Estate Planning Bulletin January, 1997
For the first time, enacted as part of the Taxpayer Bill of
Rights 2, the Internal Revenue Service has been granted the authority to
impose monetary penalties, called intermediate sanctions, upon the provision
of excess benefits by certain tax-exempt organizations to disqualified
persons. Until now, the Service could only revoke the recognition of an
organization's tax-exempt status, an action the Service was generally
reluctant to take in other than egregious cases. The intermediate sanctions
may be imposed without the revocation of an organization's exempt status or in
addition to such revocation. The new law imposes a monetary penalty upon the
person receiving the excess benefit and upon an organization's managers, but
no monetary penalty is imposed upon the organization itself. Accordingly, not
only managers of tax-exempt organizations, but also any person who enters into
a contract with such an organization, must be aware of the possible
application of the penalties to them. The new law has a retroactive effective
date, and it generally applies to transactions entered into on or after
September 14, 1995.
The penalty applies to the payment of an "excess benefit" to
or for the use of a "disqualified person" by an "applicable tax-exempt
organization." To understand the parameters of the penalty, each of these
terms must be defined. An applicable tax-exempt organization is a tax-exempt
publicly-supported charitable or tax-exempt civic organization; specifically
either (1) a tax-exempt charitable, religious, educational or other
organization described in Section 501(c)(3) other than a private foundation,
(2) a civic league or other organization described in Section 501(c)(4), or
(3) an organization which was described in (1) or (2) above at any time during
the five-year period ending on the date of the transaction.
A disqualified person is: (1) any individual who was in a
position to exercise substantial influence over the organization's affairs at
any time during the five-year period ending on the date of the transaction,
(2) certain persons related to the person described in the preceding category,
and (3) a corporation, partnership, trust or estate in which persons described
in the preceding two categories own more than 35 percent interest. It is
important to note that a disqualified person need only be in a position where
he could exercise substantial influence, actual demonstrated influence
is not required.
An excess benefit transaction is one in which the applicable
tax-exempt organization provides directly or indirectly to a disqualified
person a benefit more valuable than the consideration (including the
performance of services) received by the organization. To the extent to be
provided in tax regulations to be issued, an excess benefit transaction also
is any transaction in which the amount of any economic benefit to or for the
use of a disqualified person is determined in whole or in part by the revenues
of the organization, but only if the transaction results in impermissible
private inurement under existing law.
The new penalties are of particular concern to those who
enter into service agreements with applicable tax-exempt organizations. The
legislative history to the statute states that existing legal standards for
determining reasonable compensation are to be used to determine whether
compensation paid to a disqualified person is an excess benefit. Of particular
importance, it states that there is a rebuttable presumption of reasonableness
when (1) a compensation arrangement has been approved by an independent board
composed entirely of persons unrelated to and not subject to the control of
the particular disqualified individual, (2) the board obtained and relied upon
appropriate comparable data in making its compensation determination, and (3)
adequately documented the basis for its decision. Adequate documentation may
include, for example, an evaluation of the individual whose compensation is
being established and the basis for the determination that such compensation
is reasonable in light of that evaluation and data. Accordingly, all persons
who enter into service agreements with applicable tax-exempt organizations who
could be considered "disqualified persons" should make sure the tax-exempt
organization has followed these procedures to ensure that the rebuttable
presumption or reasonableness has been met. Failure to do so could mean the
imposition of penalties upon the service provider. Those disqualified persons
who enter into other types of contracts with service providers should be sure
that it can be established that payments made to the disqualified person for
goods do not exceed fair market value.
If a transaction is an "excess benefit transaction," a
penalty excise tax will be imposed on the disqualified person in an amount
equal to 25 percent of the excess benefit. Any organization manager who
participates in the excess benefit transaction knowing that it is such a
transaction is subject to a tax equal to 10 percent of the excess benefit,
unless the manager's participation was not willful and is due to reasonable
cause. An additional tax may be imposed upon the disqualified person if the
excess benefit transaction is not corrected within the period ending on the
earlier of the date of mailing of a notice of deficiency by the Internal
Revenue Service with respect to the 25 percent excise penalty tax or the date
upon which such tax is assessed. This means that to the extent possible an
excess benefit must be returned to the exempt organization and additional
measures must be taken if necessary to place the exempt organization in an
appropriate financial position as if it had been dealt with under the highest
fiduciary standards by the disqualified person.
Pearl B. Doherty
Attorneys
[Back to Top]
The purpose of this Web site is to provide general
information about legal developments. Because the facts in each situation vary,
any legal precedents noted may not be applicable to individual circumstances.
This information is not offered as legal advice.
