Intermediate Sanctions and Exempt Organizations
Increased IRS Scrutiny of Excess-Benefit Transactions

By Terry W. Knoepfle and Karen A. Froelich

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JUNE 2006 - The IRS has stepped up its scrutiny of compensation packages and employee benefits in tax-exempt organizations and is using IRC section 4958 to sanction “disqualified persons” and organizational managers, rather than the organizations, for excess-benefit transactions. In 2002, the IRS issued final regulations that attempted to clarify ambiguous provisions in the temporary regulations related to intermediate sanctions. In addition, Tax Court rulings, IRS technical advice memoranda (TAM), and private letter rulings (PLR) address recurring issues related to intermediate sanctions. This article outlines how IRC section 4958 works, describes the potential pitfalls for exempt organizations, and discusses recent developments.

Tax-exempt organizations must recognize the dangers that may arise from excess-benefit transactions and the increased regulatory scrutiny. When Congress passed the Taxpayer Bill of Rights 2 on January 30, 1996, it significantly changed the laws governing exempt organizations by adding section 4958 to the IRC. Before the inclusion of IRC section 4958, the IRS could, as a sanction, only revoke the organization’s exempt status if it determined that a private person had benefited from an improper transaction with an exempt organization, as a sanction. Pursuant to section 4958, the IRS can now impose “intermediate sanctions” that, instead of penalizing the exempt organization, penalize the person who benefited from the improper transaction. In addition, just as managers of for-profit organizations can be subject to penalties under the Sarbanes-Oxley Act, the IRS can punish managers of exempt organizations who approved an excess-benefit transaction.

The IRS asserts that “the purpose of IRC 4958 is to impose sanctions on the influential persons in charities and social welfare organizations who receive excessive economic benefits from the organization, rather than to punish the exempt organization itself” [Lawrence M. Brauer and Leonard J. Henzke, Intermediate Sanctions (IRC 4958) Update, Internal Revenue Service Exempt Organizations Technical Instruction Program for FY2003]. Final regulations for section 4958 became effective on January 23, 2002.

The IRS intends to aggressively enforce section 4958 and the related regulations. In August 2004, it announced an initiative to identify and stop abuses by tax-exempt organizations that pay excessive compensation and benefits to their insiders and officers (IRS News Release IR-2004-106). As part of this initiative, the IRS sent more than 2,000 letters to check compliance and more than 8,000 letters to educate organizations and individuals about compliance issues. The letters, which include questions designed to gather extensive information regarding direct and indirect compensation to disqualified persons, suggest the types of benefits which may prompt IRS action and which an organization should avoid or acknowledge as compensation. If an entity does not respond or identifies questionable activities, the IRS may initiate an examination [written statement of IRS Commissioner Mark W. Everson, “Exempt Organizations: Enforcement Problems, Accomplishments, and Future Direction,” before the Committee on Finance, 109th Congress (April 5, 2005)]. Commissioner Everson noted that 500 of the contacts had been reviewed and that the IRS was “seeing issues” in the reporting of loans, deferred compensation, and other perks.

An organization that receives a compliance letter must be certain that its responses are consistent with other IRS documentation it provides, such as Forms 90, W-2, and 1099. Because the IRS may consider any benefits that were not previously reported as compensation to be automatic excess benefits, even if the total compensation was reasonable, nonprofits that have not yet been notified should prepare for possible receipt of a compliance letter by reviewing their compensation and identifying all types of benefits offered. If the organization identifies possible unreported direct and indirect compensation or benefits, it should amend any filings that did not disclose them.

In a speech to the National Press Club on March 15, 2005, Commissioner Everson emphasized that noncompliance by nonprofit entities is one of the IRS’s four enforcement priorities and that it is increasing its resources and audit personnel in the nonprofit area. The IRS has created an Inurement and Intermediate Sanctions Coordinating Committee for the implementation of section 4958. Although committee members are available to the public to provide informal advice on section 4958 questions, the risk of intermediate sanctions remains a great concern for nonprofits and insiders.

Covered Organizations and Persons

Section 4958 applies to all organizations exempt under IRC sections 501(c)(3) (other than private foundations) and 501(c)(4). Pursuant to section 4958, the IRS may impose intermediate sanctions on any “disqualified person” who receives an excess benefit from an exempt organization, and any “organization manager” who approves the excess-benefit transaction. Payment of excessive compensation to an insider may also result in excise taxes under IRC section 4941, which addresses self-dealing acts, or IRC section 4945, which regulates excise taxes on taxable expenditures.

IRC section 4958(f)(1) and Treasury Regulations section 53.4958-3(a)(1) define “disqualified person” as anyone in a position to exercise substantial influence over the organization’s affairs at any time during the five-year period preceding the date of the excess-benefit transaction. The regulations also include a lengthy list of individuals and entities that are automatically defined as disqualified persons, including family members, board members, and executive officers. Treasury Regulations section 53.4958-3 contains additional specific information regarding which persons and entities are disqualified persons. Treasury Regulations section 53.4958-3(d) excludes from the definition of disqualified persons: 501(c)(3) organizations; certain 501(c)(4) organizations, including other organizations described in 501(c)(4); and employees who do not fall within one of the listed categories, provided they are not considered highly compensated employees or substantial contributors to the exempt organization. Treasury Regulations section 53.4958-3(e)(2) determines whether any other person is a disqualified person based on relevant facts and circumstances, including whether the person founded the organization or is a substantial contributor; how the organization compensates the person; and the authority the person exercises over the organization’s affairs.

Conversely, according to Treasury Regulations section 53.4958-3(e)(3), the following facts and circumstances tend to show that a person is not a disqualified person:

  • For religious organizations, the person has taken a vow of poverty;
  • The person is a contractor whose sole relationship is providing professional advice regarding transactions that will not benefit the contractor;
  • The person’s direct supervisor is not a disqualified person;
  • The person does not participate in significant management decisions; and
  • The person’s preferential treatment is also offered to other donors making comparable donations as part of a solicitation intended to attract a large number of contributions.

According to Treasury Regulations section 53.4958-1(d), an organization manager (e.g., officer, director, trustee, or member of a board committee) who knowingly participates in an excess-benefit transaction is also liable for penalties unless the manager is able to establish that her participation was not willful and was based on reasonable cause. “Participation” in a transaction also includes a manager’s silence or inaction when she has a duty to speak or act. “Knowing participation” is defined as actual knowledge that the transaction is an excess-benefit transaction, awareness that the transaction may violate the law, and negligent failure to make a reasonable attempt to determine whether the transaction is an excess-benefit transaction. A manager who relies on a written opinion of an appropriate professional is generally not deemed to be “knowing.”

Excess-Benefit Transaction Defined

Given the breadth of the statute and the regulations, the IRS can argue that most transactions involving an insider are excess-benefit transactions. According to a continuing professional education program by Lawrence M. Brauer and Leonard J. Henzke, Jr. (“Automatic Excess Benefit Transactions Under IRC 4958,” Planned Giving Design Center, LLC, and Tax Analysts, Inc., December 20, 2003), although the IRS’s focus generally seems to be on transactions involving compensation of officers and directors and payments to key vendors, the IRS will look at all agreements, including contracts for employment, deferred compensation, bonuses, fringe benefits, retirement, severance, and purchases, in addition to all loans, expense reimbursements, and other payments. A federal court has even found that the reversion of improvements made by a tax-exempt organization is a “transaction” under an installment contract for the purposes of determining whether an excess benefit has occurred. [See Dzina v. United States, 345 F. Supp. 2d 818 (N.D. Ohio 2004). The taxpayer was held liable for taxes for excess benefits in connection with his repossession and resale of commercial property following a tax-exempt organization’s default on an installment contract for the sale of the property, which had been improved during the contract term.]

According to Treasury Regulations section 53.4958-4(a), an excess-benefit transaction generally includes any situation in which a disqualified person receives an economic benefit from an exempt organization that exceeds the value of the benefit provided. Thus, a public charity must not provide to its leadership more than reasonable compensation, as measured against the amount that comparable organizations would pay for comparable services in comparable situations (see IRS News Release IR-2004-81, June 22, 2004). According to Treasury Regulations section 53.4958-4(a)(1), in making this determination the IRS will review all direct and indirect consideration and benefits exchanged between the disqualified person and the organization and all entities controlled by the organization. Certain listed benefits and expense reimbursements [Treasury Regulations section 53.4958-4(a)(4)] are not considered in determining whether compensation is excessive. As the previously cited CPE program by Brauer and Henzke noted and discussed in more detail below, other economic benefits received by a disqualified person must be treated as “automatic” excess-benefit transactions under section 4958.

