Background
On September 9, 2005, the U.S. Department of the Treasury issued a proposed regulation dealing with two essential provisions of the tax code effecting tax-exempt entities: Code § 501(c)(3) (which sets out the requirements for tax-exempt status); and Code § 4958 (which imposes "intermediate sanctions" on "excess benefit transactions" with "disqualified persons"). This advisory explains the provisions of the proposed regulation and highlights some of its important consequences.
To qualify for exemption from tax under Code § 501(c)(3), an entity must be organized and operated exclusively for religious, charitable, scientific or educational purposes. Where an entity is not operated exclusively for exempt purposes, it is not eligible for tax-exempt status. Additionally, no part of the entity’s net earnings may inure to the benefit of any private shareholder or individual. This is referred to as the "anti-inurement" rule. A violation of the anti-inurement rule places the entity’s tax-exempt status at risk. While the anti-inurement standard is sufficiently broad to cover any number of arrangements, it is most often encountered in connection with payment of excessive compensation to founders, senior managers or insiders.
Code § 501(c)(3)
The current Code § 501(c)(3) regulations date back to 1959. Under the statutory scheme, tax-exempt status is all or nothing—either an entity is tax-exempt or it is not. Accordingly, the only remedy the government could impose in the face of a violation of Code § 501(c)(3) requirements was to revoke the tax-exempt entity’s charter. While this sanction is entirely appropriate in the case of egregious violations, it appeared overly harsh in the face of certain benign or innocent violations. As a consequence, IRS personnel were often reluctant to revoke a tax-exempt charter where the violation did not appear serious, leaving them with few other enforcement options.
Code § 4958
Recognizing this dilemma, Congress added Code § 4958 as a part of the Taxpayers Bill of Rights 2. Code § 4958 imposes certain excise taxes on transactions that provide excess economic benefits to disqualified persons with respect to public charities and social welfare organizations described in Code §§ 501(c) and 501(c)(4). These organizations are collectively referred to as "applicable tax-exempt organizations."
An excess benefit for Code § 4958 purposes is the amount by which the value of an economic benefit provided by an applicable tax-exempt organization directly or indirectly to or for the use of a disqualified person exceeds the value of the consideration (including the performance of services) received for providing that benefit. A "disqualified person" is defined as a person who is in a position to exercise substantial influence over the affairs of the applicable tax-exempt organization, which typically includes key members of the board of directors and members of the senior management team. Code § 4958(a) imposes the liability for excise taxes on the disqualified person who received the excess benefit from, and, in some instances, on "organization managers" (typically, board members) who participate in an excess benefit transaction, such as by approving the transaction without appropriate scrutiny. The purpose of Code § 4958(a) is to provide the IRS with a range of enforcement options short of revoking the organization’s charter.
In the legislative history of the Taxpayer Bill of Rights 2, Congress briefly addressed the relationship between Code §§ 501(c)(3) and 4958, saying that intermediate sanctions for excess benefit transactions may be imposed by the IRS in lieu of (or in addition to) revocation of the organization’s tax-exempt status. In general, revocation of tax-exempt status, with or without the imposition of excise taxes, would occur only if an organization no longer operates as a charitable organization. Based on this legislative history and their reading of the two provisions of the Code, the Treasury Department and the IRS take the position that the imposition of excise tax under Code § 4958 does not foreclose the revocation of the tax-exempt status in appropriate cases. The regulators proposed standards for determining when it might be appropriate to revoke an entity’s tax-exempt status in addition to imposing intermediate sanctions in the preamble to the 1998 proposed regulations under Code § 4958.
The Proposed Regulation
The recently proposed regulation illustrates and clarifies the government’s view of the relationship between Code §§ 501(c)(3) and 4958. As expected, the proposed regulation takes the position that the remedies under Code §§ 501(c)(3) and 4958 are not exclusive of one another. Certain examples provided in the proposed regulation present situations so egregious that the outcome is never in doubt. In one example, an educational organization is established solely for the purposes of focusing on the genealogy of a single family, and in another the organization is a thinly disguised marketing operation for a local artist cooperative.
The proposed regulation also adopts a set of factors to consider in determining whether to continue to recognize tax-exempt status where there are also one or more excess benefit transactions. These factors, which draw upon the proposed regulations under Code § 4958, include the following:
- The size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after the excess benefit transaction or transactions occurred;
- The size and scope of the excess benefit transaction or transactions (collectively, if more than one) in relation to the size and scope of the organization’s regular and ongoing activities that further exempt purpose;
- Whether the organization has been involved in repeated excess benefit transactions;
- Whether the organization has implemented safeguards that are reasonably calculated to prevent future violations; and
- Whether the excess benefit transaction has been corrected or the organization has made good faith efforts to seek correction from the disqualified persons who benefited from the excess benefit transactions.
While the examples set out in proposed regulations contain no surprises, they do make clear that the IRS places a premium on process. This point is starkly illustrated in two examples. In the first, the founder of an educational organization diverts substantial amounts of the organization’s assets to the payment of personal expenses. While the board did not authorize the payment of the founder’s personal expenses, some directors had knowledge of the payments but took no action. On these facts, the IRS determined that the organization engaged in multiple excess benefit transactions and that the organization was no longer a tax-exempt entity. But in the second, an organization entered into a construction contract at prices that substantially exceeded fair market value. The contract was approved by the board without any due diligence. The construction company was owned by the organization’s CEO. Subsequently (but before any IRS audit) the board discovered the problem, removed the CEO, and adopted a written conflicts of interests policy along with rigorous contract review procedures. On these facts, the IRS reached a different result and did not revoke the organization’s tax-exempt status.
Comment: The factor involving safeguards helps to explain the question on the recently released draft form 5500 that asks whether the organization or entity has a written conflicts policy even though this is not a formal requirement. By soliciting this information in advance, the IRS has immediate access to it on audit.
Revocation of the entity’s tax exempt status is rarely an issue for a tax-exempt entity organized and operated in good faith. The emerging body of guidance under the intermediate sanctions rules provide at least a rough outline of prudent practices that diligent organizations are coming to adopt and rely on to ensure compliance. These include greater autonomy of the board, the reliance on outside consultants for help with compensation-related matters, and the adoption of governance standards aimed at greater overall transparency.
While this proposed regulation does not offer any radical new insights, boards of tax-exempts that either have not previously paid attention or know of irregularities should glean form it an important lesson: Its time to pay attention and set things straight. Taking appropriate, timely action could spell the difference between having to pay fines or having to pay fines and forfeiting the entity's tax-exempt status. The emphasis on safeguards should also encourage boards adopt formal conflicts of interest policies, which should now be considered a "best practice" even though not legally required.
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