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Intermediate Sanctions - Enforcement Begins;
Disclosure Regs Issued for Private Foundations

January 2000
By Harry J. Friedman, Greenberg Traurig, Miami Office

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First Challenge to Excess Benefit Sanctions

The first cases involving imposition of penalties in connection with findings that an exempt organization had engaged in an excess benefit transaction have now been filed with the Tax Court. The first eight petitions involve nearly $240 million dollars in excise taxes assessed by the Internal Revenue Service in connection with the transfer of assets of three formerly exempt Mississippi home health care agencies to for-profit corporations.

Section 4958 of the Internal Revenue Code imposes significant penalties on "disqualified persons" and managers of Section 501(c)(3) organizations in the event of an "excess benefit transaction." An "excess benefit transaction" is the receipt of cash, property or other economic benefits from a tax exempt organization, directly or indirectly, by any "disqualified person" (a person who can exercise influence over the organization, such as the president, a substantial contributor or a trustee) that exceeds the fair market value of the services or other consideration received by the organization providing the payment; e.g., the payment of compensation to a management level employee in excess of what other people receive for similar positions or a sale of property owned by the tax exempt organization for less than fair market value. Section 4958 has massive implications for tax exempt organizations and the way they are governed.

Intermediate Sanctions, enacted in 1996, were sought by the IRS to provide authority to penalize persons improperly benefiting from transactions with public charities and civic organizations, commonly referred to as a prohibition on "private inurement", without resorting to the draconian penalty of revocation of the organization’s tax exempt status. Intermediate Sanctions address the same issues as the prohibition on "private inurement," earnings or assets of a tax exempt organization being used for the benefit of "insiders," generally, officers, directors and other persons able to influence the control of the tax exempt organization. Because Section 4958 was recently enacted, the manner in which the IRS will enforce the law is still unclear.

See GT Alert, August 1998, for a more detailed discussion of Section 4958 and Proposed Treasury Regulations promulgated by the IRS.

Documents filed with the Tax Court indicate that the assets of the home health care agencies were transferred to for-profit entities controlled by five family members who were officers and directors of the tax exempt organizations. According to the petitions, the sale of assets followed a change in Mississippi law that allowed home health care agencies to operate for profit. Appraisals of the assets of the three tax exempt entities were obtained from a Jackson, Mississippi certified public accounting firm. The appraisals valued the assets of the tax exempt organizations as negative based on the net operating losses incurred during the years preceding the conversion from tax exempt to taxable organizations.

In issuing assessments for excise taxes to the newly formed for-profit corporations and the individuals, the IRS indicated its disagreement over assessments of the fair market value of the tax exempt organizations’ assets. Assets valued, for example, by the certified public accountant as having a negative value were valued by the IRS as worth in one case of $5.5 million, in a second case of $7.8 million and a third case of $5.2 million. The IRS has assessed taxes equal to 200% of the excess benefit in some of the cases because of the failure of the taxpayers to "correct" the excess benefit transactions prior to the issuance of the assessment notices.

These cases, like most cases that arrive at the Tax Court, involve egregious situations and are not the typical case that will implicate Section 4958, the overpayment of salaries to officers of exempt organizations. However, the cases are interesting in that they indicate that merely obtaining appraisals from independent parties may not be sufficient to preclude excise tax assessments under Intermediate Sanctions if the IRS disagrees with the valuations of assets transferred by a tax exempt organization to disqualified persons. These cases will merit further watching as they proceed through the courts.

Disregarded Entities

Under Treasury Regulations issued in 1997, certain single-member non-incorporated entities are disregarded for federal income tax purposes. For example, a single member limited liability company, permitted in most states, is generally ignored for federal income tax purposes. The income, deductions, gains and losses of the single member entity are reported by the owner as if the assets of the single member entity were owned directly by the parent entity.

Announcement 99-102, recently promulgated by the IRS, addressed the consequences of ownership of a disregarded entity by a tax exempt organization. Under the Announcement, the exempt organization that is a single member of a limited liability company must include information about the finances and operations of the disregarded entity on its own Form 990. In effect, the assets of the disregarded entity are treated as owned by the parent exempt organization for all tax purposes. In addition, the parent organization will not be required to file separate exemption applications for each disregarded entity.

Since the disregarded entity will be treated as if it is simply part of the tax exempt organization, if the disregarded entity is engaged in non-exempt activities, its existence may have an adverse affect on the tax exempt status of the parent organization. In addition, this treatment is for federal income tax purposes. Before using a disregarded entity for federal income tax purposes, exempt organizations should consider state and local tax implications. Since the disregarded entity does not itself have tax exempt status, state and local tax exemptions may not be available for property or purchases by the disregarded entity.

Changes in Form 990

Representatives of the IRS have advised of two changes that will be made in Form 990, the tax return filed by tax exempt organizations. Marcus Owens, IRS Exempt Organization Director, has indicated that in the future, organizations will be required to report excess benefit transactions under Section 4958 of the Code for prior years as well as the tax year of the return. Form 990 requires tax exempt organizations to report "excess benefit transactions," that is, transactions violating Intermediate Sanctions (See above for a discussion about Intermediate Sanctions). The change requires reporting of prior year excess benefit transactions. This will permit organizations who become aware of an excess benefit transaction that occurred in a previous year to report such transaction to the IRS.

A second change will clarify that third party management companies’ salary payments must be reported. Concern was expressed by Owens that in the past, organizations that had third party management companies avoided reporting salary payments by inserting zero because of the absence of making the payments directly to individuals.

Disclosure Rules Effective March 13, 2000

The IRS has issued final regulations that contain disclosure requirements for private foundations. Last year the IRS promulgated regulations addressing how tax exempt organizations, other than private foundations, must respond to requests for copies of their annual returns and exemption applications. The newly issued regulations advise private foundations how to comply with the same requirement.

The final regulations are not significantly different than the proposed regulations. (See GT Alert, August 1999) The regulations require a private foundation to make its three most recent tax returns available to anyone who requests the returns in person and within 30 days to anyone who requests the returns in writing. Alternatively, a private foundation may make returns available on the Internet. Unlike other exempt organizations, a private foundation is required to disclose the names and addresses of its contributors.

The new regulations eliminate the requirement under prior law for a private foundation to publish notice in a newspaper of the availability of its returns. The new rules are effective for returns filed after March 13, 2000. Initially, private foundations will have to make only their current returns available.

As with other tax exempt organizations, the increased availability of returns may result in wider dissemination of information about private foundations. Organizations should consider this in preparing their tax returns. The return may become an opportunity to publicize the mission and benefits of the organization.


© 2000 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.