Until recently, when confronted with transactions between a tax-exempt public charity (e.g., hospitals, colleges) or a social welfare organization (e.g., HMOs) and an insider which improperly benefited the insider, the IRS had only one penalty it could impose: revocation of tax-exempt status. This is a harsh penalty, which may harm innocent parties, such as beneficiaries of the organization’s charitable activities and holders of the organization’s tax-exempt bonds, and so it is seldom imposed by the IRS.
In 1996, Congress added Section 4958 to the Internal Revenue Code (the "Code"), the so-called "Intermediate Sanctions," which permits the IRS to impose penalty taxes on the insider who receives the improper benefits and on any director, officer or manager who knowingly approves the transaction that confers the benefits. In 1998, the IRS issued proposed regulations under Section 4958, which further defined certain key terms in the statute and provided guidance on certain procedures which, if followed by an organization, would substantially reduce the likelihood that Section 4958 penalty taxes would be imposed. On January 10, 2001, the IRS issued temporary regulations (effective for three years) which differ from the proposed regulations in several significant ways.
Intermediate Sanctions Overview
The initial tax on an insider is 25 percent of the excess benefit amount and, if the transaction is not promptly corrected, a second tax is imposed on the insider equal to 200 percent of the excess benefit amount. Correction is defined as undoing the transaction to the extent possible and taking any other steps necessary to put the organization in as good a position as if the insider had acted in accordance with the highest fiduciary standards. The temporary regulations provide that as part of the correction the insider must pay the amount of the excess benefit plus interest at the applicable federal rate. Any director, officer or other person with similar responsibilities (including members of committees described in the rebuttable presumption section below) who knowingly approves (or fails to disapprove or object to) an excess benefit transaction may be subject to a tax equal to 10 percent of the excess benefit amount, not to exceed $10,000 per transaction. However, according to the proposed regulations, if the director, officer or similar person relies on a reasoned written opinion of legal counsel, he or she will not be subject to the tax. Under the temporary regulations the person may, in addition, rely on an opinion of in-house counsel, accountants with relevant tax expertise and independent valuation experts.
The Intermediate Sanctions regulations impose the excise taxes described above on each Excess Benefit Transaction between an Applicable Exempt Organization and a Disqualified Person. Organizations that follow certain procedures will be entitled to a Rebuttable Presumption that the transaction is not an Excess Benefit Transaction. The remainder of this Health Law Update will discuss the key terms capitalized above, as well as the rebuttable presumption procedures. All organizations subject to Section 4958 should carefully review these definitions so they can identify in their own operations the persons and transactions to which these definitions would most likely apply. In addition, each such organization should carefully comply with the rebuttable presumption procedures for any transaction to which Section 4958 might be applicable.
Section 4958 only applies to transactions occurring on or after September 14, 1995. However, a contract that was binding on or prior to September 13, 1995 will be treated as a new contract subject to Section 4958 if the contract can be terminated without the consent of the Disqualified Person (upon the date that such termination, if made, would be effective) or is materially modified (upon the effective date of such modification). Material modification includes, but is not limited to, extension of term and increase in compensation.
Applicable Exempt Organization
An Applicable Exempt Organization is an organization that is, or has been at any time during the five years prior to the Excess Benefit Transaction (but not in any event prior to September 14, 1995):
- exempt under Section 501(c)(3) of the Code (excluding private foundations); or
- exempt under Section 501(c)(4) of the Code (including organizations that have applied for exemption under Section 501(c)(4); filed an information return as a Section 501(c)(4) organization; or otherwise represented themselves as a Section 501(c)(4) organization
The temporary regulations expressly exclude governmental entities, even if they have obtained exemption under Section 501(c)(3) or Section 501(c)(4). The temporary regulations do not provide a special rule for donor advised funds but, in the preamble to the regulations, the IRS requests comments on issues raised by distributions from a donor advised fund to or for the benefit of the donor.
Section 4958 does not alter the requirements for tax exemption under Sections 501(c)(3) and 501(c)(4) of the Code. The taxes imposed by Section 4958 are in addition to, and not in place of, the penalty of revoking an organization’s tax exempt status.
A Disqualified Person is a person or entity who, with respect to any transaction, was in a position to exercise substantial influence over the affairs of the Applicable Exempt Organization at any time during the five-year period ending on the date of the transaction (but not in any event prior to September 14, 1995).