IRS rulings illustrate an emphasis on the specific facts when determining which transactions are excess-benefit transactions. For example, in Private Letter Ruling 200421010 (May 21, 2004), the IRS found that allocated joint use of office space, common employee services, and common office equipment and supplies did not constitute an excess-benefit treatment where the contractual arrangement among a charitable trust, a nonprofit charitable corporation, and two disqualified persons reflected fair market value.

In Private Letter Ruling 200332018 (May 13, 2003), the IRS declined to rule whether a scholarship awarded to a relative of a director, officer, or nominating committee member of a community foundation, pursuant to the scholarship program’s guidelines, constituted an excess-benefit transaction, stating that such a determination is generally a factual determination. The IRS noted, however, that Treasury Regulations section 53.4958-4(a)(4)(v) includes the exception that an economic benefit is disregarded under section 4958 if it is provided to a person solely because he is a member of the class the charity intends to benefit, and concluded that the scholarships in question fell under this exemption. The IRS also noted that the nominating committee members and their relatives were not disqualified in any event if the organization followed the recusal procedures set forth in its standard procedures.

Similarly, in Private Letter Ruling 200335037 (August 29, 2003), the IRS found that a section 501(c)(3) organization did not engage in an excess-benefit transaction by making grants that also benefited the bank’s obligations under the Community Reinvestment Act of 1977. On the other hand, IRS Technical Advice Memorandum 200435022 (May 5, 2004) noted that reimbursements of expenses to an employee or an employee’s family members may be treated as automatic excess benefits to the extent they do not satisfy the requirements of Treasury Regulations section 1.62-2 and the requirements for substantiation as compensation pursuant to section 53.4958-4(c)(3).

Loans are a problem area that may receive close scrutiny from the IRS. If an organization makes a loan to a disqualified person, the IRS examines whether the amount received was a true loan or simply a payment in disguise. The IRS considers a number of factors, including whether there is written documentation (e.g., a promissory note), whether security or collateral has been given, whether interest is being charged, and whether the note has a fixed maturity date. As discussed by Fred Stokeld (“EO Conference Focuses on Charity Abuses, Section 4958 Issues,” The Exempt Organization Tax Review, January 2004), the IRS also examines whether the borrower had the ability to repay the loan at the time it was made, whether the organization maintained loan records, and how the loan payments were reported for federal tax purposes.

If the IRS decides that the payment was not a loan, then the payment will automatically be considered an excess benefit. If the transaction appears to be a genuine loan, the IRS examines whether the loan is a below-market-interest loan. The benefit of any below-market loan, if substantiated as compensation, must be added to the disqualified person’s other compensation to determine if the total exceeds reasonable compensation levels, and if it constitutes an excess benefit under section 4958. Similar problems arise in determining whether an organization’s guaranty of a disqualified person’s loan is an excess benefit.

Third-party appraisals or market reports may establish the reasonableness of a property transfer. As discussed in H.R. No. 506 [104th Congress, 2d Session (1996)] and, regarding difficulties in establishing comparability, by Consuelo L. Kertz in “New Sanctions Aimed at Non-Compliant Tax-Exempt Groups” (Taxation for Accountants, November 1996), organizations may show the reasonableness of compensation by showing similar compensation levels to individuals for functionally comparable positions within similarly situated exempt or nonexempt organizations engaged in similar activities. Other factors that help determine reasonableness include location, the availability of similar specialists in the region, other offers the person received, independent compensation surveys by nationally recognized firms, and other recorded data specifically about that person.

Penalties for Excess-Benefit Transactions

The penalties for an individual involved in an excess-benefit transaction can be severe. IRC section 4958 empowers the IRS to require correction and impose significant sanctions for excess-benefit transactions. The IRS attempts to correct the excess-benefit transaction and place the exempt organization in a financial position similar to that which it would have been in “if the disqualified person were dealing under the highest fiduciary standards,” as stated in Treasury Regulations section 53.4958-7(a) [IRS Manual, March 15, 2005]. A disqualified person may correct the excess benefit by making a payment in cash or cash equivalents equal to the correction amount plus interest [Treasury Regulations section 53.4958-7(a); IRS Manual, March 15, 2005].

As stated in Treasury Regulations section 53.4958-7(b)(4), if the excess benefit involved the transfer of specific property, then the disqualified person may return the property, if the exempt organization agrees. If a payment made by returning property is less than the correction amount, then the disqualified person must make a cash payment to the organization equal to the difference; if a payment made by returning property is greater than the correction amount, then the organization may make a cash payment to the disqualified person equal to the difference [IRS Manual, March 15, 2005]. If the exempt organization no longer exists, the disqualified person must still correct the excess-benefit transaction by paying the correction amount to another qualified organization. According to Treasury Regulations section 53.4958-7(e) and IRS Manual, the IRS is working on creating a voluntary compliance program for section 4958 issues that could include safe harbors and specific procedures for organizations to self-correct excess benefits.

In addition to requiring the correction, the IRS may impose a penalty on the disqualified person equal to 25% of the excess benefit; if the amount owed is not paid within the taxable period, the IRS may impose an additional tax equal to 200% of the excess benefit. According to IRC sections 4962 and 4963, Treasury Regulations 53.4963-1, and IRS Manual, if a disqualified person completes the correction of an excess-benefit transaction within 30 days of discovering that it was an excess-benefit transaction, the IRS will not assess the penalty. In addition, an organization manager who knowingly participates in an excess-benefit transaction may be subject to a 10% excise tax [Treasury Regulations section 53.4958-1(d)(1)]. The IRS provides for abatement of taxes on any excess-benefit transaction that an organization corrects within the correction period, as defined in IRC section 4963(e) [see IRC sections 4961(a) and 4962(a), and IRS Manual, April 1, 2003], provided the excess-benefit transaction was due to reasonable cause and not due to willful neglect [IRS Manual, March 15, 2005].

What Can Go Wrong?

Caracci v. Commissioner [118 T.C. No. 25 (2002)] highlights the difficulties that may arise under IRC section 4958 and the importance of contemporaneously undertaking the proper procedures and preparing the proper documentation.

In the 1970s, members of the Caracci family set up and ran three nonprofit, IRC section 501(c)(3) home-healthcare agencies in Mississippi. The agencies paid salaries to the family members but rarely ran a surplus. In 1995, shortly after IRC section 4958 took effect, the Caraccis established new for-profit corporations and transferred substantially all of the exempt organizations’ assets to those new entities in exchange for the assumption of their liabilities. Before the transactions closed, the Caraccis’ tax attorney advised them to obtain an outside appraisal. The outside CPA valuator, apparently basing his report on the consistent losses suffered by the exempt organizations, concluded that the liabilities to be assumed by the for-profit corporations exceeded the value of the transferred assets. The IRS disagreed and found that the exempt organizations’ assets were worth more than $20 million.

The IRS concluded that the asset transfers were excess-benefit transactions under section 4958 because the fair market value of the transferred assets far exceeded the consideration the exempt organizations received in return. The IRS named several disqualified persons in the actions, assessing $41 million in intermediate sanction excise taxes and revoking the tax-exempt status of the three agencies. The IRS did not pursue its claims against the organizations’ managers, apparently conceding that the CPA’s valuation was not unreasonable and that the managers acted reasonably in relying on the valuation. The taxpayers claimed that the fair market value was actually less than the IRS determined, and because the liabilities assumed by the corporations exceeded this value, none of the family members received any excess benefit from the transfer.

The Tax Court rejected some assumptions made by the Caraccis’ CPA. In particular, it noted that when valuing exempt entities, the entities’ earnings and profits are not as important as they are when valuing for-profit entities. The court instead focused on a comparable-value method, comparing the privately held agencies to similar publicly traded corporations. The Tax Court also specifically noted the importance of nonbook intangibles, such as the workforce in place, in valuing the Caraccis’ home-healthcare agencies.

The Tax Court ultimately concluded that the Caraccis had undervalued the assets. After determining that the family members were disqualified persons, the Tax Court held that the Caraccis had received excess benefits from the transfer and were liable for first- and second-tier excise taxes under section 4958, for a total award of approximately $11.6 million. The Tax Court concluded, however, that because the IRS had imposed section 4958 intermediate sanctions, it was improper to revoke the organizations’ tax-exempt status. The Caracci decision is currently on appeal to the Fifth Circuit Court of Appeals.

Minimizing Risk

The Caracci taxpayers may have had a better chance of avoiding liability under IRC section 4958 had they been able to invoke the rebuttable presumption of reasonableness provided under the regulations. The Joint Committee on Taxation has recommended replacing the rebuttable presumption of reasonableness with a rebuttable presumption that the organization has satisfied the minimum standards of due diligence with respect to the transaction (see “Congressional Report Proposes Dramatic Changes for Nonprofit Organizations” by Susan Cobb, Mondaq Business Briefing, March 3, 2005). While this presumption does not provide a complete shield from liability, if an organization is able to provide the requisite information, then the IRS must presume a compensation arrangement to be reasonable and transfers of property or property rights to have been made at fair market value. The IRS then has the burden of demonstrating that a specific transaction was actually an excess-benefit transaction.

This rebuttable presumption arises if three conditions set forth in Treasury Regulations section 53.4958-6(a) are satisfied. If these conditions are met, the burden of proof shifts to the IRS:

  • An authorized decision-making body of the organization, composed entirely of individuals who have no conflict of interest with respect to the arrangement, approved the compensation arrangement in advance;
  • Before making its decision, the authorized body obtained and relied on appropriate data regarding comparability; and
  • The authorized body adequately documented the basis for its determination concurrently with making that determination.

Avoiding conflicts of interest within the authorized decision-making body. In advance of any transaction that might be subject to scrutiny, an organization must adopt a comprehensive, written conflict-of-interest policy. A properly written policy ensures that any potential excess-benefit transactions are scrutinized and approved by a disinterested decision-making body. A disinterested decision-making body must not include any individual with a conflict of interest with respect to the transaction at issue. According to Treasury Regulations section 53.4938-6(c)(1)(ii), a person who attends the meeting only to answer questions is not considered to be part of the decision-making body if that person is not present during the debate or the vote, and otherwise recuses himself. Accordingly, a conflict-of-interest policy could allow a person involved in a transaction to answer questions but would prohibit that person’s participation in the deliberations.

An organization must take care to avoid any possibility of a member of the decision-making body being determined to have a conflict of interest. As set forth in Treasury Regulations section 53.4948-6(a)(1), a conflict of interest exists if a member of the decision-making body is the disqualified person, is related to the disqualified person, benefits economically from the transaction, is subject to the direction or control of the disqualified person, or is in any way compensated or paid by the disqualified person. The rebuttable presumption may be unavailable if the decision-making body is made up entirely of family members or other interested persons.

Avoiding conflicts of interest will make the IRS less likely to conclude that an excess-benefit transaction has taken place. For example, the IRS has considered section 4958 issues in the context of community foundations that award scholarships. When a community foundation asked the IRS to address when a family member of a foundation director was selected as a scholarship recipient by a donor-advised scholarship committee, the IRS concluded that the board could approve the scholarship without the transaction constituting an excess benefit “so long as the board member whose family member is benefited by the scholarship recuses himself or herself in the manner set forth in Section 53-4958-6(c) of the Regulations” (see IRS Info. 2003-0014, March 31, 2003).

Gathering and maintaining appropriate data regarding comparability. An exempt organization must acquire and use sufficient data regarding comparable compensation packages and the fair market value of property before entering into any transaction that could be considered an excess-benefit transaction. As provided in Treasury Regulations section 53.4958-6(c)(2)(i), the IRS considers the knowledge and expertise of an authorized body’s voting members in determining whether the authorized body obtained and relied on appropriate data regarding comparability. Under this standard, the authorized body must acquire information sufficient for it to determine that the compensation to be paid is reasonable or that the property is being transferred at fair market value. The authorized body should consider compensation paid by similar organizations for similar services, available compensation surveys, and actual written offers made by other entities for the disqualified person’s services. With respect to property, the authorized body should consider independent appraisals and other offers received in a competitive bidding process. The IRS has also established special standards for comparability for organizations with annual gross receipts of $1 million or less [see Treasury Regulations section 53.4958-6(c)(2)(ii), (iv), Example 5].

