Internal Revenue Code Section 4958 imposes certain excise taxes against individuals involved in an "excess benefit transaction" with an organization exempt from income tax under Code Section 501(c)(3) or 501(c)(4) ("Applicable Organization"). Although the section is effective for any transaction occurring after September 14, 1995, final regulations were just recently issued on January 22, 2002. This article will set forth the general rules regarding excess benefit transactions as well as clarification provided by the final regulations.
The excess benefit transaction rules are part of the "Intermediate Sanction" reforms which give the IRS a more effective weapon to deter transactions where a person with substantial influence over the affairs of an Applicable Organization uses that influence to be unjustly enriched. The classic example is where the founder and President of the organization is paid an excessive amount of compensation for services to the organization. In the past, the Internal Revenue Services''s ("IRS") only recourse when discovering such an abuse was to revoke the tax exempt status of the organization. This approach did not work to deter such behavior as the person responsible for, and receiving, the unjust enrichment was not penalized, only the organization. Further, in the case of a Section 501(c)(3) charitable organizations, donor's would be penalized by the organization losing its exempt status. Thus, Section 4958 was enacted to penalize the persons involved in the excess benefit transaction rather than just the organization, as well as to permit the IRS to impose the tax without revoking the tax exempt status of the organization.
An excess benefit transaction is any transaction in which an economic benefit is provided by an Applicable Organization directly or indirectly to or for the use of a "disqualified person," and the value of the benefit exceeds the value of any consideration given for it, including services. Section 4958(c)(2) identifies a second type of excess benefit transaction: any transaction in which the amount of any economic benefit provided to or for the use of a disqualified person is determined in whole or in part by the revenues of one or more activities of the Applicable Organization, where the transaction results in impermissible inurement under section 501(c)(3) or (4). The statute provides, however, that this type of transaction is only an excess benefit transaction to the extent provided in regulations prescribed by the Secretary of the Treasury. The final regulations have reserved this issue and thus have not prescribed any regulations. However, the regulations provide, the general rules regarding excess benefit transactions will be applied to any revenue sharing arrangements until the specific regulations are issued.
Under Code Section 4958, there is a tax on individuals involved in excess benefit transactions. The tax is equal to 25% of the value of the excess benefit provided and is imposed on the disqualified person. Thus, if a disqualified person is deemed by the IRS to be paid more than reasonable compensation, he/she would be subject to a 25% tax on the overpayment. In addition, if an organization manager, such as a member of the Applicable Organization''s Board, "knowingly" participates in an excess benefit transaction, that person would be subject to a 10% tax on the overpayment.
However, under the regulations, an organization manager's participation will not be considered "knowing" if, after full disclosure of the factual situation to a professional, the organization manager relies on a reasoned written opinion with respect to elements of the transaction within the professional's expertise. Thus, it is in the personal interest of members of the authorized body to seek an opinion letter from legal counsel, accountants, or consultants to limit their personal risk. The organization manager will avoid the 10% tax even if the professional turns out to be wrong, as long as he or she relied on the professional''s advice in good faith.
A disqualified person is any person who was in a position to exercise substantial influence over the affairs of an Applicable Organization at any time during the five-year period ending on the date of the transaction. Under the regulations, members of the governing body, officers, and certain relatives of the above are deemed to be disqualified persons. Also an entity that is more than 35% owned by disqualified persons will itself be a disqualified person. Section 501(c)(3) organizations are deemed not to be disqualified persons and Section 501(c)(4) organizations are deemed not to be disqualified persons with respect to other Section 501(c)(4) organizations. Likewise, nonhighly compensated employees are deemed not to be disqualified persons. For all other situations, the regulations provide that in all cases the facts and circumstances will govern.
An organization manager is any officer, director, or trustee of such organization, or any individual having powers or responsibilities similar to those of officers, directors, or trustees of the organization, regardless of title.
Should an organization be found to have entered into an excess benefit transaction, a second-level tax may be imposed on a disqualified person if there is no correction of the excess benefit on or prior to the earlier of: (1) the mailing of a deficiency notice with respect to the 25% tax or (2) the date of assessment. The second-level tax is 200% of the amount of the excess benefit. This second-level tax can be avoided if the transaction is cured within the prescribed time frame. That is, if the excess benefit is paid back to the exempt organization. The final regulations clarify what should be done in the situation where the Applicable Organization is no longer in existence or no longer tax-exempt when the excess benefit transaction is to be cured. The regulations provide for a former Section 501(c)(3) organization, that the excess benefit should be paid to another publicly supported Section 501(c)(3) organization that has been in existence for 5 years, in accordance with the dissolution provisions of the Applicable Organization's governing document, provided that the disqualified person in the transaction is not a disqualified person for the new organization. The same is true for former Section 501(c)(4) organizations however, if there is no similar Section 501(c)(4) organization in existence, then the benefit should be paid to a Section 501(c)(3) organization.
