July 2001
Charitable Organizations
and the Temporary Regulations Concerning Intermediate Sanctions: An Overview
By David G. Samuels and Morris
Shoretz, CPA On Jan. 10, 2001, the Internal Revenue Service
(IRS) issued temporary regulations with respect to the “intermediate sanctions”
legislation enacted by Congress in 1996 as part of the “Taxpayer Bill of Rights
II.”
Running through Jan. 9, 2004, with the force and effect of final regulations,
the temporary regulations have replaced and modified proposed regulations published
in 1998, which had received criticism. Accountants working with charitable organizations
should be aware of the legislation and regulations in order to alert nonprofit
officials of the possible need to consult with counsel or otherwise take steps
to avoid the potential penalties authorized by the new law.
The Purpose
of the Intermediate Sanctions
Requested by the U.S. Treasury, the intermediate
sanctions legislation provides the IRS with new and increasingly flexible sanctions
to deal with excess benefit transactions. The new statute authorizes the imposition
of excise taxes on certain insiders (defined in the statute as disqualified persons)
and on organization managers. The statute does not provide any additional remedy
with respect to charities themselves, and it does not supersede or alter the existing
remedy of revoking an organization’s tax-exempt status in instances of “private
inurement.”
Intermediate sanctions can be imposed either in lieu of, or in
addition to, the revocation of a charity’s tax-exempt status. The intermediate
sanctions legislation generally applies to excess benefit transactions occurring
on or after Sept. 14, 1995.
Calculation of the Excise Taxes
The
legislation permits the IRS to impose penalties, in the form of excise taxes,
on insiders such as officers and key employees who receive excess compensation
or other benefits.
A first tier tax of 25 percent of the excess benefit may
be imposed on a disqualified person with respect to each excess benefit transaction.
In any case in which the initial 25 percent tax is imposed and the excess benefit
is not corrected within the taxable period, a second tier excise tax equal to
200 percent of the excess benefit may also be imposed by the IRS, with both the
first and second tier taxes to be paid by the beneficiary of the excess benefit.
According to the legislative history, the IRS has authority to “abate the
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 specified period.” In such instances, the amount of the excess benefit
(reflecting both the amount that must be returned and the amount on which the
excise tax is calculated) is the difference between the benefit actually received
and the benefit that the IRS deems to be reasonable. Thus, if the IRS deems the
reasonable salary and other benefits of an insider to be $100,000, and the individual
receives $200,000, the excess benefit would be $100,000. If compensation or other
benefits are scrutinized over a multiyear period, the total excess benefit could
be much greater.
In addition to the first and second tier excise taxes, the
IRS is authorized to impose a 10 percent excise tax, up to a maximum of $10,000,
on any “organization manager” such as an officer, director, or trustee other than
the recipient of the excess benefit who has participated in an excess benefit
transaction “knowing that it is such a transaction unless such participation is
not willful and is due to reasonable cause.”
The Rebuttable Presumption
of Reasonableness
While described not in the Internal Revenue Code but
in the legislative history and temporary regulations, the most important element
of the new law possibly is the ability of charity officials to take certain steps
to permit a rebuttable presumption that compensation and other benefits paid to
an insider are reasonable. The parties are entitled to rely on a rebuttable presumption
of reasonableness with respect to a compensation arrangement with a disqualified
person if such arrangement was approved by a board of directors or trustees (or
committee thereof) that satisfied each of three separate requirements.
The
first requirement to obtain a rebuttable presumption of reasonableness states
that the board must be “composed entirely of individuals unrelated to and not
subject to the control of the disqualified person(s) involved in the arrangement.”
This stipulation is consistent with the traditional principle that compensation
of charity officials should ideally be set at arm’s length by an independent board
of directors. A reciprocal approval arrangement of the type common among smaller
charities, whereby an individual approves compensation of the disqualified person,
and the disqualified person, in turn, approves the individual’s compensation,
does not satisfy the independence requirement.
The second requirement to obtain
a rebuttable presumption of reasonableness states that the board that fixed the
compensation must have “obtained and relied upon appropriate data as to comparability
(e.g., compensation levels paid by similarly situated organizations, both taxable
and tax-exempt, 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; or actual written
offers from similar institutions competing for the services of the disqualified
person).” This is a practical requirement designed to require the board to take
steps ensuring that the resulting compensation approximates fair market value
in the geographical area where the organization is located.
This requirement
encourages boards to commission or obtain the results of independent compensation
surveys to ensure that (1) the compensation paid is reasonable, (2) the rebuttable
presumption of reasonableness is available, and (3) the potential liability of
the board members who fix the compensation is minimized, if not eliminated.
The third requirement to obtain a rebuttable presumption of reasonableness states
that the board that fixed the compensation must have “adequately documented the
basis for its determination (e.g., the record includes an evaluation of the individual
whose compensation was being established and the basis for determining that the
individual’s compensation was reasonable in light of that evaluation and data).”
Formal board minutes, compensation committee reports, and written employment
contracts, as well as written employment offers from other organizations, constitute
such documentation.
The legislative history provides that “[i]f these three
criteria are satisfied, penalty excise taxes could be imposed under the proposal
only if the IRS develops sufficient contrary evidence to rebut the evidence put
forth by the parties to the transaction.”
In order to facilitate the compliance
by charities and charity officials with respect to both the law and the regulations,
and, in particular, to obtain the benefits of the rebuttable presumption of reasonableness,
Steven T. Miller, IRS director of exempt organizations, recently wrote an article
and appended a 15-point checklist of factors for a board to consider in making
decisions on compensation. This checklist, which is merely suggestive and not
official policy, includes the following:
