Intermediate sanctions

By Philip H. Cornblatt, CPA

What are intermediate sanctions?

Prior to the enactment of Internal Revenue Code (IRC) Section 4958, the IRS had only one choice when it found a tax-exempt organization engaging in transactions with disqualified persons it felt were an "excess benefit." That choice was to revoke the organization's tax-exempt status. Congress felt this was a harsh consequence for organizations that otherwise were to the public's benefit being tax-exempt and carrying out its exempt function.

So Congress passed IRC Section 4958 to penalize the people involved in these transactions but still allow the organization to continue pursuing its exempt function. The law imposes an excise tax on each excess benefit transaction between an applicable tax-exempt organization and a disqualified person.

Which tax-exempt organizations does the law apply to?

Intermediate sanctions apply to all organizations exempt from taxation under IRC Section 501(c)(3) and (4), except for private foundations.

What is an excess benefit transaction?

Per Regulation 53.4958-4, an excess benefit is defined as "any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person, and the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing the benefit."

The most common type of excess benefit transaction the Internal Revenue Service has been attacking is compensation paid to a disqualified person. This is usually referred to as "reasonable compensation." Although any transaction between the organization and the disqualified person may be considered an excess benefit transaction based on the facts and circumstances of the transaction.

Who is a "disqualified person?"

Regulation 53.4958-3 defines a disqualified person as "any person who was in a position to exercise substantial influence over the affairs of an applicable tax-exempt organization at any time during the five-year period ending on the date of the transaction."

Those that have a substantial influence include:

voting members of the governing body;
presidents, chief executive officers or chief operating officers;
treasurers and chief financial officers;
persons with a material interest in a provider sponsored organization.

Others that, based on facts and circumstances, show substantial influence include but are not limited to:

the person who founded the organization;
substantial contributors;
the person whose compensation is based primarily on the revenues derived from the activities of the organization, or a particular department or function of the organization, that the person controls;
the person who has or shares authority to control or determine a substantial portion of the organization's capital expenditures, operating budget or compensation for employees;
the person who manages a discreet segment or activity of the organization that represents a substantial portion of the activities, assets, income or expenses of the organization, as compared to the organization as a whole;
the person who owns a controlling interest (measured by either vote or value) in a corporation, partnership or trust that is a disqualified person;
the person is a non-stock organization controlled, directly or indirectly, by one or more disqualified persons.

Included as disqualified persons are family members of those considered a disqualified person based on the above. Those family members include:

spouse;
brothers or sisters (by whole or half blood);
spouses of brothers or sisters (by whole or half blood);
ancestors;
children;
grandchildren;
great-grandchildren;
spouses of children, grandchildren or great-grandchildren.

A controlled entity with respect to a disqualified person refers to all corporations, partnerships, trusts or estates that own more than 35 percent of the combined voting power. Combined voting power includes voting power represented by holdings of voting stock, direct or indirect, but does not include voting rights held only as a director, trustee or other fiduciary.

What is the excise tax if the IRS determines the transaction is an excess benefit?

For the disqualified person, the tax is two-tiered. The first tier is the initial tax, which is 25 percent of the amount of the transaction determined to be an excess benefit. If the disqualified person does not correct the transaction within the taxable period, there is a second tier tax equal to 200 percent of the excess benefit.

To correct the transaction, the disqualified person must pay back to the organization the amount of the excess benefit plus interest based on the applicable federal rate. The taxable period is the period beginning with the date on which the transaction occurs and ending on the earlier of the date of mailing a notice of deficiency by the IRS or the date on which the tax imposed is assessed.

In addition to the tax on the disqualified person, there is a tax paid by the organization's managers. This tax is equal to the lesser of 10 percent of the excess benefit or $10,000 and is paid by all organization managers who participated in the excess benefit transaction and who knowingly participated in the transaction, unless such participation was not willful or was due to reasonable cause. The organization managers are jointly and severable liable. In addition, if the disqualified person is also an organization manager, that person would be subject to both taxes.

Who is an organization manager and what does it mean to knowingly participate?

Regulation 53.4958-1 defines an organization manager as "any officer, director or trustee of the tax-exempt organization, or any individual having powers or responsibilities similar to those officers, directors or trustees, regardless of title." An officer is any person who is specifically designated per the certificate of incorporation, the bylaws or other constitutive documents of the organization, or who regularly exercises general authority to make administrative or policy decisions on behalf of the tax-exempt organization.

A manager participates in a transaction knowingly only if the person:

has actual knowledge of the facts, so that based on those facts, the transaction would be an excess benefit transaction;
is aware that such a transaction may violate the provisions of Section 4958 excess benefit transactions; and
negligently fails to make reasonable attempts to find out whether the transaction is an excess benefit transaction, or the manager is in fact aware that it is an excess benefit transaction.

Is there a way that the manager, based on decisions at the time of the transaction, can rebut the presumption that the transaction is an excess benefit transaction?

Regulation 53.4958-1 allows an organization manager to rely on the advice of professionals. The participation of the organization's manager in the transaction that is later determined to be an excess benefit will not be considered "knowing" within the meaning of the IRC Section 4958(a)(2), if the organization manager relied on a reasoned written opinion of a professional. The professional must have been given full disclosure of the factual situation of the transaction and the elements of the transaction must be within the professional's expertise.

Appropriate professionals whose written opinion may be relied on by the organization's manager are limited to:

certified public accountants or accounting firms with expertise regarding the relevant tax law matters;
legal counsel, including in-house counsel;
independent valuation experts who:

hold themselves out to the public as appraisers or compensation consultants,
perform the relevant valuations on a regular basis,
are qualified to make valuations of the type of property or services involved, and
include in the written opinion a certification that the requirements mentioned in 1 to 3 have been met.

