In a letter to exempt organizations and tax practitioners, the IRS’ Exempt Organizations Division recently announced that in fiscal year 2005 it plans to increase its focus on "exempt organizations to stem the growing tide of abuses within the tax-exempt community."1 Specifically, the IRS will dedicate nearly one third of its examination resources toward the excessive compensation initiative, credit counseling agencies, anti-terrorism efforts and abusive tax avoidance transactions. This objective represents a 27 percent increase from year 2004 in the resources dedicated to enforcement of these four areas.
Excessive Compensation Initiative
In the announcement, the IRS stated that it plans to continue its compliance checks by sending letters to nearly 2,000 exempt organizations to determine whether organizations are providing excessive compensation. An IRS representative, at a recent conference, indicated that the IRS expects "roughly 25% of the contacts to end up in examinations."2
Under the Internal Revenue Code, an excise tax is imposed on directors, officers and "disqualified persons" of public charities that are in receipt of excess compensation from the charity.3 Excess compensation is any compensation that exceeds the fair market value of the services performed. Generally, section 4958 requires that charities pay salaries comparable to those paid by similar charities or for-profit corporations in similar circumstances. Section 4958 provides a rebuttable presumption that can be established in favor of the public charity and the disqualified person if certain criteria are met. Similarly, a private foundation self-dealer and foundation manager are subject to an excise tax on any transactions that are considered "self-dealing".4 There is no rebuttable presumption available to private foundations, however, and the self-dealing rules are more restrictive. The Internal Revenue Service is, through this enforcement action, focusing upon these types of transactions due to a perception of abuse in the area.
If an exempt organization receives one of the information letters from the IRS, it is important for the organization to respond promptly and completely to the questions posed by the IRS, preferably after consulting with tax counsel. It is our experience that in most of these situations, the exempt organization should be able to justify its compensation payments, due to the availability of comparable compensation packages both in the for-profit and nonprofit sectors. However, it is important to provide the IRS with complete information to enable them to make an informed conclusion regarding the compensation package or other insider transaction.
Credit Counseling Agencies
One of the highest priorities for the Exempt Organizations Division in 2005 is stemming the perceived abuses of tax-exempt credit counseling agencies. In 2004, Congress announced that it is concerned that some credit counseling agencies have used their tax-exempt status to circumvent consumer protection laws and take advantage of individuals who are already in financial distress.5 Specifically, some credit counseling agencies provide "no bona fide education or counseling and place every consumer onto a debt management program at unreasonable or exorbitant charge."6 The IRS announced that it will heighten its scrutiny of the organizations filing for tax-exempt status as a credit counseling organization and it will closely examine the Forms 990 of credit counseling organizations for abuses of exempt status.
To minimize the risk of violating their tax-exempt status, and to lessesn their exposure to unrelated business income tax, all credit counseling organizations should immediately review their credit counseling programs to determine if they are offering sufficient educational opportunities for consumers.7 Furthermore, each organization should offer debt management programs at a reasonable cost and only to consumers who truly need the service.
In addition to increasing its enforcement of perceived abuses by credit counseling agencies, the IRS will continue to crack down on exempt organizations funding terrorist activities. In doing so, the Exempt Organizations Division will examine a sample of foreign grant making organizations to ensure that funds are used for the intended charitable purpose and not diverted to terrorist organizations. An exempt organization can minimize its risk of making grants to terrorist organizations, while also minimizing the burden to the organization, by setting up a comprehensive compliance strategy.8
Abusive Tax Avoidance Transactions
The IRS also plans to increase its scrutiny of perceived abuses by taxexempt organizations, including IRC Section 509(a)(3) supporting organizations, IRC Section 501(c)(15) entities, Producer-Owned Reinsurance Companies and donor-advised funds and organizations involved in HUD programs.9 The IRS is concerned that some organizations lack charitable activities and are providing impermissible private benefit. To protect itself against providing impermissible private benefit, an exempt organization should review its loan and compensation activities to ensure that they are made on a reasonable basis and at a reasonable rate. Additionally, the organization should make certain that its activities further its charitable purpose.
1 IRS, "Report Outlining TE/GE Accomplishments for FY 2004, Implementing Guidelines for FY 2005", available at http://www.irs.gov/pub/irs-tege/implementing_guidelines_1104.pdf (Nov. 4, 2004).
2 Martha Sullivan, Director EO Division, TE/GE, Western Conference on Tax Exempt Organizations, Nov. 19, 2004.
3 I.R.C. Section 4958.
4 I.R.C. Section 4941.
5 Subcomm. on Investigations, 108th Cong., "Profiting in a Non-profit Industry: Abusive Practices in Credit Counseling", available at http://govt-aff.senate.gov/_files/032404psistaffreport_creditcounsel.pdf.
7 Debra Cowen & Debra Kawecki, IRS, "Credit Counseling Organizations", available at http://www.irs.gov/pub/irs-tege/eotopica04.pdf.
8 See, e.g., Janne G. Gallagher, "Grantmaking in an Age of Terrorism: Some Thoughts About Compliance Strategies," International Dateline, Second Quarter 2004; Martin B. Schneiderman, "Seeking a Safe Harbor," Foundation News & Commentary, p. 34, May/ June 2004.
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