Intermediate sanctions and executive compensation

By Carole S. Carlson, CPA, MBA
May & Barnhard, PC

The Internal Revenue Service has long been interested in "insider" financial transactions involving tax exempt organizations. The concern has always been that influential individuals might make use of a controlled or related charitable organization to unjustly enrich themselves. Prior to the enactment of Internal Revenue Code Section 4958, if the Service wanted to "punish" an organization that was engaging in inappropriate compensation arrangements, its only recourse was to revoke the entity's tax exempt status.

Because that is a very drastic step, only warranted under egregious circumstances, in Section 4958, Congress provided for an excise tax that the IRS may impose in lieu of revoking exemption. This tax is levied against any "disqualified person" who engages in an "excess benefit transaction" with a 501(c)(3) or 501(c)(4) organization, other than a private foundation. The tax may also be levied against an "organization manager" who "knowingly" approves the transaction.

The key to this piece of legislation lies in the definition of the various terms. The regulations published by the IRS provide guidance regarding who is a disqualified person or an organization manager, what an excess benefit transaction is, and how financial transactions should be structured and documented in order to avoid the excise tax.

Disqualified persons

Section 4958 defines a disqualified person as one who, at any time during the five years preceding the ate of the transaction, was "in a position to exercise substantial influence over the affairs of the organization," certain family members of such a person, and other organizations of which at least 35 percent are owned by such a person or certain family members of such a person.

Fortunately, the IRS recognized that this is quite vague, and has provided additional guidance in identifying the disqualified persons relative to a particular organization. This comes in the form of proposed regulations; the IRS expects to issue final regulstions in the first quarter of 2001.

The purpose of making this determination regarding disqualification will become clear, as we discuss the documentation requirements below:

Certain individuals are disqualified persons by reason of position. These are:

voting members of the board;
presidents, chief executive or operating officers;
treasurers, chief financial officers;
persons with a material interest in a provider-sponsored organization;
anyone, regardless of title, who has or shares ultimate responsibility for decisions of the Board;
anyone, regardless of title, who has or shares responsibility for managing financial assets or who can authorize use of funds.

As you can see, a wide net is cast by the last two categories on the list. The IRS has made it clear that it will look at the intent of the law, ignoring form in favor of substance.

Other individuals may be disqualified persons by reason of facts and circumstances. These include such factors as whether the person founded the organization; is a substantial contributor (as defined for Schedule A of Form 990); has managerial authority or serves as a key advisor to a person with such authority; or the person has a controlling interest in a business or trust that is a disqualified person.

The language in the facts and circumstances test makes it clear that is is possible for an independent contractor to be a disqualified person. Also, one need not be at the highest level of the organization to potentially be a disqualified person, since it is reasonable to assume that top executives' staff are key advisor to their superiors.

Another factor that the IRS believes shows a tendency to be a disqualified person is whether compensation is based on revenues from activities that are under the individual's control. Apparently, the Service believes that is one can maniupulate events to increase revenue, then it follows that the person may be in a position to exert sufficient control to determine one's own compensation package. There is some debate about this. Keep in mind, however, that the facts and circumstances test is just that. Meeting one or more of the factors does not automatically result in disqualification. If you believe that your organization has people who meet some of these factors, then you should consider either obtaining expert advice, or treating them as potentially disqualified and document their compensation arrangements accordingly, as discussed below.

Excess benefit transactions

An excess benefit transaction is one in which a disqualified individual or entity receives an economic benefit in excess of the value received by the organization. The excess benefit rules are applied in such issues as compensation, revenue-sharing transactions, and transfers of property. Note that the excess benefit rules are irrelevant if the recipient of the economic benefit is not a disqualified person; this is why the determination of disqualified persons relative to the organization is so important.

Compensation is the most common area for excess benefit transactions to arise. The IRS says that if it can be shown that remuneration for the performance of services is similar to what others in similar situations receive, that meets the reasonableness test, and, therefore, the compensation paid would not constitute an excess benefit. The determination of reasonableness is made based on facts that existed at the time the contract was entered into, and not on factors that come to light subsequently. (This works both ways; the IRS cannot use later data to attack reasonableness, but the organization cannot use later data to justify compensation, either.) Consequently, it is very important to document clearly factors affecting the determination of salary packages at the time the agreement is executed. Compensation, incidentally, includes cash and nonchas components and deferred compensation (vested), as well as such items as insurance premiums paid on behalf of the disqualified person, medical reimbursements, expense allowances, imputed interest on interest-free loans, and any other benefits, taxable or not, provided by the organization or its affiliates or subsidiaries, whether exempt or not.

