Intermediate Sanctions

John R. Wylie, Esq/ 
This article provided by the Engstrom Institute

I. Overview

Intermediate sanctions enable the IRS to penalize organizations described in section 501(c)(3) of the Internal Revenue Code ("IRC") for certain abuses without revoking their exempt status. The IRS can assess intermediate sanctions excise taxes when a "disqualified person" is involved in an "excess benefit transaction." IRC §4958. The primary excise taxes come in two tiers. The first tier is a 25% tax on the excess benefit received by a disqualified person. The second tier is a 200% tax on the excess benefit and can be imposed if the disqualified person fails to return the excess benefit within a specified time period. These excise taxes are assessed against the individual receiving the excess benefit. In addition to taxing the disqualified person, the IRS may also impose a 10% tax (up to $20,000) collectively on the "organization managers" who participated in the excess benefit transaction knowing it to be improper.

The IRS has issued Temporary Regulations governing the interpretation and enforcement of the intermediate sanctions provisions. These regulations provide additional interpretive guidance with respect to the application of intermediate sanctions taxes.

The following sections discuss key intermediate sanctions provisions (as clarified by the proposed regulations). It does not specifically address their potential application to a particular organization or set of facts and circumstances.

II. Disqualified Persons

A disqualified person is defined as one who exercises "substantial influence" over the organization, as well as family members of such person and entities in which any disqualified person holds at least 35% of the voting power. The term is meant to capture the concept of "private inurement" to organization insiders, which is prohibited under IRC section 501(c)(3). The definition is significant because it does not necessarily include an officer or director of the corporation, nor does it necessarily exclude persons who are not employees of the corporation. Hence, large donors who are actively involved with the corporation may be considered disqualified persons even though they hold no official position related to the corporation.

The proposed regulations state that any person having the responsibilities of chief executive officer or treasurer are deemed to exercise "substantial influence" over the organization and are, therefore, disqualified persons. Further, individuals serving as voting members on the governing body of the organization are also deemed to be disqualified persons. The regulations indicate that individuals who do not fall into the preceding categories may nevertheless exercise "substantial influence" over an organization based on an assessment of all the facts and circumstances.

III. Excess Benefit Transactions - Compensation

An excess benefit transaction is one in which an economic benefit is provided by the corporation directly or indirectly to a disqualified person and the value of the benefit exceeds the value of the consideration (including the performance of services) received by the corporation. A benefit provided by the corporation to the employee that is not intended by the corporation prior to its payment to be consideration for performance of services will not be treated as consideration. The IRS will determine whether a transaction involves an excess benefit by comparing the fair market value of the consideration provided by both parties according to current tax law standards. Of course, this comparison will be easier for certain types of transactions than for others.

Under the Temporary Regulations, certain economic benefits provided by an organization are disregarded. These include payment of reasonable expenses incurred by board members for attending board meetings. However, expenses for luxury travel and spousal travel are not disregarded and, if paid for by the organization, would be subject to an excess benefit analysis. In other words, the organization must receive value in exchange for the luxury or spousal travel equal or greater in value than the costs of such travel. Although such a value comparison may be subjective and difficult to establish, the IRS may nevertheless require it to be done.

Perhaps the primary transaction to which intermediate sanctions will be addressed is compensation of officers and other members of an organization's senior management. Compensation for services rendered will only be considered excessive if it is "unreasonable." Because the valuation of services rendered by an officer is often difficult to establish, this standard may give organizations a substantial degree of latitude in setting compensation for its officers. However, the IRS may nevertheless seek to impose excise taxes on clearly excessive compensation. The regulations indicate that all forms of cash and noncash remuneration will be considered in determining an individual's compensation. In addition, compensation will include all forms of deferred compensation, premiums for liability insurance paid on behalf of the employee, and virtually all other forms of benefits received by the employee as compensation. Revenue sharing transactions (i.e., transactions where a disqualified person and an organization both receive compensation of some nature based on the outcome of the transactions) will be scrutinized by the IRS particularly carefully.

Payment for luxury or spousal travel may be included as part of an employee's compensation package and will not be subject to excise taxes unless the total compensation package is excessive. However, if such payments are not designated as compensation when paid, they may be subject to excise tax if they are excessive with respect to the value received by the organization in the particular transaction involving the travel.

IV. Rebuttable Presumption of Reasonableness

Organizations can create a "rebuttable presumption of reasonableness" for any transaction involving disqualified persons, and particularly for compensation, by adhering to certain procedural requirements. If the presumption is established, the IRS may only impose excise taxes if it can produce sufficient evidence to establish that the compensation is unreasonable; in short, the presumption places a substantial burden of proof on the IRS.

The presumption is established when three criteria are satisfied:

1. The transaction (or compensation) is approved by a board of directors (or committee of the board) composed entirely of members who are independent of the disqualified person. This requirement may be difficult to satisfy for certain organizations, which are governed by inside boards. Fortunately, the proposed regulations appear to limit the concept of "independence" to family, financial and employment contexts. The regulations state that a board member will only have a conflict if he or she is a related to the disqualified person, is an employee subject to the control of the disqualified person, or has a material financial interest in the compensation of the disqualified person.
   
   
2. The board (or committee) must obtain and rely upon appropriate comparability data (e.g., compensation levels for similar positions paid by similarly situated organizations, independent compensation surveys, actual written offers from comparable organizations, etc.). Unique characteristics of an organization, including its size and demographics, should be considered when doing this comparability analysis.[1]
   
   
3. The board must document the basis for its determination. The documentation must describe the compensation package approved, identify the members of the board (or committee) present and voting on the compensation package (and how they voted), identify the comparison data relied upon, explain the basis or rationale for any deviation from such data, and describe the actions taken during the meeting by any members having a conflict of interest. The documentation must be prepared prior to the next meeting of the board (or committee) and must be approved by the board (or committee) within a reasonable time thereafter.

The regulations indicate that the presumption cannot be created if one or more of the board (or committee) members have a conflict of interest or if there is not sufficient comparability data. Of course, failure to establish the presumption does not mean the compensation is excessive, but it may place a burden of proof upon the nonprofit organization if the compensation is challenged. For this reason, even if the presumption cannot be strictly established as a matter of law, following the requirements set forth above as closely as possible is advisable because it will put an organization in a more favorable position with respect to such a challenge.

V. Organization Managers

The regulations indicate that "organization managers" consist primarily of officers and directors of the organization. The term also includes individuals that regularly exercise general authority to make administrative and policy decisions on behalf of the organization. Organization managers may be jointly and severally liable for the 10% excise tax on an excess benefit transaction if they participate in the transaction knowing it to be in violation of the intermediate sanctions rules. This tax could be imposed upon the board (or committee) members approving an excessive compensation package if such members have actual knowledge of facts which establish that the total compensation is excessive or fail to make reasonable attempts to ascertain whether the compensation is excessive. In addition, the members must be aware that excessive compensation violates the intermediate sanctions rules. Organization managers who oppose the compensation package or who have no duty to speak or act with respect to the package are not subject to this tax.

John R Wylie is an attorney in Colorado Springs, CO with Holme Roberts & Owen LLP.

[1] One example in the regulations addresses the compensation of a university president. In that example, the executive committee of the university board determines the compensation based on a national survey. However, the survey does not divide its data by any measure of university size or other criteria. Further, no member of the executive committee has any expertise with respect to such compensation. The regulations indicate that the date relied upon in this scenario is inadequate.