Intermediate Sanctions were enacted as part of the Taxpayer Bill of Rights II in 1996, providing the IRS with long sought-after tools to impose penalties, short of revocation of exempt status, on insiders of Section 501(c)(3) and (4) organizations who improperly benefit from the organizationsí activities. A disqualified person, generally a person who has substantial influence with regard to the organization, who participates in an "excess benefit transaction" (e.g., compensation in excess of reasonable compensation or payments for property in excess of fair market value) is liable for a tax of 25% of the excess benefit. If the transaction is not corrected, a disqualified person can be subject to an additional penalty of 200% of the amount of the excess benefit he, she or it received. In addition, organization managers who participate in an excess benefit transaction, knowingly, willfully and without reasonable cause are liable for a tax of 10% of the excess benefit, not to exceed $10,000. See GT Alert, February 2001, "IRS Issues Temporary Regulations on Intermediate Sanctions" for a discussion of the provisions of the Temporary Regulations promulgated in January, 2001.
The Final Regulation generally adopted the provisions of the Temporary Regulations with respect to most issues. However, comments received by the IRS resulted in a few changes worthy of note. The Temporary Regulations contained a safe harbor that an organization managerís participation in a transaction would not be considered "knowing" if the manager relied on the fact that the requirements giving rise to a "rebuttable presumption of reasonableness" are satisfied. The Final Regulations were changed to provide that an organization managerís participation would ordinarily not be considered "knowing" if the appropriate body has met the requirements of the rebuttal presumption with respect to the transaction. It is not necessary for the manager to have "relied" on compliance with the rebuttal presumption.
In response to comments concerning the applicability of Intermediate Sanctions to governmental entities, the Final Regulations now provide that, for purposes of Section 4958, a governmental unit or an affiliate of a governmental unit is not subject to Intermediate Sanctions, if it is exempt from taxation without regard to Section 501 of the Code or is relieved of the requirement of filing a tax return pursuant to Section 6033 of the Code.
With respect to the definition of "disqualified person," the preamble to the Temporary Regulations noted that the IRS had considered adopting a special rule with respect to so called donor advised funds and requested comments regarding potential issues that arise in applying the fair market value standard to distributions from a donor advised fund for the use of the donor or advisor. Comments objected to treating a donor or advisor of this type of fund as a disqualified person solely based on influence. In response to comments, the Final Regulations did not adopt a special rule, relying on the general rules to determine whether a donor or advisor is a disqualified person.
A change was made with respect to indirect economic benefits. The Temporary Regulations indicated that an economic benefit provided by a controlled entity will be treated as provided by the tax exempt organization subject to Intermediate Sanctions that controlled the related entity. The Final Regulations clarify that only wholly owned subsidiaries are treated as controlled for this purpose. A commentator noted that the payment of compensation by a tax exempt organization to a disqualified person for services provided to a controlled entity other than a wholly owned entity may raise private benefit issues if the other investors in the entity do not make a proportional contribution.
With the finalizing of the Intermediate Sanction Regulations, it should be expected that the IRS will move forward in its implementation of the statutory provision. The IRS on at least two occasions has sought to impose penalty excise taxes against disqualified persons in connection with alleged excise benefit transactions. We recommend that the governing body or managers of the organization comply with the "rebuttable presumption" rules in approving any transactions between a Section 501(c)(3) organization or a Section 501(c)(4) organization and a person who may be considered a disqualified person. The rebuttable presumption rule requires that transactions between the organization and the disqualified person be approved in advance by the Board of Directors or other body of the organization composed entirely of individuals who do not have a conflict of interest with respect to the compensation arrangement or property, that the approving body rely upon comparability data prior to making the determination and that the authorized body adequately document the basis for its determination. If these requirements are satisfied, the burden of proof with respect to reasonability shifts to the IRS. Compliance with these requirements will provide an entity with a stronger case if compensation arrangements or property purchases are challenged.
Changes under Section 457(b)
Prior to the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA"), Section 457(b) Plans were required to be coordinated with Section 403(b) Plan Contributions. As a result, highly paid executives of tax exempt organizations who contributed a significant amount to a Section 403(b) Plan were not able to contribute much, if at all, to a plan governed by Section 457(b).
Effective for years beginning January 1, 2002, the requirement that contributions made to a Section 457(b) Plan be reduced by Section 403(b) Plan Contributions made by the employee is repealed. As a result, if a tax exempt organization elects to maintain both a Section 403(b) Plan (or a Section 401(k) Plan) and a Section 457(b) Plan, employees will be able to enjoy a substantial amount of retirement benefits because they will be able to receive the maximum contribution amounts under both plans. The following chart illustrates the differences in contributions that may be made under the old law than under the EGTRRA on behalf of a senior employee of a tax exempt entity who performs services for an educational organization and whose compensation is $170,000.
A Section 457(b) Plan may be discriminatory and provide benefits solely for highly paid executives. Tax exempt organizations may wish to examine whether Section 457(b) Plans would be beneficial to their executives.
Joint Venture Ruling
A recent technical advice memorandum (TAM 200151045) offers additional insight into the IRSí position with respect to health care joint ventures. The Service ruled in the Technical Advice Memorandum that a health care organization (the "Organization") formed by a consortium of Section 501(c)(3) hospitals may manage a limited partnership and receive management fees without jeopardizing its exempt status or incurring unrelated business income tax liability.
Ten unrelated hospitals created an organization to provide lithotripy services to residents in a region because the State had limited the amount of certificates of need it would issue to fulfill those seeking to operate these facilities. Organization then formed a limited partnership that would own and operate a lithotripy center (the "Center"). Organization is the sole general partner but other parties including board members, trustees, member hospitals and some member hospital physicians own an aggregate of 75% of the limited partnership interests.
Under the partnership agreement, the general partner is the only person authorized to manage and control the Center and the management agreement gives the general partner the right at all times to operate the Center in accordance with charitable purposes. Medicare and Medicaid indigent care patients comprised approximately 21% to 26% of all the patients.
The IRS concluded that Organization met the operational test of Section 501(c)(3) because it participated in a partnership that furthered Organizationís exempt purposes and was authorized to act exclusively in furtherance of those purposes. The Ruling concludes that the circumstances were operationally consistent with situation 1 of Revenue Ruling 98 15, that the charitable organization controlled the joint ventureís activities and such control could be used to further charitable purposes ahead of for profit goals.
The Ruling described at length that the partnership furthered the charitable purpose of promoting health for a broad cross-section of the community. The facility had a charity care policy that was advertised to the public though its financial forms. No patient was turned away for lack of ability to pay. It had a broad-based community board representation by member hospitals. Therefore, the partnership was deemed to satisfy the community benefit standard and could insure that the benefits to the for profit limited partners were incidental to the accomplishment of charitable purposes.
In addition to the Section 501(c)(3) ruling, the IRS ruled that the activities of the partnership furthered the charitable purpose of providing health care and, thus, the distributions to Organization by the partnership were not unrelated business income for federal income tax purposes. Likewise, the management fees received by Organization, which were received for the extra time and expense required to carryout its duties as general partner and managing the partnershipís affairs, providing a medical director and planning activities, staff responsibility, preparation of budgets and other management services, were deemed not to be received in an unrelated business and, therefore, not subject to income tax..
We believe that the TAM is consistent with the teaching of the Redlands Surgical Services case. An exempt organization may be a general partner of a limited partnership composed of for profit entities and individuals so long as the tax exempt organization can operate the limited partnership predominately for charitable purposes. Partnership agreements that grant the general partner these rights are more likely to be favorably viewed under the provisions of Revenue Ruling 98-15.
© 2002 Greenberg Traurig
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