Revenue-sharing arrangements are treated a little differently than compensation. Such arrangements can result in an excess benefit regardless of the reasonableness of the compensation. What is important is whether the disqualified person is providing proportional benefits that contribute to the organization's exempt purpose. The factors used to make that determination include the relationship of the size of the payments and the quality/quantity of the services provided by the disqualified person, and the ability of the disqualified person to control the activities that produce the revenue being shared.

An example of a revenue-sharing arrangement is a university sharing royalties with a researcher who developed a patented process. Another example is compensation of the organization's investment portfolio manager based on the portfolio's rate of return.

In cases of transfer of property to or from a disqualified person, the excess benefit determination is made based on the fair market value of the property transferred. "Fair market value" is the price at which the property would sell between a willing buyer and seller, each having knowledge of the relevant facts.

There is an exclusion for payments made to directors who attend meetings. "Reasonable" expenses need not be counted as part of the compensation package for the excess benefit determination. The term "reasonable" does not include luxury or spousal travel expenses.

Organization managers

An organization manager is any officer, director or trustee, or any person with similar responsibilities, as well as any person who has authority to make administrative or policy decisions for the organization. Professionals who are independent contractors (attorneys, accountants and investment managers) are not organization managers, so long as they are acting in their professional capacities. An attorney who is also a director, for example, is considered an organization manager.

An organization manager who knowingly participates in an excess benefit transaction may also be assessed an excise tax. The individual is considered to be a knowing participant only if the person:

has actual knowledge of facts that indicate the transaction results in an excess benefit;
is aware that the excess benefit prohibition rules may be infringed upon;
negligently fails to make reasonable attempts to determine whether or not the transaction is an excess benefit transaction;
is aware that the transaction is in fact an excess benefit transaction.

Participation includes not merely voting or otherwise taking affirmative action to support the transaction, but also failing to speak or act against the transaction, when the manager has a duty to do so.

Organization managers may be released from liability if it can be shown they acted with ordinary business prudence (reasonableness test), or if they relied upon advice from counsel (including in-house counsel). Such advice must have specifically addressed the excess benefit concerns, and make reference to the applicable law. It is not necessary to seek legal counsel to prove ordinary business prudence; that is merely one option for exercising due care.

Due care and documentation

The IRS regulations provide for a rebuttable presumption that compensation is reasonable, or that a transfer of property is at fair market value, if all three of the following are true:

The transaction is approved by the Board of Directors or a subcommittee whose members have no conflict of interest;
Appropriate data was used for comparison;
The basis for the decision was adequately and concurrently documented.

There are specific rules regarding what constitutes a conflict of interest and comparability data. If you will be engaged in developing a compensation package for a disqualified person, we strongly recommend that you consult your tax professional regarding the excess benefit transaction rules.

In order to be adequate, the records must include the date of the meeting, those present, the terms of the transaction and the comparability data used and its source. It must also include — and this is extremely important — the actions taken by those who either had a conflict of interest, or were opposed. Those who have a conflict should recuse themselves or leave the room during the debate and vote. Those who are opposed should go on record as such, not merely abstain, in order to meet their duty to act.

The IRS says documentation is concurrent if the minutes are prepared by the next meeting of the body approving the transaction. This is an easy way of creating a semi-safe harbor, so if you have done all the work, please do not ruin it by failing to have the records prepared on a timely basis!

Conflict of interest

In order to provide clarification to Board members, it would be wise to establish a policy of conflict of interest. Such a policy spells out what types of activities are likely to give rise to conflicts of interest, and what action, if any, the Board member is expected to take to cure the situation. For example, the policy might state that a conflict of interest exists if a director has greater than a 5 percent ownership interest in a potential vendor. The remedy might be that the director should absent himself during discussion or voting on the contract. The policy should be broad enough to cover most situations without becoming excruciatingly detailed. We recommend obtaining expert assistance in crafting a conflict of interest policy.

Excise taxes

The excise tax on disqualified individuals provided for by Section 4958 amounts to 25 percent of the excess benefit. If the situation is not corrected within the taxable period in which the violation occurs, the tax may be increased to 200 percent of the excess benefit. Correction is achieved by repaying 100 percent of the excess benefit to the organization.

Organization managers found to have participated in an excess benefit transaction are subject ot an excise tax of 10 percent of the excess benefit, up to a maximum of $10,000.

While Section 4958 provides sanctions for excess benefit transactions which fall short of outright revocation of exempt status, the IRS may still initiate action resulting in loss of exempt status. The IRS will want to see that preventive measures have been established to make certain that excess benefit transactions do no occur. And for those organization who have not had a problem in the past, prudence would dictate taking advantage of the rebuttable presumption option outlined above.