United States: IRS Issues Temporary Regulations On Intermediate Sanctions

After a two-year wait, the IRS issued revised Treasury Regulations on Intermediate Sanctions. The form of the released Treasury Regulations surprised exempt organization practitioners. The IRS had issued Proposed Regulations in July, 1998, and held hearings on March 16 and 17, 1999. Final Regulations have been anticipated for some time. Instead of issuing Final Regulations, the IRS issued Temporary Regulations. Temporary Regulations have the same force and effect as Final Regulations for up to three years. The IRS will be required to issue Final Regulations before the end of the three year period when the Temporary Regulations will expire. IRS officials explained that the decision to issue the Regulations in temporary and reproposed form, instead of final form, was a result of the numerous changes contained in the Temporary Regulations. Temporary Regulations are preferable to Proposed Regulations because they do have full force and effect during the three year period prior to the promulgation of Final Regulations.

Intermediate Sanctions, enacted as part of the Taxpayer Bill of Rights II in 1996, provided the IRS with a long sought-after tool to impose penalties, short of revocation of exempt status, on insiders of Section 501(c)(3) and (4) organizations who improperly benefit from the organization’s activities. The statute provides for first-tier taxes of 25% of the "excess benefit" on a disqualified person as well as 10% of the excess benefit on any organization manager (capped at $10,000) who participates in an "excess benefit transaction." If the transaction is not corrected, disqualified persons can be subject to an additional penalty of 200% of the amount of the excess benefit received. A disqualified person is defined in the Code as someone in a position to exercise substantial influence over the affairs of a Section 501(c)(3) or (4) organization. An excess benefit transaction is defined in the law as "any transaction in which an economic benefit is provided by a [Section 501(c)(3) or (4) organization], directly or indirectly, to or for the use of any disqualified person, if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received [by the organization] providing such benefit." The excess benefit is the amount by which the value of the economic benefit provided the disqualified person exceeds the value of the consideration received by the exempt organization. For example, compensation payments to a disqualified person in excess of reasonable compensation for the services rendered would constitute an excess benefit subject to penalties. Intermediate Sanctions also apply to revenue sharing transactions between disqualified persons and exempt organizations if the transaction would result in private inurement under Section 501(c)(3) or (4), to the extent provided in Treasury Regulations.

The legislative history provided a mechanism for an exempt organization to create a rebuttable presumption that a transaction is not an excess benefit transaction. The arrangement must be approved by the exempt organization’s board of directors, relying on appropriate data as to the comparability of the compensation or fair market value of the consideration received by the organization and contemporaneous documentation must be made of the determination.

The IRS has utilized Intermediate Sanctions in at least two publicly acknowledged situations. The first involved the well-publicized activities of the Bishop’s Estate in Hawaii. The other involved a purchase by insiders of several nursing homes in Mississippi.

The Treasury Decision accompanying the promulgation of Temporary Regulations indicates that the IRS received a large number of comments on the Proposed Regulations. A number of these comments resulted in changes contained in the Temporary Regulations issued in January.

The Proposed Regulations indicated that a correction required not only a return of the amount of the excess benefit, but also an "interest element" to make the exempt organization whole. The Temporary Regulations provide that the applicable federal rate, compounded annually, for the month in which the excess benefit transaction occurred, is an appropriate rate of interest.

The Temporary Regulations contain special rules for determining when contingent and certain non-cash compensation is deemed paid for purpose of Intermediate Sanctions. The Temporary Regulations provide that the transaction will generally occur on the date the benefit or nonqualified property vests. However, where a disqualified person elects, under Section 83(b) to include in income property transferred subject to a risk of forfeiture, the general rule will treat the economic benefit as received on that date. The Proposed Regulations left this unclear.

Temporary Regulations also clarify that governmental entities that may hold exempt status under Section 501(c), as well as under other provisions of the Code, will not be subject to Intermediate Sanctions.

A number of changes were made to the definition of "disqualified persons." Temporary Regulations clarify that per se categories of disqualified persons are defined by a reference to the actual powers and responsibilities held and not merely by the title given the person by the organization. This avoids possible problems for organizations where a president, in fact, has substantially no responsibility for the operation of the organization. Also, with respect to persons with managerial authority, the Temporary Regulations revise the factors tending to show substantial influence, including whether the person has or shares authority to control or determine a substantial portion of the organization’s capital expenditures, operating budget or compensation and manages a discrete segment or activity of the organization that represents a substantial portion of the activities. This should tend to limit those persons with managerial authority who would be subject to Intermediate Sanctions. Factors tending to show no substantial influence have been modified to include the fact that a person is an independent contractor whose sole relationship is providing professional advice.

Subsequent to the promulgation of the Proposed Regulations, the Court of Appeals for the Seventh Circuit issued its decision in United Cancer Council, Inc. v. Commissioner, which concluded that private inurement cannot result from a contractual relationship negotiated at arms-length with a party having no prior relationship with the organization, regardless of the relative bargaining strength of the parties or the resultant control over the organization created as a result of a contract. Temporary Regulations address this issue by providing that Intermediate Sanctions do not apply to any "fixed payment" made to an individual or entity pursuant to an initial contract regardless of whether the payment would otherwise constitute excess benefits. "Fixed payment" is defined as compensation specified in the agreement or determined by a fixed formula that requires no discretion. Payments based on revenues will be treated as a fixed formula if they are awarded without further action by the organization.

The Temporary Regulations address a number of comments in connection with the rebuttable presumption rules by adding several examples illustrating appropriate comparability data. The Temporary Regulations rejected comments that suggested a mechanism for satisfying the requirements with respect to large groups of employees. Individual consideration of an employee’s compensation will still be required.

The Temporary Regulations provide that with respect to fixed payments, including those pursuant to a formula, the rebuttable presumption can arise at the time the parties enter into the contract giving rise to the payment. In the case where payments are not fixed, the rebuttable presumption can only occur after discretion is exercised, except if the maximum amount payable under the contract is subject to a cap, which is a reasonable compensation amount.

With respect to revenue sharing, the Temporary Regulations failed to address the standards that will be applied. Instead, the IRS indicated it will continue to consider these issues.

The Temporary Regulations have provided more guidance on how the IRS will apply Intermediate Sanctions and the manner in which the exempt organizations can avoid excess benefit transactions. We anticipate that the IRS will move diligently to implement Intermediate Sanctions. Section 501(c)(3) or (4) organizations should consider the impact of Intermediate Sanctions in all dealings with all persons who have influence over the organization’s activities.

© 2000 Greenberg Traurig