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Excess Benefit Rules Provide Way to Avoid Penalty Tax


Boards of public charities will have to do a lot more work than many have bothered with in the past to create a "rebuttable presumption" that the compensation of their top executives is reasonable. They will be responsible not only for setting the salary of the chief executive but also certain other key officers. And they will have to watch any transaction in which they are personally involved.

The proposed regulations for implementation of "excess benefit" taxes under the 1996 intermediate sanctions legislation give a wealth of detail for public charities seeking to avoid penalties under the law.

Passed by Congress to give the IRS authority to impose sanctions, other than revocation of exemption, on improper conduct by public charities, the statute imposes a tax on "disqualified persons," officers, directors, and others who are in a position to "exercise substantial influence over the affairs of the organization," for any benefit they receive from the organization in excess of the value they give back for the benefit. Typically, the statute will be used to recover excessive compensation or other perks, although the IRS has regularly emphasized that it intends to use its power only in egregious situations.

Proposed as Regulation Sections 53.4958-1 through 53.4958-7 and published in the Federal Register August 4, 1998, the rules help define excess benefit transactions and disqualified persons, and establish procedures to create a rebuttable presumption that compensation is fair. The rules cover public charities exempt under Section 501(c)(3) of the Tax Code and social welfare organizations exempt under Section 501(c)(4). They do not cover private foundations (which are also exempt under Section 501(c)(3)), because foundations have their own special rules for self dealing and other limitations.

Disqualified Persons

Although the term is the same as that used in dealing with private foundations, the definition of disqualified person in this context is substantially broader. The intermediate sanctions section of the Code, Section 4958, defines a disqualified person as one who, within five years prior to the date of a transaction, was in a position to exercise substantial influence over the affairs of the organization.

The proposed regulations declare certain persons disqualified by virtue of their positions with the organization. These include directors and trustees on the governing board, the president, chief executive or chief operating officers who have or share "ultimate responsibility for implementing the decisions of the governing body or supervising the management, administration or operation of the organization," and the treasurer and chief financial officer. In addition, they include persons with a "material financial interest" in a provider-sponsored organization if a charitable hospital participates in the organization.

The regs specifically exclude from the definition other public charities and employees who earn less than the level to be classified as "highly compensated" under pension plan rules, who are not otherwise designated as disqualified and who are not substantial contributors (as determined under the test for public charity status under Section 509).

The examples make clear that economic benefits considered in determining whether the person meets the "highly compensated" level does not include only direct compensation. Under the examples, an artist-employee whose painting is purchased by a museum for $90,000 has become highly compensated and therefore not necessarily excluded from the definition of disqualified person.

Facts and Circumstances Test

Others, including organizations or individuals who may not immediately appear to be covered, may be disqualified under a "facts and circumstances" test. (Remember that in legal terminology the term "person" includes entities as well as individuals.)

The factors to be considered as suggesting influence include that the person founded the organization, the person is a substantial contributor, the person has authority to control or determine a significant portion of the organization's capital expenditures, operating budget, or compensation of employees, the person has managerial authority, or the person owns a controlling interest in a corporation, partnership or trust that is a disqualified person.

Factors tending to show a lack of influence include that the person has taken a bona fide vow of poverty as an employee, agent or on behalf of a religious organization, or that the person is an independent contractor, such as an attorney, accountant or investment counsel.

The regulations include a number of examples. A headmaster of a private school with power to hire and fire staff, change curriculum and discipline students is disqualified. A program officer at a community organization who is not highly compensated is not disqualified. A company that manages bingo games on behalf of a charity, where the bingo revenue is more than half the total annual revenue, is a disqualified person. An individual who owns all the stock of the bingo game company is also a disqualified person with respect to the charity.

Where a charitable hospital and a for-profit company have entered into a limited liability company to operate the hospital and the LLC employs an outside management company to run the venture, the outside management company is a disqualified person with respect to the charitable hospital corporation.

A law school dean is disqualified. A radiologist on the staff of a hospital who does not control a department and has no significant administrative duties is not disqualified, while the head of the cardiology department, which is a major source of patients and revenue for the hospital, is a disqualified person when the cardiologist has significant managerial duties, including allocation of budget and determination of bonus compensation. Where a substantial contributor receives no consideration or special treatment other than that afforded other contributors of similar amounts, the contributor is not deemed a disqualified person.

