Establishing the Rebuttable Presumption

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

Overview of "Intermediate Sanctions"

In 1996, Congress enacted the Taxpayers Bill of Rights 2, which, in part, gave the Internal Revenue Service (IRS) new authority to assess excise taxes against applicable tax-exempt organizations in certain circumstances. These new excise taxes, now codified in Section 4958 of the Internal Revenue Code of 1986, as amended (the "Code"), are commonly referred to as the "intermediate sanctions" rules. Prior to the enactment of these rules, the IRS could penalize a tax-exempt organization that violated the prohibitions against private inurement only by revoking the organization's tax-exempt status. Under Section 4958 and the regulations promulgated thereunder, the IRS now has the authority to impose these "intermediate sanctions" as a penalty in the event certain tax-exempt organizations violate the private inurement rules.

In general, the intermediate sanctions rules impose excise taxes on transactions that provide excess economic benefits to disqualified persons of organizations exempt under Code section 501(c)(3) (and social welfare organizations described in Code section 501(c)(4)). "Disqualified person" means anyone who exercises "substantial influence" over the applicable tax-exempt organization (as well as family members of such person and entities in which any disqualified person holds at least 35% of the voting power). An "excess benefit transaction" means any transaction in which an economic benefit is provided by the applicable tax-exempt organization 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 such organization.

Disqualified persons who benefit from an excess benefit transaction with an applicable tax-exempt organization are liable for a tax of 25% of the excess benefit. Such persons are also liable for a tax of 200% of the excess benefit if the excess benefit is not corrected (i.e., the value of the excess benefit is paid back to the organization, including interest). Organization managers, including members of the board of directors, who participate in an excess benefit transaction knowingly, willfully and without reasonable cause, are jointly and severally liable for a tax of 10% of the excess benefit (not to exceed $20,000).

Temporary regulations, recently promulgated by the IRS, provide a procedure by which an applicable tax-exempt organization may significantly reduce the risk of the IRS imposing intermediate sanctions. If followed, an organization can create a "rebuttable presumption" that a particular transaction is not an excess benefit transaction. The procedure requires that a number of formal steps be followed to establish the presumption, and these steps can be both cumbersome and awkward. However, compliance with these steps, which are outlined below, shifts the burden of proof to the IRS to produce "sufficient contrary evidence" before it can levy the sanctions. While not providing insurmountable protection, establishing the rebuttable presumption, if possible, is a prudent approach for an exempt organization that is a party to a transaction with a disqualified person.

Procedure for Creating the Rebuttable Presumption

Generally, to create the rebuttable presumption of reasonableness, an organization must satisfy three distinct requirements. Those requirements are as follows:

1. An authorized body of the organization, composed entirely of individuals who do not have a conflict of interest in the transaction, must approve the transaction with the disqualified person in advance of the effective date of the transaction;
2. the authorized body must obtain and rely upon appropriate comparability data prior to making its decision; and,
3. the authorized body must adequately document the basis of its determination concurrently with making that determination.

The Temporary Regulations expand on the meaning of these requirements and the practical steps necessary to satisfy them.

Approval by an Authorized Body

An authorized body of an organization, composed entirely of individuals who do not
have a "conflict of interest," must approve the transaction with the disqualified
person in advance of the effective date of the transaction.

An "authorized body" means either the board of directors of an organization, or an authorized committee of the governing body (or, in some limited cases, independent third parties authorized by the governing body in accordance with applicable state law to act on its behalf). A committee of the board may perform this function, but only if also permitted by applicable state law to act on behalf of the governing body, and authorized by the board to perform this function.

The authorized body cannot include (for purposes of approving or disapproving the proposed transaction) any person who has a "conflict of interest." A person has a conflict of interest if he or she falls into one or more of the following categories:

1. Disqualified persons participating or economically benefitting from the proposed transaction;[1]
2. any person in an employment relationship subject to the direction or control of a disqualified person described in paragraph 1.;
3. any person with the right to receive compensation or other payments subject to approval by the disqualified person described in paragraph 1.;
4. any person with a material financial interest affected by the proposed transaction;
5. any person who stands to receive or who has already received approval from the disqualified person described in 1. for a transaction that will provide such person with an economic benefit; or
6. any person who might benefit from a separate transaction that arguably is approved as part of a reciprocal agreement with the disqualified person at issue.

Finally, it is important to note that the decision by the authorized board must precede the effective date of the transaction with the disqualified person. The authorized board cannot make retroactive decisions in order to establish the rebuttable presumption of reasonableness.

Reliance on Comparability Data

The authorized body must obtain and rely upon
appropriate comparability data prior to making its decision.

