Steering Clear of IRS "Intermediate Sanctions" Violations

In 1996 Congress made important changes to federal policies governing tax-exempt organizations by enacting section 4958 of the Internal Revenue Code – commonly known as the "intermediate sanctions" law. The law allows the IRS to impose sanctions on certain persons who receive or approve excessive economic benefits from tax-exempt charities and social welfare organizations – including many hospitals, tax-exempt health clinics, educational institutions, charities and other organizations. Section 4958 provides a remedy short of revoking an organization’s tax-exempt status by allowing the IRS to impose penalty excise taxes on the individuals who are involved in such transactions.

Final regulations implementing the intermediate sanctions law were published in January 2002. This article builds on the rules’ requirements and more recent developments to provide a roadmap to compliance with this important law.

Excess Benefits Transactions

The intermediate sanctions law imposes taxes on persons who are influential to tax-exempt enterprises and who either benefit from, or approve transactions that are not consistent with fair market value ("FMV"). Specifically, section 4958 provides for the imposition of personal excise taxes on "disqualified persons" ("DPs") who benefit from "excess benefit transactions." Taxes may also be imposed on the "organization managers" ("Managers") who approve those transactions under certain circumstances.

An excess benefit transaction occurs when an exempt organization provides an economic benefit to a DP and receives less than the value of the benefit in return. Transactions that are reasonable and consistent with FMV will not constitute excess benefit transactions. The most common form of excess benefit transaction involves unreasonable compensation for services, but excess benefit transactions can also involve exchanges of property such as rent or loan arrangements between an exempt organization and a DP that contain terms that are inconsistent with FMV. Excess benefit transactions can result from direct or indirect dealings between a tax-exempt organization and a DP, including through intermediary entities such as an exempt organization’s taxable subsidiary.

Disqualified persons who receive excess benefits are subject to two penalty excise taxes. First, the DP must pay a tax equal to 25 percent of the amount in excess of FMV. Second, if the transaction isn’t "corrected" – generally meaning "undoing" the transaction by repaying the amount of the excess benefit plus interest before the IRS mails a deficiency notice -- an additional penalty of 200 percent of the excess benefit is assessed.

Managers who knowingly approve an excess benefit transaction are also subject to an excise tax unless their participation in the transaction was not "willful" and was due to "reasonable cause." Managers are subject to a tax equal to 10 percent of the value of the excess benefit, not to exceed $10,000 per transaction.

Steering to Comply with the Intermediate Sanctions Rules

What should individuals who are affiliated with tax-exempt organizations do to steer clear of potential intermediate sanctions violations? A pragmatic approach to compliance is as easy as 1-2-3.

Step 1 - - Know Where You Sit When it comes to intermediate sanctions compliance, understanding where you sit in the eyes of the law is a good place to start. Some individuals will understand that they are automatically classified as a "disqualified person," and/or "organization manager" by virtue of their position in the tax-exempt enterprise. The rules will be less clear with respect to others, although even here a good understanding will help promote compliance.

A disqualified person or "DP" is a person who is in a position to exercise "substantial influence" over the tax-exempt organization during a 5-year "look back" period before the date of an excess benefit transaction. DPs also include the family members of DPs and entities which are controlled by such persons.

"Deemed" DPs: Certain persons are automatically "deemed" to have substantial influence over the exempt organization, including: voting members of the governing body, persons holding a position comparable to that of president, CEO, COO, CFO or treasurer, as well as any person with a material financial interest in a provider-sponsored organization that includes a tax-exempt hospital.

The law defines Managers to consist of the exempt organization’s directors, officers, trustees and persons who have similar roles, plus members of certain "authorized bodies" (discussed under Step 3 below). These Managers will also be classified as DPs so they face potential double exposure with respect to any benefit they personally receive from the organization, and as Managers for their role in approving excess benefit transactions. Generally, employees of an exempt organization who are not "highly compensated" and certain other tax-exempt organizations who are not in a position to exercise substantial influence over the organization, are not considered DPs.

