IRS Increases Enforcement Activity for Non-Profits; Congress Examines
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IRS Examines Tax-Exempt Compensation
Late last year, the Tax-Exempt and Government Entities Division of the
Internal Revenue Service announced that its top priority for 2005 was to
strengthen its enforcement presence within the tax-exempt community. It
launched the Tax-Exempt Compensation Enforcement Project, and will have
contacted approximately 2,000 tax-exempt organizations by year end with
inquiries as to the compensation paid (generally for the year 2002) by those
entities. The IRS will then commence audits of selected organizations. In
late July, the Commissioner of the Tax-Exempt and Government Entities Division
announced that the Division expects to conduct approximately 1,400 examinations
of exempt organizations per year for the foreseeable future. The Division’s
budget has been increased by almost 10 percent to support this effort.
|“...the Commissioner of the
Tax-Exempt and Government Entities Division announced that the
Division expects to conduct approximately 1,400 examinations of
exempt organizations per year for the foreseeable future.”
A tax-exempt organization is always permitted to pay reasonable compensation
for the services it receives. High compensation may be paid, provided it
is warranted by the value of the services performed for the exempt organization.
In order to determine what is reasonable, the organization must look to
what similar organizations pay for similar work. The focus of IRS inquiry
is the exempt organization’s compensation practices and procedures for determining
what is “reasonable,” including the manner in which executive compensation
is reported. In addition to general compensation practices, however, IRS
inquiries have also focused on the amounts earned by the five highest paid
officers, directors, employees and independent contractors, or their related
An organization that overcompensates key people may suffer revocation
of its tax-exempt status. More likely is the imposition of “inter-mediate
sanctions,” penalties imposed under Internal Revenue Code Section 4958 on
a recipient of excess compensation where the recipient is a senior level
executive. Penalties can be as much as 200 percent of the excess compensation.
In addition, penalties can be imposed on directors who knowingly approve
the excess compensation. See GT Alert, February 2002, IRS Finalized Intermediate
Sanctions Regulations, for a more detailed discussion of intermediate sanction
Changes have been made to the Form 990 (annual information return) regularly
filed by exempt organizations to allow the IRS to more effectively gather
and evaluate compensation data. More extensive changes, directed at improving
compensation policy practices, will likely be included in the 2007 version
of the form. The IRS has stated that it expects reporting of loans, “sweetheart”
deals, deferred compensation and various perks to have been inappropriate
in many cases.
Many organizations may discover inadvertent failures to report particular
benefits as compensation. Unfortunately, such unreported benefits will be
deemed “automatic” excess benefit transactions in the eyes of the IRS. Transactions
deemed automatic excess benefits are subject to penalties, regardless of
whether the compensation involved is reasonable. If an exempt organization
discovers such a failure, it should immediately issue a corrected W-2 to
the individual whose compensation was underreported.
|“One way for an exempt
organization to reduce the risk of an unfavorable audit is to
conduct, or have counsel conduct, a thorough review of its
compensation policies now.”
One way for an exempt organization to reduce the risk of an unfavorable
audit is to conduct, or have counsel conduct, a thorough review of its compensation
policies now. Procedures for setting compensation for executives, and the
comparability of the package offered relative to what similar organizations
are paying, should be documented. At a minimum, the IRS will expect such
procedures to include (1) advance approval by an independent body, (2) reliance
on comparables and (3) adequate concurrent documentation of compensation
decisions. Compensation awarded under such procedures is afforded a presumption
of reasonableness. An independent and informed board committee (or other
governing body) approving compensation remains key to good practice.
Other enforcement issues of high priority to the IRS are post-issuance
compliance by tax-exempt bond issuers (with ‘95-’96 bonds likely to receive
attention first) and participation by tax-exempt entities in tax shelter
transactions. It is hoped that the IRS will pursue an educational, rather
than punitive, approach to these cases.
