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IRS Holds Hearings on Intermediate Sanctions;
IRS Loses UBIT Case

April 1999
By Harry J. Friedman, Greenberg Traurig, Miami Office

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IRS Hearings

On March 16 and March 17, 1999, the IRS held hearings with regard to Proposed Intermediate Sanctions Regulations. Intermediate Sanctions were enacted as part of the Taxpayers’ Bill of Rights-2 in 1996. Intermediate Sanctions authorize the IRS to impose excise taxes on certain individuals and managers of public charities and civic organizations that engaged in "excess benefit transactions" with the organizations, e.g., an employment agreement that provides for compensation in excess of reasonable compensation for the services provided. 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 revocation of exempt status of the organization. The law, as enacted by Congress, defines the persons subject to Intermediate Sanctions, described as "disqualified persons," as persons who have substantial influence over the affairs of the organization.

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 and comparable transactions and other relevant information, and (iii) documented the basis for the decision and approved the transaction in advance of the payment. If these criteria are met, penalties could be imposed only if the IRS develops contrary evidence to rebut the prohibitive value of the evidence put forth by the parties.

The law as enacted left a number of items to be filled in by the IRS through the promulgation of Treasury Regulations. Proposed Treasury Regulations were issued on July 30, 1998. (See the August, 1998 GT Alert, describing the Proposed Treasury Regulations.)

The testimony at the hearings highlight a number of problems with the Proposed Regulations. Several witnesses were concerned about a provision of the Proposed Regulations that required director’s and officer’s liability insurance to be treated as compensation to directors and officers. Compliance with this requirement will require an organization to issue a Form W-2 or 1099   to a director to avoid the premium being treated as an excess benefit transaction. Elimination of this requirement was suggested by several speakers.

The Proposed Regulations provided a "safe harbor" for small organizations with gross receipts up to $1 million. Several speakers suggested that the "safe harbor" for small organizations be expanded to include organizations with gross receipts up to $5 million. The simplified comparability data allowed to a small organization should, in the opinion of several speakers, correlate with the organization’s capacity to invest in an expensive compensation analysis. A number of speakers also addressed the Proposed Regulations’ definition of "disqualified persons." Many believed that the definition contained in the Proposed Regulations was overly broad and did not limit the impact to persons actually in positions to control public charities. Several speakers suggested that the Proposed Regulations incorrectly treat middle managers, who merely share some authority over financial transactions, as disqualified persons. The speakers argued that this was beyond the intent of Congress. Also of concern, was the provision in the Proposed Regulations that persons whose compensation is based in whole or in part on revenues of the organization were disqualified persons. One speaker noted that this was a common method for employing fundraisers, suggesting that merely providing services to the organizations based on the revenues should not bring one within the scope of Intermediate Sanctions. Another speaker observed that physicians are frequently compensated through incentive arrangements based on revenues. The speaker suggested that in the case of physicians, the absence of managerial authority should eliminate a physician from being a disqualified person.

A number of speakers also addressed the absence of a "first bite rule" in the Proposed Regulations. The recent decision of Court of Appeals for the Seventh Circuit in United Cancer Counsel v. Commissioner (See the March, 1999 GT Alert discussing this case) and its impact on the Proposed Regulations. Several speakers suggested that the UCC case supported a "first bite rule"; that is, that an unrelated party should not be a "disqualified person" with respect to he/she/ its first contract with the organization since it is not within the traditional standard of private inurement. Also noted was the Seventh Circuit Court’s rejection of a facts and circumstances test for determining who was an "insider" for private inurement purposes requiring the IRS to promulgate a more objective test of who is a disqualified person.

The treatment of revenue sharing transactions as excess benefit transactions also was the subject of some comments. Several speakers were concerned that the IRS was rejecting a number of prior general counsel memoranda and other published statements on what types of revenue sharing transactions were permissible. A suggestion was made that the Proposed Regulations should incorporate those prior general counsel memoranda that were issued in the 1980s on this issue. IRS officials repeated that the finalization of Treasury Regulations was on the 1999 Business Plan. Officers and directors of charitable organizations should watch closely for these Regulations which have been described by a number of government officials as the most important legal change for charities in thirty years.

Income From Affinity Credit Card Programs Remains Tax Exempt

The IRS’ string of losses in challenging affinity credit card programs was continued in a recent decision issued by the Tax Court in Sierra Club v. Commissioner. In the original Sierra Club case in 1994, the Tax Court had rejected the IRS’ assertion that income from the affinity credit card arrangement constituted taxable fees for services. The Ninth Circuit Court of Appeals had reversed and remanded a partial summary judgment in favor of the Sierra Club on the issue of the affinity credit card income, determining that the Tax Court had not viewed the evidence in a light most favorable to the IRS. In this new decision, the Tax Court once again rejected the IRS’ assertion of taxable income.

Generally, income earned by an exempt organization from the licensing of its name and logo are treated as royalties and not subjected to tax as unrelated trade or business income. The IRS has frequently sought to treat income from affinity credit card arrangements as unrelated trade or business income from services, taking the position that the services provided by the exempt organization in connection with the arrangement was sufficient to conclude that the income earned was more than royalties.

In the original Sierra Club case, the Tax Court found that the affinity credit card arrangement did not constitute fees for services by the exempt organization. The Tax Court’s earlier decision was followed in three subsequent cases involving university alumni associations. In each of the cases, the Tax Court rejected the IRS’ argument that the exempt organization had performed services with regard to the affinity credit card arrangement requiring that the income be treated as taxable unrelated trade or business income. The IRS appears to take the position that any performance of service will result in taxable income. The Tax Court, in contrast, has ruled that certain services are permissible.

In the recent decision, the Tax Court, addressed each item in the contract between the financial organization and the exempt organization. The Tax Court concluded that the exempt organization’s ability to exercise its rights of approval with respect to marketing proposals evidenced a right to protect its name and mark and did not constitute services for tax purposes. Also, rejected was the contention by the IRS that a portion of the income constituted advertising revenue and/or revenue in exchange for the exempt organization’s endorsement and promotion of the program. All of these items were deemed by the Tax Court to merely be royalty income received in exchange for the licensing of a logo and name.

The IRS has not determined whether it will appeal the Tax Court’s decision. It has hoped that with this continuation of losses the IRS will not make further challenges to "standard" affinity credit card arrangements. Exempt organizations should review the outstanding cases in structuring affinity credit card arrangements to ensure that the agreement fits within the scope of arrangements approved by the Tax Court. Moreover, the credit card program/royalty issue highlights the need to examine all transactions involving licenses between exempt organizations and private parties to ensure they fit within the royalty exemption from unrelated trade or business income.


©1999 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.