Initial Contract Exception. There is an exception from the excess benefit transaction rules for the first written contract with a person who prior to entering into the contract was not a disqualified person to the Applicable Organization and the contract calls for fixed amounts of compensation. Thus, under the initial contract exception, Section 4958 will not apply to the initial contract even if it otherwise would be considered an excess benefit transaction. However, the initial contract exception is lost if the original contract is substantially modified later. For this purpose, an initial contract is defined as a binding written contract between an Applicable Organization and a person who was not a disqualified person immediately prior to entering into the contract. A fixed payment means an amount of cash or other property specified in the contract, or determined by a fixed formula specified in the contract, which is paid or transferred in exchange for the provision of specified services or property. A fixed formula may incorporate an amount that depends upon future specified events or contingencies (e.g., revenues generated by activities of the organization), provided that no person exercises discretion when calculating the amount of a payment or deciding whether to make a payment. The final regulations clarify that whether a written contract exists is a matter of state law. Thus, an exchange of writings setting forth the substantial terms may be sufficient, if they would constitute a binding contract under applicable state law.
Presumption of Reasonableness Where Procedures Followed. In order to give organization boards some peace of mind in their decisions on compensation, the regulations create a safe harbor in Treasury Regulation §§ 53.4958-6. If the conditions in this regulation are followed, they create a rebuttable presumption that payments under a compensation arrangement are reasonable and the burden of proof is shifted to the IRS to prove otherwise. To follow the safe harbor rules, the following actions must be taken:
1. Advance Approval. The compensation arrangement must be approved in advance by an authorized body of the organization composed entirely of individuals who do not have a conflict of interest regarding the transaction.
2. Reliance on Data. The authorized body must obtain and rely upon appropriate data as to comparability prior to making its determination. Such data may include compensation levels paid by similarly situated organizations (whether taxable or tax-exempt) for functionally comparable positions, and current compensation surveys compiled by independent firms.
3. Documentation. The authorized body must document the basis for its determination. This means that the authorized body must keep a written record of (1) the terms of the transaction and the date it was approved; (2) the members of the authorized body who were present during debate on the transaction and how each voted on it; (3) the comparability data that the authorized body relied on and how it was obtained; and (4) any actions taken with respect to consideration of the transaction by persons who would have been members of the authorized body but had conflicts of interest.
An "authorized body" is: (1) the governing body of the organization; (2) a committee of the governing body, to the extent permitted by state law; or (3) other parties authorized by the governing body of the organization to act on its behalf in approving compensation arrangements, to the extent permitted by state law.
However, the regulations provide that a person will not be considered a member of the governing body if he or she is the one to be compensated but is only in attendance to answer questions regarding the transaction and recuses himself or herself from the debate or voting on the transaction. Thus, if an Executive Director is also a member of the Board of Directors that is going to decide on an employment contract for the Executive Director, he or she may answer questions on the proposed compensation, but not take part in the debate or vote on the matter. The final regulations also clarify that a single person may constitute an authorized body if state law permits a single person to be a committee of the governing body or a party authorized by the governing body.
There is also a special rule for smaller organizations regarding comparable data. If the organization has average annual gross receipts less than $1 million, data on compensation paid by three comparable organizations will be sufficient. However, the regulations take no position on how much data is needed for larger organizations.
Applicable organizations should familiarize themselves with these excess benefit transactions so that they can take adequate measures to ensure compliance and avoid the draconian taxes imposed under Section 4958. The initial contract exception can be helpful to avoid Section 4958 for first-time contracts. However, when it comes to deciding on compensation arrangements the governing body should take advantage of the safe harbor rebuttable presumption by establishing the necessary procedures. Likewise, organization managers should seek written opinions on which to rely from professionals regarding the reasonableness of the compensation agreed to. The final regulations also point out that compliance with the excess benefit transaction rules does not relieve the organization from also complying with the other rules for tax exemption. That is, the IRS could still revoke an organization's tax exemption if it finds that transactions resulted in prohibited private inurement even though the excess benefit transaction rules were met. For example, a transaction qualifying for the initial contract exception could still threaten tax exempt status even though it would not be an excess benefit transaction. The preamble to the final regulations provide that until the IRS issues written guidance on what factors it will consider when determining whether to revoke exempt status it will continue to consider all facts and circumstances.
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