Congressional Hearings on Tax-Exempt Hospitals
The House Ways and Means Committee has recently held hearings on tax-exempt
standards for hospitals. The Committee Chairman, Rep. Bill Thomas (R-CA),
described the question as “(W)hat is the taxpayer getting in return for
the tens of billions of dollars per year in tax subsidy?” Health-related
entities account for almost 60% of the total revenues of Section 501(c)(3)
organizations. Tax-exempt hospitals account for three quarters of the revenues
of all health-related organizations.
Chairman Thomas noted the trend of the IRS to lessen the requirements
for a hospital to obtain tax-exempt status. For federal tax exemption, a
hospital is not required to provide charity care. In 1983, the IRS dropped
the requirement to maintain an emergency room. Thus, the Committee is asking
whether there really is a community service mission that differentiates
tax- exempt hospitals (which seem to engage in increasingly commercial behavior)
from for profit hospitals. Certainly the provision of health care is common
to both types of organizations, but the charitable component has been eroded.
The Senate Finance Committee, under Chairman Grassley, is conducting
its own survey of at least ten tax-exempt hospital systems to gather information
on actual practices. Fact-finding with regard to the provision of charity
care and the exempt hospitals’ costs and manner of charging for such care
are the focus of the Committee’s efforts.
It should be noted that the same issues have been examined in several
states with regard to property tax exemptions of hospitals. In many states,
more is required of a hospital to maintain tax-exempt status, including
providing charity care of a certain amount. Usually, the test is that a
parcel of real estate owned by a tax-exempt entity must be used exclusively
for exempt purposes to qualify for a property tax exemption. This is the
“quid pro quo” for being exempt from local property taxes.
Illinois has recently been active in challenging the property tax exemptions
of health-related exempt organizations. In reported cases, an important
factor was the absence or insignificance of the charity care provided. See
e.g. 4/21/05 recommendation of Champaign County Board of Review (as reported
in the BNA Daily Tax Report 4/26/05) that property tax exemptions for Carle
Foundation Hospital and related entities be denied (charity care was less
than .5%); Eden Retirement Center Inc. vs. Dep’t. of Revenue (Illinois Supreme
Court 12/2/04); Illinois Department of Revenue vs. Provena Covenant Medical
Center, No. 01-PT-0014.
|“The recent congressional
hearings on tax-exempt organizations calling for more regulation
of the non-profit sector is evidence of the growing interest in
Washington in tax-exempt organizations.”
We expect in this day of large federal deficits and general concerns
over the merits of the nonprofit sector and the implicit subsidies that
tax exemption provides, that the merit of continuation of tax exemption
would be the subject of examination. The recent congressional hearings on
tax-exempt organizations calling for more regulation of the non-profit sector
is evidence of the growing interest in Washington in tax-exempt organizations.
All of these hearings may produce legislation that will have significant
impacts on the non-profit sector in general and tax-exempt hospitals in
particular. Interested persons should continue to pay attention to this
trend. The report presented June 22, 2005 to the Senate Finance Committee
by The Panel on the Non-profit Sector is designed to help tax-exempts increase
accountability and integrity by outlining steps to ensure that the board
of directors understands and can fulfill its ethical and financial duties
(including independent auditing) in promoting the charitable mission of
the organization. The full report is available at
Similar efforts are underway on the state level. Legislative activity
this year in Colorado, Connecticut, Kansas, Massachusetts, Minnesota, New
York and North Carolina has included charitable reforms. Effective January
1, 2005, California enacted the California Non-profit Integrity Act, which
requires certain charities to form an audit committee and prepare audited
financial statements subject to strict independence requirements. This Sarbanes-Oxley
style legislation is the first accountability law aimed specifically at
non-profits. It seems unlikely to be the last.
This Alert was written by
Tracy Green Landauer in the New York office
and Harry J. Friedman in the Phoenix office. The Alert also describes recent Congeressional questioning of the merits of tax exemptions for hospitals.
Please contact Ms. Landauer at 212.801.6863 or Mr. Friedman at 602.445.8000
or your Greenberg Traurig liaison if you have any questions regarding the
subject matter of this Alert.
© 2005 Greenberg Traurig
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