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Managers of Charities May Be Subject to New Excise Tax

August 1998
By Harry J. Friedman, Greenberg Traurig, Miami Office

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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 organization’s 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 parties.

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 manager’s 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 hospital’s 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 person’s 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.

Rebuttable Presumption

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 practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs.