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Section 300
Private Inurement and Excess Benefit Transactions

¶330 Excess Benefit Transactions

This body of law (IRC §4958), which was added to the federal tax law in 1996, represents the most dramatic and important package of federal statutory tax rules concerning tax-exempt charitable organizations since the basic statutory scheme in this field was enacted in 1969. In addition to refocusing and reshaping the private inurement doctrine (¶310) and the private benefit doctrine (¶320), intermediate sanctions are having an impact on the composition and operation of many boards of directors of tax-exempt organizations, including boards of trustees of colleges and universities.

With enactment of the Pension Protection Act of 2006 (Pub. L. No. 109-280), the concept now explicitly reaches to certain vehicles and entities used to manage charitable contributions — donor advised funds and supporting organizations. (IRC §4958)

¶331 Concept of Intermediate Sanctions

The concept of intermediate sanctions involving tax-exempt colleges, universities, other public charities, and social welfare organizations emphasizes the taxation of those persons who engage in impermissible private transactions with these entities, rather than revocation of the entities' tax exemption. With this approach, tax sanctions — structured as penalty excise taxes — may be imposed on disqualified persons who improperly benefited from the transaction (see ¶332.2) and on the organization managers who participated in the transaction knowing that it was improper (see ¶332.3). The penalty is not imposed on the organization. The law also contains a rebuttable presumption of reasonableness that imposes responsibilities on institutions regarding its transactions with a disqualified person (see ¶333).

¶332 Terminology

The intermediate sanctions rules were enacted in January 2002, and enactment introduced new terminology. Here are the principal terms and their meaning.

¶332.1 'Applicable Tax-Exempt Organization'

As noted, these sanctions apply with respect to tax-exempt public charities (IRC §501(c)(3)) and social welfare organizations (IRC §501(c)(4)). These organizations include institutions of higher education. These entities are collectively termed, for this purpose, applicable tax-exempt organizations (IRC §4958(e)(1); Treas. Reg. §53.4958-2(a)(1)). Organizations of this nature include any organization that was this type of exempt organization at any time during the five-year period ending on the date of the transaction (IRC §4958(e)(2); Treas. Reg. §53.4958-2(b)(1)). There are no exemptions from these rules: all tax-exempt public charities, including nongovernmental colleges and universities, are applicable tax-exempt organizations.

A social welfare organization is covered by these rules if it has received recognition of tax exemption from the IRS, has filed an application for recognition of exemption, has filed an information return with the IRS as a social welfare organization, or has otherwise held itself out as a tax-exempt social welfare organization (Treas. Reg. §53.4958-2(a)(3)).

A foreign organization that receives substantially all of its support from sources outside the United States is not an applicable tax-exempt organization (Treas. Reg. §53.4958-2(b)(2)).

¶332.2 'Disqualified Person'

The term disqualified person means

(1) any person who at any time during the five-year period ending on the date of the transaction involved was in a position to exercise substantial influence over the affairs of the organization (whether by virtue of being an organization manager or otherwise);

(2) a member of the family of an individual described in the preceding category; and

(3) an entity in which individuals described in the preceding two categories own more than a 35 percent interest (IRC §4958(f)(1)(A)-(C); Treas. Reg. §53.4958-3(a)(1), (b)(1), (2)).

Effective August 17, 2006, the term also includes

(4) a disqualified person as described in (1) through (3) with regard to a §509(a)(3) supporting organization;

(5) a donor or donor advisor to a donor advised fund with respect to transactions with the fund; and

(6) an investment advisor to a §509(a)(3) supporting organization (IRC §4958(f)(1)(D)-(E).¹

As to the first of these categories, a person is in a position to exercise substantial influence over the affairs of an applicable tax-exempt organization if that person is a voting member of the organization's governing body or is (or has the powers or responsibilities of) the organization's president, chief executive officer, chief operating officer, or chief financial officer (Treas. Reg. §53.4958-3(c)).

Certain facts and circumstances tend to show this substantial influence, such as being the organization's founder, making major contributions to it, having managerial control over a discrete segment of the organization, or serving as a key advisor to a person who has managerial authority (Treas. Reg. §53.4958-3(e)(2)).

Certain facts and circumstances tend to show a lack of substantial influence, such as service as an independent contractor (e.g., lawyer, accountant, or investment advisor (Treas. Reg. §53.4958-3(e)(3)). Certain persons are deemed not to have the requisite substantial influence, such as an employee who receives economic benefits that are less than the compensation referenced for a highly compensated employee (IRC §414(q)(l)(B)(i)) and public charities (Treas. Reg. §53.4958-3(d)).