As a general rule, an authorized body has appropriate data as to comparability if, given the knowledge and expertise of its members, it has information sufficient to determine whether the proposed transaction is reasonable, in the case of compensation, or at fair market value, in the case of a property transfer. Reasonable compensation means the amount that would ordinarily be paid for like services by like enterprises under like circumstances. Note that the Temporary Regulations define broadly the term compensation to include all forms of cash and noncash compensation, as well as the payment of insurance premiums (unless otherwise excluded as a nontaxable fringe benefit); the payment of any penalty, tax or expense incurred as an intermediate sanction; and the payment of other compensatory benefits, other than nontaxable fringe benefits.

In the case of compensation determinations,[2] the comparability data considered appropriate by the IRS includes (but is not limited to) one or more of the following types of information:

1. Compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions;
2. the availability of similar services in the geographic area of the applicable tax-exempt organization;
3. current, sufficiently detailed compensation surveys compiled by independent firms; or
4. actual written offers from similar institutions competing for the services of the disqualified person.

In the case of property transactions, either of the following types of comparability data could be considered according to the IRS:

1. Current independent appraisals of the value of all property to be transferred; or
2. offers received as part of an open and competitive bidding process.

Finally, note that the authorized body must not only obtain appropriate comparability data, it must also rely on that data. Reliance requires that the members of the authorized body be provided with copies of the comparability data, with enough time for adequate review, which will vary depending on the length and complexity of such data, and the opportunity to ask questions regarding such data.

Adequate Documentation

The authorized body must adequately document the basis of its determination
concurrently with making that determination.

An authorized body must adequately document its decision regarding a transaction with a disqualified person concurrently with making that determination in order to claim the rebuttable presumption. The Temporary Regulations articulate four steps the authorized body should follow to document adequately the decision and the decision-making process in order to establish the presumption. Those steps are:

1. The authorized body should reflect in the minutes of its meetings the terms of the transaction that was approved and the date it was approved;
2. the authorized body should record (a) the members of the authorized body who were present during debate on the transaction that was approved, and (b) those members who voted on it (although not entirely clear from the wording of the Temporary Regulations, it seems reasonable that recording the outcome of the vote, and naming specifically any members who abstained from the vote, would satisfy this requirement);
3. the authorized body should describe in its minutes the comparability data obtained and relied upon by the authorized body and how the data was obtained; and
4. the authorized body must report any actions taken with respect to consideration of the proposed transaction by anyone who is otherwise a member of the authorized body but who has a conflict of interest with respect to the transaction.

While the Temporary Regulations do not provide specifically how to document the taking of the four steps above, the safest course of action is probably for an organization to prepare and approve detailed resolutions that include in the recitals (i) a description of the proposed transaction, (ii) a summary or description of the comparability data obtained and relied upon by the authorized body, (iii) the organization's basis for entering into the transaction (both business reasons and reasons relevant to the organization's charitable activity), and (iv) a recitation that each member of the governing body was given adequate opportunity to review the terms of the transaction and the comparability data. Appropriate documents should be attached to the resolutions as exhibits if practical or at least clearly referenced in the resolutions. For example, if a transaction was evidenced by a written contract, whether an employment contract, sales agreement, lease, etc., such contract should be referenced in the resolutions and attached to the minutes. Also, any written comparability data should be attached, or if too cumbersome to attach, referenced in the documenting records and kept in duplicate copy. The minutes should recite the action of the authorized body, and the reasons for its decision if not otherwise set forth in the resolutions.

Although not required by the Temporary Regulations, it would be appropriate, and consistent with common practice, for the disqualified person (and any other member of the authorized body who has a conflict of interest as described above) to be available to the authorized body to answer questions, and then to excuse himself or herself during the body's deliberation and decision-making process. The minutes should reflect this as well.

In addition to documenting the decision adequately, it also must be recorded concurrently with the decision. Once a final decision has been made regarding the transaction with the disqualified person, the Temporary Regulations require the authorized body to prepare the documenting records before the next meeting of the authorized body or 60 days after the final action, whichever is later.

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

[1] Also, as briefly defined earlier, "disqualified person" means any person who exercises "substantial influence" over the applicable tax-exempt 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 Temporary Regulations, however, expound upon this definition in great detail and broaden the scope of persons that will fall within the definition. The Temporary Regulations should be reviewed thoroughly on this point.

[2] A "small organization" (i.e., an organization with annual gross receipts, including contributions, of less than $1 million), can satisfy this part of the rebuttable presumption criteria by obtaining data from three comparable organizations in the same or similar communities for similar services. To determine whether an applicable tax-exempt organization may apply the small organization rule, it may calculate its gross receipts based on the average of its gross receipts during the three prior tax years. Also, if the applicable tax-exempt organization controls or is controlled by another organization, it must include the gross receipts of such other organization when making the small organization determination.