This reliance on professionals is referred to as a "rebuttable presumption."

What is reasonable compensation?

Regulation 53.4958-4 defines reasonable compensation as "the amount that would ordinarily be paid for like services by like enterprises (whether taxable or tax-exempt) under like circumstances." Compensation for the determination of reasonableness includes, but is not limited to, the following:

All forms of cash and non-cash compensation, including salary, bonuses, severance payments, and deferred and non-cash compensation.
Unless excludable from income as de minimis under IRC Section 132(a)(4), the payment of liability insurance premiums for, or the payment or reimbursement by the organization of:

any penalty, tax or expense of correction owed under these excess benefit rules;
any expense not reasonably incurred by the person in connection with a civil judicial or civil administrative proceeding arising out of a person's performance of services on behalf of the tax-exempt organization; or
any expense resulting from an act or failure to act with respect to which the person has acted willfully and without reasonable cause.

All other compensatory benefits, whether included in income for income tax purposes. These benefits include all welfare benefit plans such as medical, dental, life insurance, severance pay and disability benefits. Also included are taxable and non-taxable fringe benefits (other than the benefits described in IRC 132). Expense allowances and reimbursements are included unless they are pursuant to an accountable plan under Regulation 1.62-2(c). The economic benefit of below-market loans also is included.

When is reasonableness determined?

The timing to determine reasonableness of a fixed payment takes into account the facts and circumstances that existed on the date the parties entered into the contract to which the payment is made. In the case of any payment that is not a fixed payment under a contract, reasonableness is determined based on the facts and circumstances as they existed on the date paid.

What is a fixed payment?

A fixed payment is an amount of cash or property that is specified in a contract or determined by a fixed formula in a contract, which is to be paid or transferred in exchange for providing specified services or property. A fixed formula may depend upon future specified events or contingencies, provided that no person may exercise discretion when calculating the amount or deciding whether to make the payment. A specified event or contingency may be performance based, either on revenues generated or some other objective measure of one or more activities of the tax-exempt organization.

If the IRS determines that the excise tax is due, how is it reported?

The tax-exempt organization that engaged in the excess benefit transaction reports the transaction and the amount of the tax imposed on the disqualified person on Form 990 or 990EZ for the period during which the excess benefit transaction occurred. If the organization's managers are charged the excise tax for knowingly participating in the transaction, then that is also reported on Form 990 or 990EZ.

The disqualified person who engaged in the excess benefit transaction reports the transaction and the amount due on Form 4720 and files it along with the excise tax payment due.

The organization manager who knowingly participated in the excess benefit transaction also reports the transaction and the amount due on Form 4720 and files it along with the excise tax payment due.

When is the period of limitations?

The period of limitations for assessing the excise taxes begins on the date the tax-exempt organization files Form 990 or 990EZ for the tax period during which the excess benefit occurred, or on the date the return is due, whichever is later. The limitations period ends either three years or six years after it begins.

The three-year limitation period is valid if the tax-exempt organization reported the excess benefit transaction on its Form 990 or 990EZ in the period during which the excess benefit transaction occurred. In this case the period of limitations the excise tax may be assessed against the disqualified person and organization managers is three years.

The six-year limitation is valid if the tax-exempt organization filed its Form 990 or 990EZ but failed to disclose the excess benefit transaction. It would also be valid if the tax-exempt organization did disclose the transaction but the excise tax penalties were not paid.

There is no limitation period if the tax-exempt organization does not file a Form 990 or 990EZ.

Can the excise tax be abated?

If it is established to the satisfaction of the IRS that the excess benefit transaction was due to reasonable cause and not due to willful neglect and the excess benefit transaction was corrected within the correction period, then the excise taxes may be abated. The correction period begins on the date the excess benefit transaction occurs and ends 90 days after a notice of deficiency by the IRS.

What should tax-exempt organizations do?

Tax-exempt organizations should avoid doing transactions with a disqualified person. This is not always possible, especially when it comes to compensation.

All transactions with a disqualified person need to be fully documented at the time of the transaction. While it is never possible for the disqualified person to get out of the penalty due to having a rebuttable presumption, it is possible for the organization's managers.

The tax-exempt organization needs to document the fair market value of the transaction. For compensation, this may be accomplished by receiving comparable data based on industry surveys, documented compensation of persons holding similar positions in similar organizations, expert compensation studies or other comparable data. Organizations with gross receipts of less than $1 million per year only need compensation data for three similar positions in similar communities. For larger organizations, the regulations do not specify the number of comparability sources that the compensation study must compare to. At a minimum it should be at least three, but these studies should be more comprehensive than what would be allowed for the smaller organizations.

The decision-making body must approve the transaction and the remuneration paid for the transaction. The approval must be without discussion or voting by the disqualified person or any other decision maker that would be in a position where the transaction might represent a conflict of interest.

The decision-making body must document the basis for its determination concurrently with the approval. That documentation contains:

the terms of the transaction and the date approved,
the members of the decision-making body who were present during the debate on the transaction and those who voted on it,
the comparability data or other means used to determine fair market value and a record of how that data was obtained, and
any actions by decision-making members that have a conflict of interest.

The documentation needs to be prepared before the latter of the next meeting of the decision-making body or 60 days from the decision to approve the transaction. The decision-making body needs to approve the documentation within a reasonable time after that period.

Following these procedures the tax-exempt organization's managers would have their rebuttable presumption that the transaction is not an excess benefit even if the IRS later determines that intermediate sanctions apply.

Philip H. Cornblatt, CPA, is a senior tax manager with Reznick Fedder and Silverman and a member of the MACPA's Non-for-Profit Committee.

Contact this Author: < Philip Cornblatt > philip.cornblatt@reznickgroup.com

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