'Member of the Family.' The term member of the family is defined as

1. spouses, ancestors, children, grandchildren, great-grandchildren, and the spouses of children, grandchildren and great-grandchildren, namely, those individuals so classified under the private foundation rules (IRC §4946(d)); and
2. the brothers and sisters (whether by the whole- or half-blood) of the individual and their spouses (IRC §4958(f)(4)); Treas. Reg. §53.4958-3(b)(1)).

Thus, this term is defined more broadly in the public charity setting than is the case with private foundations.

'35 Percent Controlled Entity.' An entity that is a disqualified person because one or more disqualified persons own more than a 35 percent interest in it is called a 35 percent controlled entity (IRC §4958(f)(3)(A); Treas. Reg. §53.4958-3(b)(2)(i)). These entities include the following:

1. Corporations in which one or more disqualified persons own more than 35 percent of the total combined voting power
2. Partnerships in which one or more disqualified persons own more than 35 percent of the profits interest
3. Trusts or estates in which one or more disqualified persons own more than 35 percent of the beneficial interest

The term voting power includes voting power represented by holdings of voting stock, actual or constructive, but does not include voting rights held only as a director or trustee. In general, constructive ownership rules apply for purposes of determining 35 percent controlled entities (IRC §4958(f)(3)(B); Treas. Reg. §53.4958-3(b)(2)(iii)).

'Donor or Donor Advisor.' A donor or donor advisor is a disqualified person with respect to any transaction with the donor advised fund with which he is associated.

Disqualified Person at a Supporting Organization. Because the new definition of "donor advised fund"² in IRC §4966(d)(2) defines such funds as owned or controlled by a sponsoring organization, disqualified persons in sponsoring organizations, likewise, are now covered by the §4958 rules. In addition, an investment advisor to the donor advised fund owned or controlled by the supporting organization is considered a disqualified person.

For disqualified persons in a donor advised fund or supporting organization, the amount subject to the excise tax penalty differs from the amount under the standard excess benefits rules. See ¶332.5.

¶332.3 'Organization Manager'

An organization manager is a trustee, director, or officer of the applicable tax-exempt organization, as well as an individual having powers or responsibilities similar to those of trustees, directors, or officers of the organization (IRC §4958(f)(2); Treas. Reg. §53.4958-1(d)(2)(i)). Principles similar to those under the law pertaining to private foundations are to be followed in determining who is an organization manager.

Example 332.3-A

Example 332.3-B

'Knowing.' Whether the intermediate sanctions may be imposed on the organizational manager revolves around the term knowing. The regulations specify what actions constitute knowing participation:

1. Actual knowledge in and of itself
2. Awareness of the possibility that the specific transaction may violate the law governing excess benefit transactions and
3. "Negligently" failing to make reasonable attempts to find out whether, in fact, the transaction is an excess benefit transaction (Treas. Reg. §53.4958-1(d)(4))

The regulations state that knowing does not mean generally "having reason to know"; instead, the manager must have reason to know with regard to a specific fact or particular rule. The regulations provide two safe harbors:

1. Reliance on an opinion of an appropriate professional, such as legal counsel or a CPA, after full disclosure of the facts.
2. The institution meets the requirements of the rebuttable presumption (see ¶333).

Even if the institution does not meet the rebuttable presumption requirements, the organization manager still may not have acted knowingly, and the IRS must make its determination based on all the facts and circumstances.

¶332.4 'Excess Benefit Transaction'

This tax law regime has at its heart the excess benefit transaction. In the instance of one of these transactions, tax sanctions are imposed on the disqualified person or persons who improperly benefited from the transaction and perhaps on any organization managers who participated in the transaction knowing that it was improper.

For most situations, an excess benefit transaction is any transaction in which an economic benefit is provided by an applicable tax-exempt organization, directly or indirectly, to or for the use of any disqualified person, if the value of the economic benefit provided by the exempt organization exceeds the value of the consideration (including the performance of services) received for providing the benefit. (IRC §4958(c)(1)(A); Treas. Reg. §53.4958-4(a)(1)). This type of benefit is known as an excess benefit (IRC §4958(c)(1)(B)).

For tax years beginning after August 17, 2006, special rules apply to donor advised funds and sponsoring organizations (see ¶335).

The statute also allows the IRS to treat as an excess benefit circumstances where the amount of the economic benefit is determined in whole or in part by the revenues of the organization and the transaction results in impermissible private inurement (IRC §4958(c)(2)). These revenue sharing arrangements are discussed in ¶332.4.1.