Other DPs: For persons not falling into one of the categories referenced above, a "facts and circumstances" test is used to determine whether the person has substantial influence over the exempt enterprise. Factors that tend to suggest substantial influence over the affairs of the exempt organization include the fact that the person is the organization’s founder or a substantial contributor. Other factors that suggest substantial influence include:

• the person’s compensation is primarily based on activities of the organization that the person controls;
  
• the person has or shares substantial budgetary authority, i.e., authority to determine a substantial portion of the organization’s capital expenditures, operating budget, or employee compensation;
  
• the person has substantial management authority, i.e., the person manages a discrete segment of the organization that is a substantial portion of the activities, assets, income, or expenses of the organization as a whole;
  
• the person owns a controlling interest in an entity that is itself a DP; or
  
• the person is a nonprofit organization controlled by one or more DPs.

These facts, either individually or in combination, will contribute to a classification as a DP under the facts and circumstances test. On the other hand, certain persons will generally not be classified as DPs: individuals who are professional advisors to the organization (i.e., an accountant, attorney or financial advisor) under contract for the purpose of providing professional advice, persons whose direct supervisor is not a DP, and individuals who do not participate in management decisions affecting all or a substantial subset of the organization. While these factors mitigate against finding a person a DP, the IRS could still find other facts and circumstances that lead to DP status.

Since "deemed" DPs comprise only a small subset of potential DPs, ambiguity is likely regarding whether a particular individual will be classified as a DP under the facts and circumstances test. Objective consideration of a person’s actual and perceived power and influence within the exempt organization can provide useful insight into this issue. Department heads, "big producers" (i.e., fund raisers, referral sources) and individuals who are viewed as leaders in an important department, division or subset of the organization are more likely to be considered DPs. Thus, physicians who are one of a handful in a hospital department that produces substantial revenues in support of an organization’s bottom-line (i.e., cardiology, gastroenterology, surgery, etc.) are probably more likely to be viewed as DPs than some others. Moreover, the individual physicians who lead the influential department are even more likely to be DPs.

Who Are You?: Assessing and understanding where you sit in the eyes of the intermediate sanctions law is an essential place to start on the road to compliance. If you occupy a position of leadership or authority within the organization such that you make, either independently or with others, decisions of a managerial or financial nature that impact the organization as a whole, then it may make sense to assume you are a DP, and in some cases, a Manager for purposes of the law. Likewise, its reasonable to assume you’re a DP if your compensation is reported on the organization’s Form 990, if you receive high levels of compensation as compared with your peers, and if you hold the title and/or authority over key portions of the organization.

Step 2 - - Know the Deal The intermediate sanctions law doesn’t prohibit all dealings between tax-exempt organizations and DPs; only transactions that are not reasonable or are inconsistent with FMV. For that reason, understanding the precise terms of a proposed transaction is essential to promoting compliance. For compensation arrangements, the law defines compensation to encompass all forms of cash and noncash compensation, including salaries, fees, deferred compensation, bonuses, severance payments, fringe benefits (other than de minimis fringe benefits), insurance premiums, retirement plan contributions, and most other employee benefits, whether or not they are taxable, that a DP receives from the exempt organization.

What is Fair?: Standards that have historically been used under section 162 of the Internal Revenue Code to determine reasonableness of compensation are applicable, and the presence of a cap on total compensation will serve as a relevant (positive) factor in determining reasonableness. For exchanges involving property, the IRS applies the same FMV standard that it uses in other contexts—fair market value is the price at which an exchange would occur between willing buyer and willing seller, where neither is under any compulsion to buy, sell or transfer, and both have knowledge of relevant facts.

For the DP and Managers involved in any transaction, an essential stop on the journey to compliance is to understand the specific details of the particular transaction so that those details can be evaluated objectively. Given who can be subject to potential excise tax penalties under the intermediate sanctions law, everyone involved in the transaction – including the intended beneficiary – should step back and seriously question whether the deal is "reasonable" or whether it may be "too good to be true."