The IRS has acknowledged that it is difficult for exempt organizations to determine what is reasonable compensation for a disqualified person. Statistics regarding comparable salaries are not readily available, and individual compensation studies from specialists are expensive. Furthermore, practitioners are reluctant to make voluntary disclosures without a commitment from the IRS that it will not impose penalty taxes, which the IRS cannot give. Although the IRS has been reported to be developing a database that will include compensation information gathered from Form 990 filings, there is no evidence that such a database would be for public use.

Until September 2005, the only guidance regarding revocation standards related to excess-benefit transactions was that they were “under study” (see IRS Manual; March 15, 2005). On September 9, 2005, the IRS issued a proposed regulation to clarify its view of the relationship between IRC sections 501(c)(3) and 4958. “Standards for Recognition of Tax-Exempt Status if Private Benefit Exists or if an Applicable Tax-Exempt Organization Has Engaged in Excess Benefit Transaction(s)” (REG-11257-05, 3, issued September 9, 2005) is to be codified at Treasury Regulations Parts 1 and 53, and is available for download at

The proposed amendment to Treasury Regulations section 1.501(c)(3)-1(g) takes the position that the remedies under the Code sections are not exclusive. It also states that the IRS will consider all relevant facts and circumstances in determining whether revocation is appropriate, including, but not limited to, the following:

  • The size and scope of the organization’s regular, ongoing activities that further its exempt purposes before and after the transaction occurred;
  • The size and scope of the excess-benefit transaction in relation to the size and scope of the organization’s regular and ongoing activities that further its exempt purposes;
  • Whether the organization has been involved in numerous excess-benefit transactions;
  • Whether the organization has implemented safeguards “reasonably calculated to prevent future excess benefit transactions”; and
  • Whether the excess-benefit transaction has been corrected or the organization has made good-faith efforts to obtain a correction from any disqualified persons who benefited from the transaction.

The amended regulation notes that the final two factors above will weigh strongly in favor of continuing the exemption if the organization discovers the excess-benefit transaction and acts before the IRS discovers it. Correction alone is not, however, a sufficient basis for continuing the exemption. Therefore, it appears that an organization that has operated in good faith, identified its excess-benefit transactions without IRS intervention, and implemented safeguards will rarely have its tax-exempt status revoked. If the organization takes appropriate action and adopts formal safeguards, it may need to pay a fine, but it will probably be able to protect its tax-exempt status. If, however, an organization does not pay careful attention to the intermediate sanction rules, the risks of losing exempt status are great.

The IRS has noticed several problems in compensation reports, such as poor methodology, lack of underlying documentation, and incomplete documentation. According to Fred Stokeld as cited above, the IRS notes that these problems could be avoided by having consultants prepare the compensation reports in compliance with the requirements for appraisers set forth in Treasury Regulations section 170A-13(c)(3) and in the rules for expert witness reports set forth in Tax Court Rule 143(f).

Caracci also creates uncertainty for organizations regarding what methods to use. Because the valuation issue remains unsettled, advisers to exempt organizations should avoiding giving assurances that their valuation will withstand IRS scrutiny. This uncertainty is another good reason for an exempt organization to have compensation evaluations and property appraisals scrutinized by someone other than the organization’s regular accounting firm or consultants, if possible. If an organization uses an outside firm in connection with potential excess-benefit transactions, the valuations and appraisals may draw less-severe scrutiny.

The importance of gathering sufficient valuation information was also demonstrated in IRS Private Letter Ruling 200243057 (October 25, 2002), which deals with section 4958 issues. Taxpayer “B,” who founded a section 501(c)(3) entity and was formerly its president and executive director, was a used-car salesman. B created the entity to allow individuals to donate their used vehicles for a tax deduction and to choose the charity to which the proceeds would be sent. The entity operated on the same premises as a used-car lot owned by B’s son, and the entity used the lot to offer its vehicles for sale to the public alongside vehicles sold by B’s son. The entity’s original board consisted of B, B’s wife, B’s father-in-law, and a CPA, who resigned in 1998. The IRS determined that the salary paid to B in 1999 and a severance package paid to him when he left the agency were excess benefits because, among other things, neither B nor the agency was able to provide evidence of comparable salaries for similar services. The IRS concluded that all of B’s salary could presumptively be treated as an excess benefit. The IRS also indicated, however, that if credible, probative evidence could be provided showing the value of services provided by B, it might reduce the excess-benefit amount.