Deemed Disqualified Persons
The temporary regulations state that persons in the following categories will be deemed to have substantial influence (and, as a result, are Disqualified Persons) with respect to an Applicable Exempt Organization:
- voting directors or trustees of the organization’s governing body;
- persons who have or share ultimate responsibility for implementing the decisions of the organization's governing body or supervising the organization’s management or operations (e.g., presidents, chief executive officers, or chief operating officers unless the person holding such a title can demonstrate that he or she does not in fact have or share such responsibility);
- persons who have or share ultimate responsibility for managing the organization’s financial assets (e.g., treasurers or chief financial officers); and
- with respect to a hospital which is an Applicable Exempt Organization and participates in a provider-sponsored organization ("PSO"), persons with a material financial interest in the PSO, such as physicians.
Statutory Disqualified Persons
In addition, by statute, Disqualified Persons also include:
- a family member of a Disqualified Person (i.e., spouse, sibling (by whole or half blood), sibling’s spouse, ancestors, children, grandchildren, great grandchildren, and spouses of children, grandchildren and great grandchildren); and
- a corporation, partnership, trust or estate in which a Disqualified Person owns, directly or indirectly, an interest (defined by voting powers, profits interest, or beneficial interest, respectively) in excess of 35 percent.
The temporary regulations exclude from the definition of Disqualified Person the following:
- an Applicable Exempt Organization which is exempt under Section 501(c)(3) of the Code;
- an Applicable Exempt Organization that is exempt under Section 501(c)(4), with respect to another 501(c)(4) organization;
- a governmental entity, if the economic benefit is transferred for exclusively public purposes; and
- an employee of an Applicable Exempt Organization (i) whose total compensation would not qualify him or her as a "highly compensated employee" under the Internal Revenue Code rules (at present, one who receives less than $85,000 per year); (ii) who is not a Disqualified Person or a family member of a Disqualified Person (each as described above); and (iii) who is not a "substantial contributor" with respect to, or officer or director of, the organization. Treasury representatives have stated that the $85,000 per year will not be pro-rated for part-time employees (i.e., a part-time employee earning $79,000 would not be a Disqualified Person).
An initial contract will not be subject to Section 4958, to the extent that payments under the contract are fixed and not discretionary.
Facts and Circumstances Test
With respect to persons or entities that do not fall into one of the categories described above, substantial influence with respect to an Applicable Exempt Organization will be determined by the facts and circumstances. Under the temporary regulations, facts and circumstances tending to show substantial influence over an Applicable Exempt Organization include, but are not limited to:
- founding the organization;
- being a "substantial contributor" with respect to the organization for the year in question and the four preceding years;
- having compensation primarily based on revenues derived from activities of the organization controlled by the person;
- having or sharing authority over a substantial portion of the organization’s capital expenditures, operating budget or employee compensation;
- having managerial authority with respect to the organization or a substantial discrete segment or activity of the organization; or
- having a controlling interest (measured by vote or value) in a corporation, partnership or trust that is a Disqualified Person.
Facts and circumstances tending to show no substantial influence with respect to an organization include but are not limited to:
- having taken a bona fide vow of poverty with respect to a religious organization;
- being an attorney, accountant or investment manager or advisor, or other independent contractor whose sole relationship to the Applicable Exempt Organization is providing professional advice (without having decision-making authority) with respect to a transaction and who will not benefit financially from the transaction, directly or indirectly, aside from customary fees received for professional services rendered;
- not having a supervisor who is a Disqualified Person;
- not participating in management decisions affecting the Applicable Exempt Organization or a substantial discrete segment or activity of the organization; or
- receiving preferential treatment resulting from a donation that is offered to all other donors making a similar donation as part of a solicitation intended to attract a substantial number of donations.
The temporary regulations also state that, with respect to multiple Applicable Exempt Organizations under common control (e.g., a health care system), the determination of substantial influence shall be made separately with respect to each organization. In other words, a person determined to have substantial influence with respect to one Section 501(c)(3) hospital in a system will not, solely as a result of that determination, be determined to have substantial influence with respect to other such hospitals or other Applicable Exempt Organizations in the system.
Excess Benefit Transaction
An Excess Benefit Transaction is any transaction in which an economic benefit is provided by an Applicable Exempt Organization, directly or indirectly, to or for the use of a Disqualified Person, and the value of the economic benefit exceeds the value of the payment, property or services provided by the Disqualified Person to the organization for such economic benefit. In making a determination whether an Excess Benefit Transaction has occurred, the IRS will consider all benefits provided to the Disqualified Person, except for the exclusions described below. An economic benefit is provided indirectly when it is provided by an entity controlled by, or acting as an intermediary for, an Applicable Exempt Organization. Control is defined as a 50 percent interest, by vote or value. An intermediary is a person or entity that receives an economic benefit from an Applicable Exempt Organization and, pursuant to an oral or written understanding with the organization, provides an economic benefit to a Disqualified Person without a significant business or exempt purpose of its own for providing such benefit.
Sale, lease or other use of property: A sale, lease or other arrangement for the use of property between an Applicable Exempt Organization and a Disqualified Person is not an Excess Benefit Transaction if the payment for the acquisition or use is fair market value. The organization should have contemporaneous evidence of fair market value (e.g., an appraisal by a qualified, independent appraiser).
Compensation: Under the temporary regulations, an economic benefit will not be treated as compensation for services unless the Applicable Exempt Organization clearly indicates by some form of contemporaneous written substantiation its intent to treat the benefit as compensation when paid (e.g., by reporting it on IRS Forms W-2, 1099 or 990) or establishes to the satisfaction of the IRS reasonable cause for not doing so, or the Disqualified Person reports the benefit as income on an original or amended IRS Form 1040 for the year in which the benefit is received. An employment contract or board vote could also constitute contemporaneous written substantiation. In order to constitute evidence of the organization’s intent to treat the benefit as compensation, the filing by the organization or other action must occur prior to the commencement of any IRS examination with respect to the benefit. If the organization fails to establish its intent to treat a particular economic benefit as compensation, the temporary regulations would treat that entire economic benefit as an excess benefit amount subject to the Section 4958 excise taxes.
Items of compensation include, but are not limited to, payment (in cash or in kind) of salaries, fees, bonuses, severance payments, all forms of deferred compensation (whether funded or not) unless attributable to prior year services, insurance premiums (and indemnification for liabilities not covered by insurance) and all other benefits (e.g., medical, dental and life insurance, disability benefits, expense allowances, foregone interest on loans). The temporary regulations clarify that including items in compensation for determining reasonableness does not govern the income tax treatment of these items.
Economic benefits to be disregarded for purposes of Section 4958 include the following:
- all fringe benefits excluded from income under Section 132 of the Code (except for certain liability insurance premiums, or indemnification, which is discussed below);
- economic benefits provided to a member of, or donor to, an organization, if the benefit is available and is in fact provided, to non-Disqualified Persons paying membership fees, or making donations, in similar amounts;
- economic benefits provided to a volunteer for an organization (e.g., advance ticket purchases, gift shop discounts) if available to the public for a membership fee of $75 per year or less;
- economic benefits provided solely as a member of the charitable class that the organization intends to benefit as part of its tax-exempt mission; and
- payment of insurance premiums, or indemnification, except for insurance premiums, or indemnification for: (a) Section 4958 taxes, penalties, or correction amounts; (b) legal and other expenses unrelated to the Disqualified Person's services to the organization; and (c) acts which are willful or without reasonable cause.
Compensation is reasonable if it is an amount that would ordinarily be paid for like services by like enterprises under like circumstances. Compensation paid to a Disqualified Person may not exceed what is reasonable under all the facts and circumstances at the time the contract was entered into. The temporary regulations provide that reasonableness of compensation will be determined in accordance with standards developed under Section 162 of the Code, taking into account all benefits provided to the Disqualified Person (except those specifically excluded as described above), including deferred compensation as it vests. Relevant factors taken into account in determining reasonableness of compensation are whether or not the compensated duties are substantially performed and whether or not any bonus or revenue-sharing arrangement is subject to a cap. Approval of a contract by a court or state or local agency does not constitute a determination of reasonableness that is binding on the IRS. If reasonableness of compensation cannot be determined based on circumstances existing on the date when the contract was made (e.g., because of an incentive-based bonus not subject to a cap), then the determination will be made based on all facts and circumstances up to and including the date of payment. In no event shall the facts and circumstances existing at the time the contract is questioned by the IRS be taken into account in determining reasonableness of compensation.
A contract that an Applicable Exempt Organization can terminate without the consent of the Disqualified Person is treated as a new contract as of the date that such termination, if made, would be effective. This means, for example, that a contract that renews annually but is subject to termination without cause upon notice by either party at least 90 days prior to the end of each annual term should be reviewed for reasonableness each year. In addition, a "material modification" to a contract will cause it to be treated as a new contract for purposes of determining reasonableness as of the effective date of such modification. Material modification includes, but is not limited to, extensions of term and increases to compensation.