Step 3 - - Demand and Abide by the Process Under the intermediate sanctions law, compensation payments and other transactions will benefit from a "rebuttable presumption" that the transaction terms are reasonable and consistent with FMV if:

• the transaction is approved in advance by an "authorized body" with no conflict of interest in the transaction such as a board, committee or other party authorized under state law to approve transaction on the exempt organization’s behalf;
  
• the authorized body obtained and relied upon "appropriate data as to comparability" prior to making its decision; and
  
• the authorized body adequately documented the basis for its decision concurrent with the determination.

Once the rebuttable presumption is established, the IRS can only show that the transaction is not reasonable or is inconsistent with FMV by demonstrating that the comparability data was unreliable or improper. Therefore, abiding by the process to establish the rebuttable presumption can be of substantial benefit to both Managers and DPs.

Getting the Presumption: Independence, comparable data and contemporaneous documentation are essential requirements to obtaining the rebuttable presumption.

• Independence means that members of an authorized body who approve the transaction must not have a conflict of interest or financial interest in the transaction being discussed, and persons who do have a conflict of interest must not participate in the process, nor may they be present during debate or voting.
  
  
• The authorized body must review appropriate data as to comparability in their decisions. Importantly, recent court decisions confirm that the data must be closely comparable to the exact type of transaction or arrangement, and take the specific features of the deal into account. For compensation deals, acceptable comparability data includes data regarding compensation paid by other similar organizations (both tax-exempt and for profit) for comparable positions, independent compensation surveys, independent appraisals, and actual written offers from similar institutions that are competing for a DP’s services. If the authorized body determines that reasonable compensation is higher or lower than the range of comparable data obtained, the authorized body must document the basis for its decision.
  
  
• Contemporaneous documentation requires that records of the authorized body specify the terms of the compensation arrangement or transaction that was approved and the date of approval. The records must also show who was present during the debate and who voted on it, what comparability data was used, how that data was obtained, and what actions the authorized body took with respect to persons who had a conflict of interest with respect to the transaction. The decision must be documented contemporaneously -- no later than the next meeting of the authorized body or 60 days after final action is taken, and the documentation itself must be reviewed and approved by the authorized body as reasonable, accurate and complete within a reasonable time after it is prepared.

The Value of the Presumption: In practical terms, establishing the rebuttable presumption is important to both the Managers who approve a transaction, and the DPs who benefit from a transaction. Under the intermediate sanction rules so long as a Manager’s participation in an excess benefit transaction is not willful and was due to reasonable cause, the Managers will benefit from the presumption of reasonableness even if they are ultimately deemed to be wrong in an enforcement context. This means that the Managers can effectively eliminate their own potential liability in their capacity as organizational managers by establishing the rebuttable presumption.

But DPs can also garner benefits from the process used to establish the rebuttable presumption. Under section 4962 the IRS has the ability to "abate" the 25% penalty plus interest for excess benefit transactions under certain circumstances. To benefit from the potential abatement, the excess benefit transaction must be corrected in a timely manner within a defined correction period, and the transaction must be due to "reasonable cause" and not be due to "willful neglect." As a general matter, a DP will have "reasonable cause" when he/she exercises ordinary business care and prudence, and the DP will not demonstrate "willful neglect" so long as the excess benefit was not due to the DPs conscious, intentional or voluntary failure to comply with section 4958.

The IRS and courts are sticklers for precision in the abatement context (and abatement is never guaranteed.) Nevertheless, in practical terms the presence of a valid, independent assessment of reasonableness can be of benefit to DPs by providing an essential foundation for the abatement of an excess benefit tax. Thus, the use of a well-followed process to assess, support and where appropriate, adjust compensation levels to promote reasonableness may serve as an important insurance policy for DPs and Managers alike.

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The intermediate sanctions law provides a new vehicle to hold key insiders and decision-makers in tax-exempt organizations personally responsible for their actions. And while the law has a punitive orientation, by specifying a process that can be followed to obtain a presumption of reasonableness, Congress demonstrated that it was as concerned with preventing inappropriate transactions as penalizing those that are identified after the fact. The law’s emphasis on enhanced individual accountability coupled with a defined process to obtain a presumption of reasonableness, provides the incentive, tools and roadmap for steering clear of intermediate sanctions violations.