¶332.4.1 The Compensation Question: Value of Benefit Exceeds Value of Consideration

Common types of transactions that fall under this "excess benefit" include the payment of personal expenses, transfers to or for the benefit of disqualified persons, and non-fair-market-value transactions benefiting these persons. An economic benefit may not be treated as consideration for the performance of services unless the organization clearly intended and made the payments as compensation for services (IRC §4958(c)(1)(A); Treas. Reg. §53.4958-4(c)(1)). In determining whether payments or transactions of this nature are in fact forms of compensation, the relevant factors include whether

1. the appropriate decision-making body approved the transfer as compensation in accordance with established procedures; and
2. the organization provided written substantiation that is contemporaneous with the transfer of the economic value at issue (Treas. Reg. §53.4958-4(c)(1)).

Automatic Excess Benefits. Benefits that do not comply with these rules are known as automatic excess benefits and are subject to the penalties even if the amounts involved are reasonable (see www.irs.gov/pub/irs-tege/eotopice04.pdf). In general, these are payments, which are described as compensation for services, but for which the organization has no supporting documentation as to the agreement with the disqualified person to perform the services. Other transactions may include payment of expenses, loans, or other transactions at below fair market value.

With the exception of nontaxable fringe benefits (IRC §132) and certain other types of nontaxable transfers (such as employer-provided health benefits and contributions to qualified pension plans), an organization is not permitted to demonstrate at the time of an IRS audit that it intended to treat economic benefits provided to a disqualified person as compensation for services merely by claiming that the benefits may be viewed as part of the disqualified person's total compensation package. Rather, the organization is required to provide substantiation that is contemporaneous with the transfer of the economic benefits at issue.

The regulations provide that contemporaneous written substantiation may be evidenced by the following:

1. The organization reports the amount on a W-2 or 1099 and reports the amount on its Form 990 (the organization also may file an amended tax return with this information as long as the IRS has not started an audit of the organization or the disqualified person).
2. The disqualified person reports the income on his/her federal income tax return (or amended return) prior to the start of an IRS audit or notice of the excess benefit transaction. Treas. Reg. §53.4958-4(c)(3).

The phraseology directly or indirectly means the provision of an economic benefit directly by the organization or indirectly by means of a controlled entity. Thus, an applicable tax-exempt organization cannot avoid involvement in an excess benefit transaction by causing a controlled entity to engage in the transaction. Neither can it confer an economic benefit indirectly on a disqualified person through an intermediary entity (Treas. Reg. §53.4958-4(a)(2)). All consideration and benefits exchanged between a disqualified person and an applicable tax-exempt organization — and all entities the organization controls — are taken into account to determine whether an excess benefit transaction has occurred.

Treas. Reg. §53.4958-4(a)(2)(iv) provides four useful examples of an indirect benefit.

Disregarded Benefits. The following economic benefits are disregarded for these purposes:

1. The payment of reasonable expenses for members of the governing body of an organization to attend board meetings
2. An economic benefit received by a disqualified person solely as a member of (if the membership fee does not exceed $75) or volunteer for the organization
3. An economic benefit provided to a disqualified person solely as a member of a charitable class (Treas. Reg. §53.4958-4(a)(4))

In addition, the intermediate sanctions rules do not apply to any fixed payment made to a person pursuant to an initial contract (Treas. Reg. §53.4958-4(a)(3)(i)). A fixed payment is an amount of money or other property specified in the contract, or determined by a fixed formula specified in the contract, which is to be paid or transferred in exchange for the provision of specified services or property (Treas. Reg. §53.4958-4(a)(3)(ii)). An initial contract is a binding written contract between an applicable tax-exempt organization and a person who was not a disqualified person immediately prior to entering into the contract (Treas. Reg. §53.4958-4(a)(3)(iii)). A compensation package can be partially sheltered by this initial contract exception; for example, an individual can have a base salary that is a fixed payment pursuant to an initial contract and also have an annual performance-based bonus, which is subject to the excess benefit transaction analysis.³

Practice Tip

In the Interim Report on the Colleges and Universities Compliance Project, which the IRS released on May 7, 2010, IRS commented on how few colleges and universities use the initial contract exception to protect compensation paid to their officers, directors, and key employees.

