The Internal Revenue Service recently issued final regulations describing the factors it considers when determining whether to revoke an organization’s tax exempt status as a result of one or more excess benefit transactions. The new regulations, issued on March 28, 2008, make clear that the exempt organization will benefit from taking affirmative steps to prevent, detect, and remedy excess benefit transactions, even if those steps are taken after an excess benefit transaction occurs.
Overview of the Excess Benefit Transactions Rule
Under Section 4958 of the Internal Revenue Code, the IRS can impose excise taxes on “disqualified persons” who engage in excess benefit transactions with section 501(c)(3) public charities and section 501(c)(4) social welfare organizations. Disqualified persons are those in a position to exercise substantial influence over the affairs of a tax-exempt organization, including directors and officers.
An excess benefit transaction is one in which the organization provides an economic benefit to a disqualified person that exceeds the value of the services or goods provided to the organization in return. Examples of excess benefit transactions may include unreasonable compensation, excessive travel expenses or other benefits, or the purchase of property from a disqualified person for a price in excess of fair market value.
The disqualified person who benefits from the transaction is subject to an excise tax equal to 25% of the excess benefit. If the disqualified person does not correct the transaction by returning the excess benefit to the organization plus interest, the IRS may impose an additional 200% tax on the excess benefit. Additionally, directors or officers who knowingly approved the transaction are subject to a tax of 10% of the excess amount, up to $10,000 per transaction.
This rule is often referred to as the “intermediate sanctions rule” because the excise taxes imposed by the IRS are viewed as an intermediate sanction between taking no disciplinary action and the severe consequence of revoking an entity’s tax-exempt status. The imposition of excise taxes does not preclude revocation of exemption, however, and the final rules help to clarify the factors the IRS considers in deciding whether revocation is appropriate.
Revocation Factors Stress the Benefit of Trying to Do the Right Thing
Although the IRS will consider all relevant facts and circumstances in determining whether to continue to recognize the tax-exempt status of an organization that engages in one or more excess benefit transactions, the following factors play an important role in the decision:
1. The size and scope of the organization’s activities that advance exempt purposes both before and after the excess benefit transaction took place;
2. The size of the excess benefit transaction compared to the organization’s exempt activities;
3. Whether the organization has participated in “multiple” excess benefit transactions, (defined as either (a) repeated instances of the same (or substantially similar) excess benefit transactions, or (b) more than one excess benefit transaction, whether the same type of transaction or the same persons are involved);
4. Whether the organization has implemented safeguards that are reasonably calculated to prevent future excess benefit transactions; and
5. Whether the organization has corrected or made a good faith effort to seek correction from the disqualified person who benefited from the transaction.
The IRS will consider all these factors in combination with each other, but will weigh more heavily in favor of continuing to recognize exemption where the organization discovers the excess benefit transaction and takes action before the IRS discovers the excess benefit transaction. Additionally, the regulations note that correction after the excess benefit transaction is discovered by the IRS, by itself, is never a sufficient basis for continuing to recognize exemption.
Exempt Organizations Should Address Excess Benefit Transactions Proactively
Exempt organizations should be proactive in implementing adequate safeguards to prevent future excess benefit transactions, and correcting such transactions when they are discovered. To this end, an organization should consider the following actions.
Rebuttable presumption procedure. The organization should follow the rebuttable presumption procedure when approving transactions with disqualified persons. The rebuttable presumption procedure requires the organization to approve the transaction in advance by an authorized body composed of individuals who do not have a conflict of interest; ensure the authorized body obtains and relies upon appropriate comparability data; and ensure the decision is appropriately documented. When properly performed, the procedure gives the organization the benefit of a presumption that the compensation is fair and reasonable.
Conflicts of interest. The organization should adopt a written conflicts of interest policy that includes contract review procedures for transactions with disqualified persons.
Expense reimbursements. To avoid “automatic” excess benefit transactions, the organization should ensure that expense reimbursements and similar payments are made under an accountable plan or treated as compensation by reporting the payment on IRS Forms W-2 or 1099.
Correction. If the organization discovers an excess benefit transaction, it should make good faith efforts to correct the transaction. Correction involves undoing the excess benefit to the extent possible, and requiring the disqualified person to make payments equal to the excess benefits plus interest to the organization. Examples of corrective action illustrated in the regulations include:
- Renegotiating compensation packages with management using appropriate comparability data going forward.
- Hiring legal counsel to recover excess amounts an organization may have paid to disqualified persons.
The IRS will take into account the organization’s good faith effort with respect to correction, and even if an organization has failed to correct an excess benefit transaction, it may still retain its tax-exempt status if other factors, in combination, warrant continued exemption.
Conclusion
The new excess benefit transaction regulations affirm the benefits of a proactive approach to managing transactions between an exempt organization and its disqualified persons. Organizations subject to these rules should implement safeguards to avoid excess benefit transactions, and take adequate steps to correct such transactions as soon as they occur.