In Private Letter Ruling 200413014 (March 26, 2004), the IRS used a similar approach in determining whether an organization’s process for setting the coupon rate of bonds to be sold by a nonprofit corporation and issued to a limited liability company constituted an excess benefit. The IRS ruled that the rate-setting process was part of an open and competitive bidding process under Treasury Regulations section 53.4958-6(c)(2)(i) and that the auction process for setting the rate was a common commercial competitive-bidding process for independently and fairly determining the coupon rate of bonds sold to the public. The IRS focused on the nonprofit corporation’s reliance on appropriate comparability data before making its determination.

Creating adequate documentation. Even if a conflict-free decision-making body uses excellent comparable information, it is meaningless if the organization has not properly documented the facts. According to Treasury Regulations section 53.4958-6(c)(3), the authorized body should create written documentation that includes the transaction’s terms and the date it was approved, identifies the members of the authorized body present during the debate and voting on the matter, shows the comparability data the authorized body relied upon and the source for the data, and describes any actions taken with respect to members with a conflict of interest. In addition, IRS Director of Exempt Organizations Steven T. Miller prepared “Easier Compliance Is Goal of New Intermediate Sanction Regulations,” a 15-point checklist regarding documentation that exempt organizations should prepare and maintain.

According to Treasury Regulations section 53.4958-6(c)(3)(ii), if the authorized body decides that it will pay more than the comparable data indicates, it must include the basis for its decision in the documentation. This documentation must be prepared before the next meeting of the authorized body or 60 days after the action was taken, whichever is later, and the authorized body must review and approve the records.

It is particularly important that exempt organizations create contemporaneous writings establishing that payments to executives, officers, and vendors are payments for services rendered or for some other benefit to the organization. If an exempt organization does not clearly indicate its intent to treat the benefit as payment for services rendered, the IRS will automatically treat it as an excess benefit. According to Treasury Regulations section 53.4958-4(c)(1), an organization is considered to have clearly stated its intent to provide a benefit as compensation “only if the organization provides written substantiation that is contemporaneous with the transfer of the economic benefit at issue.”

Treasury Regulations section 53.4958-4(c)(3) states that written substantiation may be accomplished by reporting the transaction as compensation on the proper tax forms or through use of an employment contract (or similar writing) executed on or before the transfer. If an exempt organization fails to report an economic benefit for “reasonable cause,” as determined under Treasury Regulations section 301.6724-1, however, then the exempt organization is treated as having indicated its intent to provide the benefit as compensation for services. According to Treasury Regulations section 53.4958-4(c)(1), if the written contemporaneous substantiation requirements are not satisfied and the organization cannot establish that it provided the economic benefit in exchange for consideration other than the performance of services (as might occur with a loan), then the IRS will treat the benefit as an automatic excess-benefit transaction even if the benefit or any other compensation is reasonable.

Use Sarbanes-Oxley

In 2002, Congress passed the Sarbanes-Oxley Act (SOX), which imposes strict reporting and accountability standards on publicly traded companies. Although SOX does not apply directly to nonprofit organizations, many contend that nonprofits should view the reporting provisions in SOX as recommendations for avoiding the documentation problems that can lead the IRS to find an excess-benefit transaction (see “Greater Scrutiny for Nonprofits” by Margaret Graham Tebo, ABA Journal, June 2004).

Pursuant to SOX, public companies must, among other things, designate an independent audit committee of board members with no financial or management connections to the company. Accordingly, nonprofits, especially mid-sized or large organizations that conduct outside audits, should have a separate audit committee and board members who are truly independent. Nonprofits should not use their regular accounting firms for preparing compensation or property valuation reports, because SOX prohibits public corporations from doing so. Several states, including California (S.B. 1262, 2004) have introduced legislation with reforms similar to those contained in SOX that would apply to nonprofits. In addition IRS documents (see IRS News Release IR 2004-81, June 22, 2004) reference SOX in the nonprofit context, while admitting that it was not enacted to address issues in tax-exempt organizations. Many indications point to the possibility that SOX guidelines may become standard requirements in the nonprofit sector. Complying with them now represents prudent advice.

Terry W. Knoepfle, JD, CPA, is an associate professor of taxation and business law, and Karen A. Froelich, PhD, is an associate professor of management, both in the college of business administration of North Dakota State University, Fargo, N.D.




















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