¶332.4.2 Revenue-Sharing Arrangements

The term excess benefit transaction includes any transaction in which the amount of any economic benefit provided to or for the use of a disqualified person is determined in whole or in part by the revenues of one or more activities of the organization, but only if the transaction results in impermissible private inurement (IRC §4958(c)(2)). In this context, the excess benefit is the amount of impermissible private inurement. This type of arrangement is known as a revenue-sharing arrangement. The tax regulations are silent on this subject, although a section in the regulations has been reserved for them (Treas. Reg. §53.4958-5). Until final regulations are published regarding revenue-sharing transactions, these transactions should be evaluated under the general rules defining excess benefit transactions (see Treas. Reg. §53.4958-4), which apply to all transactions with disqualified persons, regardless of whether the person's compensation is computed by reference to revenues of the organization (IRM 7.27.30.5).

Under the law in existence before enactment of the intermediate sanctions rules in 1996, certain revenue-sharing arrangements were determined by the IRS to not constitute private inurement (e.g., GCMs 38283, 38905, and 39674). It continues to be the case that not all revenue-sharing arrangements constitute improper private inurement. The legislative history of the intermediate sanctions rules states, however, that the Department of the Treasury and the IRS are not bound by any particular prior rulings in this area.

¶332.5 Special Rules for Donor Advised Funds and Supporting Organizations

The Pension Protection Act of 2006 added special rules that apply to excess benefit transactions with regard to donor advised funds and supporting organizations. First, for purposes of these funds and organizations, the definition of excess benefit transaction includes any loan, grant, compensation, or other similar payment from the fund or organization to the disqualified person, and in the case of supporting organizations to a substantial contributor. A substantial contributor is an individual who contributes more than $5,000, which represents more than two percent of the total contributions received by the organization for the tax year. A creator of a trust also is considered a substantial contributor. All of these types of transactions are treated as automatic excess benefit transactions, and unlike the standard excess benefit, described in ¶335, for purposes of donor advised funds/supporting organization transactions, the entire amount of the payment is treated as the excess benefit (IRC §4958(c)(3)).

As noted in ¶335, certain transactions are considered automatic excess benefit transactions, even if the amount involved is reasonable, and require contemporaneous documentation or other legal agreements. If an agent finds "automatic" excess benefit transactions, the entity will not be able to explain why the payment was legitimate compensation.

For purposes of donor advised finds and supporting organizations, any loan, grant, compensation, or similar arrangement made to a disqualified person or in the case of supporting organizations, a substantial contributor, is treated as an automatic excess benefit transaction. However payments made pursuant to a bona fide lease or sale agreement are treated under the standard rules, not the special rules.

¶333 Rebuttable Presumption of Reasonableness

This body of law includes a rebuttable presumption of reasonableness, with respect to a compensation arrangement and/or other transactions, such as property transfers or uses, between an applicable tax-exempt organization and a disqualified person (Treas. Reg. §53.4958-6). This presumption arises under the following circumstances:

1. The arrangement was approved by a board of directors or trustees (or a committee of the board) of an applicable tax-exempt organization that was composed entirely of individuals who were unrelated to, and not subject to the control of, the disqualified person or persons involved in the arrangement;
2. The board obtained and relied on appropriate data as to comparability; and
3. The board adequately documented the basis for its determination (Treas. Reg. §53.4958-6(a)).

Independent Board. The first of these criteria requires an independent board or an independent committee of the board (as opposed to a captive board). The standard as to independence, for governing bodies and committees, is based on the concept of an absence of a conflict of interest (Treas. Reg. §53.4958-6(c)(1)(iii)). An individual is not regarded as a member of a governing body or committee when it is reviewing a transaction if that individual meets with the members only to answer questions, otherwise recuses himself or herself from the meeting, and is not present during debate and voting on the transaction (Treas. Reg. §53.4958-6(c)(1)(ii)). A committee of a governing body may be composed of any individuals permitted under state law to serve on the committee and may act on behalf of the governing body to the extent permitted by state law (Treas. Reg. §53.4958-6(c)(1)(i)(B)).

A transaction approved by a committee of a governing body does not satisfy the first prong if, under the governing documents of the organization or state law, the committee's decision must be ratified by the full governing body in order to become effective.

Appropriate Data. As to the second of these criteria, appropriate data includes compensation levels paid by similarly situated organizations, both tax-exempt and taxable, for functionally comparable positions; the location of the organization, including the availability of similar specialties in the geographic area; independent compensation surveys by nationally recognized independent firms; and written offers from similar institutions competing for the services of the disqualified person. For property transfers, appropriate data includes current and independent appraisals and offers received as part of an open and competitive bidding process (Treas. Reg. §53.4958-6(c)(2)(i)).

In the case of an organization with annual gross receipts of less than $1 million, when reviewing compensation arrangements, the governing body or committee is considered to have appropriate data as to comparability if it has data on compensation paid by three comparable organizations in the same or similar communities for similar services Treas. Reg. §53.4958-6(c)(1)(ii)).