Special Rules for Revenue Sharing Transactions
This section of the temporary regulations has been reserved so that the IRS can continue to consider the large number of comments it received on this section of the proposed regulations. If this section is issued in the future, it will be issued in proposed form and will not be effective until issued in final form. In the meantime, revenue-sharing transactions will be analyzed by the IRS under the general rules, discussed above, which apply to Excess Benefit Transactions.
Compensation provided by an Applicable Exempt Organization to a Disqualified Person shall be presumed to be reasonable, and the sale, lease or other arrangement for the use of property between an Applicable Exempt Organization and a Disqualified Person shall be presumed to be at fair market value, if:
- the terms are approved by the governing body, or a committee thereof, of the applicable exempt organization, or an entity controlled by it, composed entirely of individuals who do not have a conflict of interest with respect to the proposed transaction;
- the governing body, or committee thereof, obtained and relied upon appropriate comparability data prior to making its determination; and
- the governing body, or committee thereof, adequately documented the basis for its determination concurrent
The rebuttable presumption only applies to payments that are: (a) fixed in advance; (b) determined by a formula that is fixed in advance; (c) made pursuant to a qualified pension, profit-sharing or stock bonus plan even if the employer exercises discretion with respect to the plan; or (d) not fixed in advance but subject to a cap.
The Disqualified Person will not be treated as having been a member of the governing body, or committee thereof, if he or she only meets with the other members only to answer questions but is not present when the transaction is considered and voted upon. If state law permits, the organization may authorize a third party to act on its behalf in approving such transactions and, if the procedures described above are followed, the organization may still claim the benefit of the rebuttable presumption. If state law or the organization’s governing documents require ratification by the full board of a committee’s decision for it to be effective, then the conflict of interest procedural requirements, described below, must be met by the full board and not the committee.
In many cases in a tax dispute, the taxpayer has the burden of proof. However, if an organization complies with the rebuttable presumption requirements, the burden of proof shifts to the IRS. That is, the IRS must prove that the economic benefit received by the Disqualified Person is not consistent with fair market value. The IRS may rebut the presumption by presenting additional information showing that the compensation was not reasonable, or the sale, lease or other arrangement for the use of property was not at fair market value.
If an organization does not comply with the rebuttable presumption requirements with respect to a transaction, the temporary regulations state that the IRS may not infer from that fact that the transaction in question is an Excess Benefit Transaction.
Conflicts of Interest
A member of the governing body, or committee thereof, has a conflict of interest with respect to a transaction if the member is:
- a Disqualified Person or a family member of a Disqualified Person (each as described above);
- in an employment relationship subject to direction or control of a Disqualified Person;
- receiving payments subject to approval by a Disqualified Person;
affected financially by the proposed transaction; or
- depending upon a Disqualified Person to approve a transaction with respect to which the member is a Disqualified Person (i.e., a reciprocal arrangement).
The temporary regulations state that relevant comparability data includes, but is not limited to:
- compensation levels paid by similarly-situated organizations, both taxable and tax-exempt, for functionally comparable positions;
- the availability of similar services in the organization’s geographic area;
- current compensation surveys compiled by independent firms; and
- written offers from similar organizations competing for the services of the Disqualified Person; and
- independent appraisals of the property to be sold, leased or otherwise made use of pursuant to the arrangement between the Disqualified Person and the Applicable Exempt Organization; and
- offers received as part of an open and competitive bidding process.
The temporary regulations contain a special rule for appropriate comparability data for Applicable Exempt Organizations with annual gross receipts, on a consolidated basis taking into account affiliated organizations, of $1,000,000 or less (on either an annual or a three-year rolling average basis).
Under the temporary regulations, adequate documentation consists of minutes or other records of the governing body, or committee thereof, showing:
- the terms of the transaction and the date it was approved;
- the members present and a record of the vote, or abstention, of each;
- the comparability data and how it was obtained; and
- the actions taken with respect to any member with a conflict of interest with respect to the proposed transaction.
If the reasonable compensation or fair market value for a transaction is higher or lower than the range of comparability data, the governing body, or committee thereof, must record the basis for its decision. For the decision to be documented concurrently, the records must be prepared by the later of 60 days or the next meeting of the governing body, or committee thereof, following the final action with respect to the transaction and must be received and approved as reasonable, accurate and complete within a reasonable time thereafter.