In addition, according to the statute, a disqualified person includes the spouse, brother or sister (by whole or half blood) and their spouses, ancestors, children, grandchildren, great grandchildren and spouses of the descendants, plus 35-percent controlled companies. A 35-percent controlled company is a corporation, partnership or trust in which a disqualified person has 35 percent of the voting power, or a 35 percent profits interest or beneficial interest.

Excess Benefit Transactions

An excess benefit transaction is one in which the charity provides an economic benefit to a disqualified person, directly or indirectly, which exceeds the value of the consideration, including the performance of services, received by the organization in return. The regs specify that a benefit shall not be treated as compensation for performance of services unless the organization clearly indicates its intent to treat the benefit as compensation when the benefit is paid.

Certain economic benefits are disregarded, such as payment of reasonable expenses for board members to attend board meetings, but this does not include "luxury travel or spousal travel."

Benefits provided solely as a member of, or a volunteer for, the organization are not considered if provided to members of the public for a membership fee of $75 or less. Benefits provided to a disqualified person solely as a member of a charitable class in furtherance of a charitable mission are also exempt.

Payment of premiums on an insurance policy covering any taxes imposed under the statute are not deemed a benefit if treated as compensation. (Most directors and officers liability policies do not cover the requirement to pay excise taxes.)

In determining the value of other benefits, property must be valued at its fair market value.

The Act covers transactions occurring after September 15, 1995, except those required by written contracts in effect on that date and not subsequently modified substantially.

Reasonable compensation is determined as of the time that the agreement is entered into and not on the basis of later discovered information. Where the full facts are not known when the contract was made, such as a contract including a bonus based on facts existing on the last day of the year, the determination will be made when the payment is made.

Compensation includes all forms of salary, fees, bonuses and severance payments made, all forms of deferred compensation earned and vested, whether or not funded by the organization, and all other benefits, including foregone interest on loans.

Revenue-Sharing Transactions

A revenue-sharing transaction is one in which payment is made to the disqualified person based in whole or in part upon the revenues of one or more activities of the organization. The IRS has always been suspicious of revenue-sharing transactions because they may lead to compromises in the organizational mission or provide benefits to the recipient which are not based upon matters within the recipient's control.

The proposed regulations make clear that a revenue sharing transaction may constitute an excess benefit even if the economic benefit is not excessive "if, at any time, it permits a disqualified person to receive additional compensation without providing proportional benefits that contribute to the organization's accomplishment of its exempt purpose."

The regs provide three examples. An in-house investment manager who receives a bonus based on a percentage of the increase in value of the investment portfolio over the year does not have an excess benefit transaction because the arrangement provides incentive to provide the highest quality service while reducing expenses, the manager has some degree of control over the activities, and the manager can increase his or her personal compensation only when the organization receives a proportional benefit.

A company which manages gaming operations for the organization is a disqualified person. It pays the organization a percentage of net profits, defined as gross revenue less rental of equipment, wages for staff, prizes for winners and other specified operating expenses. It retains the balance, after paying the expenses and the charity its percentage, as its fee. Because the company controls the operations, owns the equipment and employs the staff, it can control the net revenues relative to gross. The structure does not provide the company with an appropriate incentive to maximize benefits and minimize costs to the organization because it benefits whether expenses are high and net revenues low, or if expenses are low and net revenues high. The arrangement is an excess benefit transaction.

In another, a university professor receives a percentage of royalties on an invention produced by the professor during work for the university and assigned to the university to patent. Because the professor has no control over the use of the patent, the payment is a reward for the professor for producing work of especially high quality, and because the professor and the university benefit proportionally from the royalties, the arrangement is permitted.

The regulations point out that during the period prior to the publication of final regulations only the excess benefit of an improper revenue-sharing transaction will be taxed. After the publication of final regulations, the entire payment will be taxed.

Rebuttable Presumption

An organization will create a rebuttable presumption of fairness of compensation if it follows the following procedures:

  • The arrangement is approved by the organization's governing body or a committee thereof composed entirely of individuals who do not have a conflict of interest with respect to the transaction, the group has obtained and relied on "appropriate data as to comparability" prior to its decision, and the group adequately documents its basis for decision concurrently with making the decision.
  • A person will not have a conflict of interest if the person is not a disqualified person with respect to the transaction, is not in an employment relationship subject to the direction or control of the disqualified person, is not receiving compensation or other payments subject to approval by the disqualified person, has no material financial interest affected by the transaction, and does not approve a transaction benefiting a disqualified person who has, or will, in turn approve a transaction involving the member.
  • A person who has a conflict will not be considered to have been a member of the decision making group if the person meets with other members only to answer questions and leaves the meeting and is not present during debate and voting on the transaction.
The regulations also attempt to spell out the requirements for "appropriate data." Relevant data would include, but not be limited to, data on similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions, the availability of similar services in the geographic area, independent compensation surveys from independent firms, actual written offers from similar institutions competing for the services of the disqualified person, and independent appraisals of the value of property that the organization intends to purchase from, sell to or provide to the disqualified person.