IRS has found that tax-exempt organizations often make the effort but do not obtain the type of comparability data that, in the IRS view, supports the rebuttable presumption. The regulations, in Treas. Reg. §53.4958-6(c)(2)(iv), offer five examples that are worth reviewing of what constitute appropriate comparability data. In all examples, compensation refers to the aggregate value of all benefits provided in exchange for services.

Example 333-A

Example 333-B

Example 333-C

Example 333-D

Example 333-E

In its final rule in 73 Fed. Reg. 16519, 16520 (March 28, 2008), IRS makes clear that if an organization makes a good faith effort to collect the data for purposes of meeting the requirements of the rebuttable presumption and the transaction is later found to be an "excess benefit transaction," the good faith effort will be treated as a factor weighing in favor of retaining tax exemption.

Adequate Documentation. As to the third of these criteria, adequate documentation includes an evaluation of the individual whose compensation level and terms were being established and the basis for the determination that the individual's compensation was reasonable in light of that evaluation and data. The fact that a state or local legislative or agency body may have authorized or approved a particular compensation package paid to a disqualified person is not determinative of the reasonableness of the compensation paid.

For a decision to be documented adequately, the written or electronic records of the governing body or committee must note all of the following:

1. The terms of the transaction that was approved
2. The date it was approved
3. The members of the governing body or committee who were present during debate on the transaction or arrangement that was approved and those who voted on it
4. The comparability data obtained and relied on by the governing body or committee and how it was obtained
5. The actions taken with respect to consideration of the transaction by anyone who is otherwise a member of the governing body or committee but who had a conflict of interest with respect to the transaction or arrangement (Treas. Reg. §53.4958-6(c)(3)(i))

If the governing body or committee determines that reasonable compensation for a specific arrangement or fair market value in a specific transaction is higher or lower than the range of comparable data obtained, the governing body or committee must record the basis for the determination (Treas. Reg. §53.4958-6(c)(3)(ii)).

The documentation must be made concurrently with the determination. This means that records must be prepared by the next meeting of the governing body or committee occurring after the final action or actions of the body or committee are taken. Records must be reviewed and approved by the governing body or committee as reasonable, accurate, and complete within a reasonable time thereafter.

If these three criteria are satisfied (an instance of non-qualification for this presumption is in PLR 200244028), penalty excise taxes may be imposed only if the IRS develops sufficient contrary evidence to rebut the probative value of the evidence put forth by the parties to the transaction (Treas. Reg. §53.4958-6(b)). For example, the IRS could establish that the compensation data relied upon by the parties was not for functionally comparable positions or that the disqualified person, in fact, did not substantially perform the responsibilities of the position.

A similar rebuttable presumption arises with respect to the reasonableness of the valuation of property sold or otherwise transferred (or purchased) by an organization to (or from) a disqualified person if the sale or transfer (or purchase) by an organization to (or from) a disqualified person is approved by an independent board that uses appropriate comparability data and adequately documents its determination.

In its Exempt Organizations Continuing Professional Education (CPE) Technical Instruction Program, the IRS has presented a series of articles on IRC §4958 and the rebuttable presumption.⁴ The 2002 article includes two checklists.

In its Interim Report on the Colleges and Universities Compliance Project, IRS reported that more than half of the private organizations at all size levels reported using a procedure intended to satisfy the rebuttable presumption process for at least one of the six highest paid officers, directors, trustees, or key employees (55% in the case of small; 71% in the case of medium; and 63% in the case of large organizations), but all institutions, regardless of size, relied on rebuttable presumption factors other than comparability data. The report states that the IRS considers this an area of continued focus.

¶334 Type of Transactions

For colleges and universities, the most common type of transaction that may be scrutinized for excess benefits is compensation and compensation packages; however, the IRS also has found loans and expense payments to be problematic.

The criteria for determining the reasonableness of compensation and the fair market value of property are not stated in the intermediate sanctions regulations (other than in connection with the rebuttable presumption of reasonableness (¶332.5)). Pre-existing tax law standards apply in determining reasonableness of compensation and fair market value.

¶334.1 Compensation

Payment of compensation that is not reasonable is a type of excess benefit transaction. Compensation for the performance of services is reasonable "if it is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances" (Treas. Reg. §53.4958-4(b)(1)(ii)(A)). Generally, the circumstances to be taken into consideration are those existing at the date when the contract for services was made. When reasonableness cannot be determined on that basis, the determination is made based on all facts and circumstances, up to and including circumstances as of the date of payment.⁵ The IRS may not consider "circumstances existing at the date when the contract is questioned" in making a determination of the reasonableness of compensation (Treas. Reg. §53.4958-4(b)(2)(i)).

