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Intermediate Sanctions Applicable To Transactions Involving Tax-Exempt Organizations

By Katrina M. Clingerman

The Taxpayer Bill of Rights 2 ("TBOR2") was signed into law on July 30, 1996. This law imposes excise taxes as an intermediate sanction in cases where tax-exempt organizations (described in Sections 501(c)(3) and 501(c)(4) of the Internal Revenue Code of 1986, as amended (the "Code")) engage in an "excess benefit transaction" with a "disqualified person." Final regulations interpreting and applying the statutory language were adopted by the Internal Revenue Service ("IRS") on January 22, 2002.

IRS Code Section 501(c)(3) prohibits any organization described therein from permitting its net earnings to inure to the benefit of any private shareholder or individual. This provision has been interpreted as prohibiting the inurement of any of the organization’s income or assets to any insider and is generally referred to as the prohibition on private inurement. Historically, the only penalty available to the IRS with respect to an occurrence of private inurement was revocation of an organization’s tax-exempt status. Thus, the IRS had to choose between revocation and leaving the transaction unpunished. TBOR2 and the final regulations adopted thereunder provide the IRS with an intermediate penalty – thus, the provisions are referred to as "intermediate sanctions."

Although any finding of inurement by an organization may still result in revocation of the organization’s tax-exempt status, the IRS may now impose intermediate sanctions as a less harsh alternative to revocation. The new rules focus the penalty on any wrongdoers rather than the organization itself and also provide necessary guidance to tax-exempt organizations regarding how to avoid private inurement.

Effective Date

TBOR2 and the final regulations thereunder apply retroactively to transactions occurring on or after September 14, 1995. However, they do not apply to transactions arising under a written contract that was binding on September 13, 1995, and continued in force throughout the time of the transaction.

Application of Intermediate Sanctions to Tax-Exempt Organizations

For purposes of intermediate sanctions, the term "disqualified person" means any individual who is in a position to exercise substantial influence over the affairs of the tax-exempt organization at the time of the transaction, or who was in such a position during the five-year period prior to the transaction at issue. This term will also include certain family members of a disqualified person and entities which are thirty-five percent controlled by a disqualified person.

The term "excess benefit transaction" means a transaction whereby the economic value given to a disqualified person exceeds the value received by the tax-exempt organization. This law is targeted at three specific types of excess benefit transactions: (a) transactions in which a disqualified person engages in a non-fair-market-value transaction with a tax-exempt organization, (b) transactions whereby a disqualified person receives unreasonable compensation, and (c) financial arrangements under which a disqualified person receives payment based upon the organization’s net earnings in a transaction that violates the private inurement prohibitions. Examples of possible excess benefit transactions include loans, compensation arrangements, rental agreements and sales or acquisitions of property.

The existing tax law standards will apply with respect to determining the reasonableness of compensation and the fair market value. Further, any transaction will be afforded a rebuttable presumption of reasonableness if the decision is made by an independent committee in compliance with procedures set forth in the regulations.

Computation of Excise Taxes Imposed Upon Disqualified Persons and Other Individuals

A disqualified person who benefits from an excess benefit transaction will be subject to a twenty-five percent excise tax upon the value of the excess benefit received. The "excess benefit" is defined as the amount by which the value provided to the disqualified person in a transaction exceeds the amount received in exchange by the tax-exempt organization. For example, if a disqualified person is paid compensation which is disproportionate to the actual value of his or her services, the excess compensation given would be the value of the "excess benefit." A disqualified person who fails to timely correct the overpayment received in an excess benefit transaction may be subject to an additional penalty tax equal to two hundred percent of the excess benefit.

Organization managers (e.g., officers, directors, or trustees) may be subject to a ten- percent excise tax if they participate in an excess benefit transaction with knowledge that it is an improper transaction. However, the maximum amount of any tax imposed upon an organization manager is limited to $10,000 for any single excess benefit transaction. A manager can avoid the excise tax by relying upon a reasoned written opinion provided a professional. The professional may be the organization’s legal counsel, a certified public accountant, or an independent valuation expert, provided the facts are fully disclosed to the professional and the subject of the opinion is within the professional’s expertise.

Planning For The Application Of Intermediate Sanctions To Your Organization

Given the fact that this law imposes new filing and reporting requirements, we encourage you to contact us to discuss how your organization can best comply with these provisions. We can also advise affected organizations regarding procedures for the retroactive review of Page 3 transactions entered into after September 14, 1995, and any steps that may be available to correct current noncompliance with these regulations.