of excess benefit transactions,
those involving revenue sharing between a disqualified person and a public charity or
civic organization, would be defined by the IRS in the proposed regulations.
The legislative history of Intermediate Sanctions expresses the intent that parties
could rely on a rebuttable presumption of reasonableness that a transaction does not
provide an excess benefit if: (i) disinterested board of directors members
(unrelated to and not under the control of the disqualified person), (ii) considered
available specific information on comparable transactions and other relevant information,
and (iii) documented the basis for their decision and approved the transaction in advance
of payment. If the three criteria are met, penalties would be imposed only if the IRS
develops contrary evidence to rebut the probative value of the evidence put forth by the
Intermediate Sanctions impose three different taxes in connection with an excess
benefit transaction. Two of the taxes are imposed on the disqualified person who receives
the excess benefits. A disqualified person who participates in an excess benefit
transaction is initially liable for a tax equal to 25% of the excess benefit. If the
excess benefit is not corrected after discovery, the disqualified person may then be
liable for a tax of 200% of the excess benefit. The second tax is intended to force the
disqualified person to return the excess amount, plus an amount to take into consideration
the time the funds were held, to the organization.
In addition, a member of the governing body or other officer of the organization,
described as a manager, who knowingly and willfully participates in the excess benefit
transaction is subject to a penalty of 10% of the excess benefit not to exceed an
aggregate of $10,000 per transaction. This tax is intended to make governing boards and
officers act diligently to prohibit such transactions. A managers participation in
an excess benefit transaction will generally not be knowingly if he or she relies on a
reasoned written opinion of legal counsel.
Regulations Define Who is a Disqualifies Person
The proposed regulations identify certain persons as having substantial influence over
the affairs of the exempt organization. Any individual who serves as a voting member of
the governing board of the organization; any individual who has the power or
responsibilities of president, chief executive officer or chief operating officer; any
individual who has the power or responsibilities of a treasurer or chief financial
officer; and any person who has a material financial interest in certain
provider-sponsored organizations in which a tax exempt hospital is a participant, is
treated as disqualified persons. Generally, employees who have incomes of less than
$80,000 are deemed not to be disqualified persons if they are not one of the above named
persons and do not make substantial contributions to the organization.
Other than those specified individuals, the determination of whether an individual or
entity has substantial influence is based on facts and circumstances. The proposed
regulations offer some guidance on the factors that would or would not tend to show the
existence of substantial influence. Managerial control of a discreet segment of the
organization may be sufficient to show substantial influence. A substantial contributor
may be a disqualified person. However, preferential treatment received based on the size
of a donation will not be a factor if offered to others making similar sized donations.
Examples contained in the proposed regulations indicate that some physicians will be
treated as having substantial influence in the affairs of a hospital, notwithstanding the
fact that the physicians are not on the governing board nor serve as officers. In one
example, a doctor is in charge of a cardiology department that is a principal source of
patients to the hospital. The doctor has extensive responsibility for budgetary matters.
He will be treated as having substantial influence over the hospitals affairs, and,
thus, a disqualified person. On the other hand, a radiologist with no managerial authority
over the staff will not be treated as a disqualified person.
Commentators prior to the issuance of the regulations had urged that the IRS should
include a "first bite" exclusion: an individual could not be a disqualified
person with respect to his or her first contract. However, the proposed regulations do not
adopt this position.
Compensation Must be Properly Reported
Compensation paid for services will be treated as reasonable if it is an amount that
would ordinarily be paid for like services by like organizations under like circumstances.
This evaluation is to be made as of the date the contract is entered into by the parties.
If the facts are not available to make the determination at that time (e.g., the amount of
a bonus is to be determined later), the facts up to the date of payment are to be
considered. A contract that is subject to cancellation by the exempt organization without
the disqualified persons consent will be a new contract at each time that the
cancellation would be effective. In order for a payment to be treated as compensation, the
exempt organization must clearly show an intent for the payment to be treated as such,
principally by reporting the amount as compensation to the IRS.
Revenue Sharing Transactions
The proposed regulations define a revenue-sharing transaction as constituting an excess
benefit transaction if the transaction permits a disqualified person to receive additional
compensation without providing proportional benefits that contribute to the
accomplishments of its exempt purposes. The fact that consideration does not exceed the
value of the benefits is not relevant. This issue is illustrated by examples in the
proposed regulations. An investment manager who receives a bonus based on the increase in
the value of the portfolio has not participated in an excess benefit transaction. On the
other hand, a bingo operator who receives the same benefit from an agreement to share net
profits regardless of the net profits because it also receives the expenses of the
activity, has participated in an excess benefit transaction.
The proposed regulations provide additional guidance on the manner of creating the
rebuttable presumption contained in the legislative history. The makeup of the body
approving the transaction is described. Illustrations of the types of comparability data
that will be acceptable is found in examples. A special rule for small organizations is
provided in the proposed regulations.
Revocation Still Possible
The proposed regulations are clear that Intermediate Sanctions will not affect the
substantive statutory requirements for tax exemption as a public charity or civic
organization. Organizations that wish to be exempt must still operate with "no part
of their net earnings inuring to the benefit of any private shareholder or
individual." The IRS has indicated that in certain circumstances revocation of exempt
status would still be the appropriate remedy for a transaction that indicates the
organization is being operated in violation of that prohibition.
Guidance for Management
Intermediate Sanctions are intended to provide the IRS with a meaningful penalty to
police transactions between certain exempt organizations, public charities and civic
organizations, and insiders who have the ability to divert exempt organization profits and
assets for their own benefit. Because the penalties do not harm the public as would
revocation of the exemption of an important public resource, these penalties will be more
frequently applied than revocation.
We recommend that public charities and civic organizations endeavor to comply with the
rebuttable presumption requirements in setting compensation and dealing with individuals
and entities who may be disqualified persons. We suggest that initially, before entering
into agreements, public charities and civic organizations should determine whether the
other parties constitute disqualified persons. If they are disqualified persons,
compliance with the rebuttable presumption requirements not only helps in the burden of
proof, but also creates a record to support the action.
Compliance with the rebuttable presumption requirements also mandates that the
organization adopt a conflict of interest policy. We believe that all exempt organizations
should adopt a written conflict of interest policy that is communicated to all members of
the governing board and managers with decision-making authority. The importance of having
such a policy is evidenced by the present position of the IRS to reject exemption
applications of health care organizations that have not adopted such a policy. The
conflict policy must be given more than lip service; the organization must comply with it.
©1998 Greenberg Traurig
This GT ALERT is issued for informational purposes only and is not intended
to be construed or used as general legal advice. Greenberg Traurig attorneys provide
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