Compensation for these purposes means all items of compensation provided by an applicable tax-exempt organization in exchange for the performance of services. This includes the following:

1. Forms of cash and noncash compensation, such as salary, fees, bonuses, and severance payments
2. Forms of deferred compensation that are earned and vested, whether or not funded and whether or not the plan is a qualified one
3. The amount of premiums paid for insurance coverage (including liability), as well as payment or reimbursement by the organization of charges, expenses, fees, or taxes not ultimately covered by the insurance coverage
4. Other benefits, whether or not included in income for tax purposes, including payments to welfare benefit plans on behalf of the persons being compensated, such as plans providing medical, dental, life insurance, severance pay, and disability benefits, and taxable and nontaxable fringe benefits, including expense allowances or reimbursements or foregone interest on loans that the recipient must report as income for tax purposes.
   Treas. Reg. §53.4958-4(b)(1)(ii)(B)

For colleges and universities, executive compensation is one focal point of the Colleges and Universities Compliance Project. In particular, the IRS is examining the use of comparability data and compensation practices and procedures to establish compensation of executives and other highly paid individuals; the impact the initial contract exception might have on the setting of compensation; and the use of the rebuttable presumption procedure.

¶334.1.1 Executive Compensation Compliance Initiative

Before the IRS launched its Colleges and Universities Compliance Project, it launched an Executive Compensation Initiative, which was intended to halt abuses by tax-exempt organizations that pay excessive compensation and benefits to their officers and other insiders. The TE/GE division reviewed the old Form 990, including how organizations answered the question about excess benefit transactions and other compensation information.⁶ In March 2007, the IRS released the findings from the first two phases of its project.⁷

In these phases, the IRS did not find widespread abuse of executive compensation paid to insiders or disqualified persons. In fact, it found that where there was high compensation, the public charities often used the rebuttable presumption to support the compensation; 54 percent of organizations commissioned comparability studies, with 97 percent of the studies looking both to similar type and sized organizations; 97 percent of organizations commissioning comparability studies set compensation within the range of the obtained comparability data.

Of more concern were the reporting errors on Form 990. Significant reporting errors and omissions were found when it came to compensation paid to officers or other employees. For example, out of 50 public charities reporting compensation over $250,000, none initially filed schedules detailing the compensation paid to officers or employees, but upon receipt of the IRS compliance check letter, 41 filed acceptable amended returns.

The problems that IRS did find fell into the following areas:

• Excessive salary and incentive compensation
• Loans
• Payments for vacation homes, personal legal fees, or personal automobiles that were not reported as compensation
• Payments for personal meals and gifts to others on behalf of disqualified persons that were not reported as compensation
• Payments to an officer's for-profit corporation in excess of the value of services provided by the corporation

From these two phases of the initiative, 25 of the organization examinations resulted in proposed or assessed 4958 excise taxes aggregating in excess of $21 million against 40 disqualified persons or organization managers — small numbers but large dollars.

¶334.2 Loans

Loans were a larger issue than the salaries in the IRS executive compensation study. Fifty-three percent of those loans were made with terms more favorable than commercial loans, and 31 percent were not repaid in accord with the stated terms. Either of these circumstances may constitute an excess benefit.

In the case of loans to a donor or donor advisor with respect to donor advised funds or substantial contributors in the case of supporting organizations, these are treated as automatic excess benefit transactions, regardless of reasonableness and compliance with the terms of the agreement. The same automatic excess benefit rules apply to grants, compensation, expense reimbursements, and similar payments to these disqualified persons.

IRS made clear that its selection of organizations for compliance checks and examinations was not statistically valid and could not be used to project compliance or noncompliance onto the entire tax-exempt sector. However, based on the information it gathered in Phase II of the project, it will undertake a third phase of examination to examine loans.

¶334.3 Other Excess Benefit Transactions

Excess benefit transactions also may include rental arrangements, borrowing arrangements, sales of assets, and other transactions between an applicable tax-exempt organization and a disqualified person. A court held that the transfers of assets by public charities to disqualified persons, where the value of the assets "far exceeded" the consideration paid for them, were excess benefit transactions.