Smaller organizations with annual gross receipts of less than $1 million (which may be determined over a three year average) will be considered to have appropriate data if they obtain data from five comparable organizations in the same or similar communities for similar services. For purposes of determining whether the small organization rule applies, organizations affiliated with another entity by common control or governing documents must aggregate the income of all the affiliates.

Again, examples help illustrate the points. In example 1, a $200 million university seeking to rely on a national survey of university presidents will not have appropriate data where the survey does not divide its data by any measure of university size or other criteria. In example 2, a hospital commissions a customized compensation survey from an independent firm covering pay at a significant number of hospitals, sorted by a number of different variables, including size, nature of service, level of experience, etc. The data is appropriate.

For a decision to be adequately documented, the records must note the terms of the transaction and the date approved, the members present during the discussion, the comparability data obtained and relied upon and how the data was obtained, and the actions taken with respect to the transaction by anyone who is otherwise a member of the decision-making group but who had a conflict of interest with respect to the transaction.

Concurrent Documentation

If the group determines that a specific arrangement should be higher or lower than the range of comparable data, the group must record the basis for its decision. To be documented "concurrently," the minutes must be prepared by the next meeting of the group and approved by the group within a reasonable time thereafter.

The fact that the procedures to create a rebuttable presumption have not been followed does not cause the transaction to be deemed an excess benefit transaction, but an organization will have a more difficult time proving its reasonableness if challenged after the fact. The IRS has made clear that it retains the right to revoke exemptions, in addition to imposing the taxes, in appropriate cases.

Taxes are Stiff

What happens when an excess benefit transaction occurs? Organizations are required to self-report on their Form 990 tax information returns, but the IRS obviously has the power to investigate without the self-reporting.

The initial tax on the disqualified person is 25% of the amount of the excess benefit. If it is not corrected before the IRS mails a notice of deficiency for the tax or the date on which the tax is assessed, the disqualified person is subject to an additional fine of 200% of the excess.

Correction can normally be achieved by paying back the excess amount, plus interest, or otherwise making the organization entirely whole and protected against any loss.

A separate tax is imposed upon any organization manager who knowingly participates in the decision to approve the transaction unless such participation was not willful and was due to reasonable cause. Such a manager may be jointly and severally liable with other managers participating in the decision for a tax of 10% of the excess benefit, not to exceed $10,000 for each transaction. An organization manager includes any officer, director or trustee or a non-board member serving on a decision-making committee.

"Participation" specifically includes "silence or inaction" by the manager "where the manager is under a duty to speak or act," as well as affirmative action by the manager. A manager will be deemed to be "knowing," however, only if the manager has actual knowledge that the transaction would be an excess benefit transaction, is aware that such an act may violate the statute, and negligently fails to make reasonable attempts to ascertain whether the transaction is an excess benefit transaction. "Knowing" does not mean having reason to know, but evidence tending to show that a person had reason to know the facts is relevant in determining whether the person had actual knowledge.

Participation will be deemed willful if it is voluntary, conscious and intentional, whether or not motivated to avoid the restrictions of the law. It will not be willful if the manager does not know that the transaction is an excess benefit transaction.

Participation will be due to reasonable cause if the manager has exercised responsibility on behalf of the organization with ordinary business care and prudence. Participation will ordinarily not be considered knowing or willful if a manager relies on a "reasoned written legal opinion" of counsel after full disclosure of the facts to the counsel. An opinion will not be considered "reasoned" if it merely recites the facts and recites a legal conclusion. The absence of a legal opinion does not give rise to an inference that the manager participated knowingly and willfully in an excess benefits transaction.

No investigation may be initiated of a church without meeting the standards for church tax inquiries and examination under Section 7611 of the Code. The IRS must have a "reasonable belief" that a tax is due from a disqualified person before initiating an inquiry.

don_kramer.jpgThe preceding is a guest post by Don Kramer, Editor or Nonprofit Issues.

Topics: IRS Nonprofit Board