¶335 Scope of Proscription and Tax Penalties

Intermediate sanctions penalties may be imposed by the IRS in lieu of or in addition to revocation of an organization's tax-exempt status. In general, intermediate sanctions are to be the sole sanction imposed in those cases in which the excess benefit does not rise to such a level as to call into question whether, on the whole, the organization functions as a charitable or social welfare organization.⁸

In practice, the revocation of tax-exempt status, with or without the imposition of these excise taxes, is to occur only when the organization no longer operates as a charitable or social welfare organization, as the case may be. Pre-existing law principles apply in determining whether an organization no longer operates as an exempt organization. For example, in the case of a charitable organization, the loss of tax-exempt status would occur in a year, or as of a year, the entity was involved in a transaction constituting a substantial amount of private inurement.

As under pre-existing law, a three-year statute of limitations applies, except in the case of fraud (IRC §6501; Treas. Reg. §53.4958-1(e)(3)).

The IRS has the authority to abate an intermediate sanctions excise tax penalty if it is established that the violation was due to reasonable cause and not due to willful neglect, and the transaction at issue was corrected within the appropriate taxable period (IRC §4962; Treas. Reg. §53.4958-1(c)(2)(iii)).

A disqualified person who benefited from an excess benefit transaction is subject to and must pay an initial excise tax equal to 25 percent of the amount of the excess benefit (IRC §4958(a)(1); Treas. Reg. §53.4958-1(a), (c)(1)). For standard excess benefit transactions, the excess benefit is the amount by which a transaction differs from fair market value, the amount of compensation exceeding reasonable compensation, or the amount of impermissible private inurement resulting from a transaction based on the organization's gross or net income. For donor advised funds and supporting organizations, however, the excess benefit is the full amount of the payment.

An organization manager who participated in an excess benefit transaction, knowing, as the term is defined in the statute (see ¶332.3), that it was such a transaction, is subject to and must pay an initial excise tax of 10 percent of the excess benefit (subject to a maximum amount of tax as to a transaction of $10,000 through August 17, 2006, when it increased to $20,000 for tax years beginning after that date), where an initial tax is imposed on a disqualified person and there was no correction of the excess transaction within the taxable period (IRC §4958(a)(2); Treas. Reg. §53.4958-1(d)(1)). This tax is not imposed, however, where the participation in the transaction was not willful and was due to reasonable cause.⁹ If more than one organization manager or other disqualified person is liable for an excise tax, then all of these persons are jointly and severally liable for the tax (IRC §4958(d)(1); Treas. Reg. §53.4958-1(c)(1), (d)(8)).

An additional excise tax may be imposed on a disqualified person where the initial tax was imposed and if there was no correction of the excess benefit transaction within a specified period. This period is the taxable period, which means — with respect to an excess benefit transaction — the period beginning with the date on which the transaction occurred and ending on the earliest of the following:

1. The date of mailing of a notice of deficiency with respect to the initial tax or
2. The date on which the initial tax is assessed
   (IRC §4958(f)(5); Treas. Reg. §53.4958-1(c)(2)(ii)).

In this situation, the disqualified person is subject to and must pay a tax equal to 200 percent of the excess benefit involved (IRC §4958(b); Treas. Reg. §53.4958-1(c)(2)(i)).

¶335.1 'Correction'

The term correction means undoing the excess benefit transaction to the extent possible and taking any additional measures necessary to place the applicable tax-exempt organization in a financial position that is not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards (IRC §4958(f)(6); Treas. Reg. §53.4958-7). The correction amount with respect to an excess benefit transaction is the sum of the excess benefit and interest (at a rate that at least equals the applicable federal rate, compounded annually) on that benefit; generally, the correction must be made using cash or cash equivalents (Treas. Reg. §53.4958-7(c)).

Note that any correction under the donor advised fund/supporting organization rules may not be held in a donor advised fund (IRC §4958(f)(6)).

¶336 Reimbursements and Insurance

Any reimbursements by an applicable tax-exempt organization of excise tax liability are treated as an excess benefit unless they are included in the disqualified person's compensation during the year in which the reimbursement is made. (This rule is consistent with that noted above, which is that payments of personal expenses and other benefits to or for the benefit of disqualified persons are treated as compensation only if it is clear that the organization intended and made the payments as compensation for services.) The total compensation package, including the amount of any reimbursement, is subject to the requirement of reasonableness. Similarly, the payment by an applicable tax-exempt organization of premiums for an insurance policy providing liability insurance to a disqualified person for excess benefit taxes is an excess benefit transaction unless the premiums are treated as part of the compensation paid to the disqualified person and the total compensation (including premiums) is reasonable.

¶337 Returns for Payment of Excise Taxes

Under the law in existence prior to enactment of the excess benefit transactions rules, charitable organizations and other persons liable for certain excise taxes must file returns by which the taxes due are calculated and reported. These taxes are those imposed on public charities for excessive lobbying expenditures (IRC §§4911, 4912) and for political campaign expenditures (IRC §4955), and on private foundations and/or other persons for a wide range of impermissible activities
(IRC §§4940-4948). The return is IRS Form 4720.

Disqualified persons and organization managers liable for payment of an intermediate sanctions excise tax as the result of an excess benefit transaction are required to pay the taxes by filing Form 4720 (Treas. Reg. §53.6011-1(b)). In general, returns on Form 4720 for a disqualified person or organization manager liable for an excess benefit transaction tax are required to be filed on or before the 15th day of the fifth month following the close of that person's tax year (see instructions) (Treas. Reg. §53.6071-1(f)(1)).

¶338 Effective Dates

Except for donor advised funds and supporting organizations, the intermediate sanctions penalties generally are effective with respect to excess benefit transactions occurring on or after September 14, 1995. The sanctions do not apply to any benefits arising out of a transaction pursuant to a written contract that was binding on that date and continued in force through the time of the transaction and the terms of which have not materially changed.

Penalties applicable to donor advised funds and supporting organizations are effective for tax years beginning after August 17, 2006.

¶339 Excess Benefits Issues in Higher Education

The issues in the higher education context are essentially the same as those in the private inurement context (see ¶317); that is, transactions with disqualified persons, such as compensation, expense reimbursement, loans, rental arrangements, and asset sales, need to be tested against the standard of reasonableness.

With enactment of the Pension Protection Act, colleges and universities need to review the management of their donor advised funds to avoid the automatic excess benefit transactions that arise with the receipt of loans, grants, and similar payments by the donor and donor advisor. Likewise supporting organizations should ensure they are familiar with the new rules, including the new reporting requirements.

The revised Form 990 includes numerous questions on compensation and other areas that can give rise to excess benefit transactions. Review Part VII of the core form and Schedule J. In addition, Appendix G to the form provides a summary of excess benefit transactions.

Colleges and universities should strive to meet the rebuttable presumption of reasonableness (¶333). Even if the terms of the presumption cannot be satisfied, colleges and universities should create and maintain the type of documentation specified by the presumption. The rebuttable presumption checklists will be useful.

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¹ IRC §4958 (f)(1)(D)-(F), added by Secs. 1232 and 1242, Pension Protection Act of 2006, Pub. L. 109-280 (Aug. 17, 2006). [back to text]

² For a full discussion of donor advised funds, see ¶1763. [back to text]

³ See PLR 200601030 (Oct. 12, 2005) for a discussion of bonuses (approves long-term bonus program for senior management who are not executive officers). [back to text]

⁴ Exempt Organizations Continuing Professional Education (CPE) Technical Instruction Program: FY 2002, Brauer, Tyson, Henzke and Kawecki, "An Introduction to I.R.C. 4958 (Intermediate Sanctions)"; FY 2003 Brauer and Henzke, "Intermediate Sanctions (IRC 4958) Update." [back to text]

⁵ Two common methods of making a reasonable compensation determination are the independent-investor test and the multifactor test. While these cases involve the for-profit world, the Tax Court has said that the same factors apply to the nonprofit world to determine reasonableness of compensation. See B.H.W. Anesthesia Foundation v. Commissioner, 72 T.C. 681, 686 (1979). For a recent case on the independent investor test, see Miller & Sons Drywall, Inc. v. Commissioner, T.C. Memo. 2005-114; see also Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999). The circuits tend to apply different variations of the multifactor test. See, e.g., Mayson Mfg. Co. v. Commissioner, 178 F.2d 115 (6th Cir. 1949), and E.J. Harrison and Sons, Inc. v. Commissioner, T.C. Memo. 2003-239 for a discussion of the 9th Circuit's multi-factor test. [back to text]

⁶ IR-2004-106, Aug. 10, 2004. [back to text]

⁷ See Report on Exempt Organizations Executive Compensation Compliance Project—Parts I and II, March 2007; www.irs.gov/pub/irs-tege/exec._comp._final.pdf. [back to text]

⁸ For example, with regard to donor advised funds, donors, donor advisors, and fund management are subject to an excise tax of 125 percent of the benefit, unless excess benefit transaction penalties have been imposed. IRC §4967, added by the section 1231(a) of the Pension Protection Act. [back to text]

⁹ The Internal Revenue Manual provides examples of "reasonable cause" and non-willful neglect. See IRM 7.27.30.9.3. [back to text]