The Department of the Treasury released proposed regulations on September 9 concerning Section 501(c)(3) and 501(c)(4) tax-exempt organizations that provide important guidance for avoiding revocation of tax-exempt status. The "bottom line" of the proposed regulations is that excess benefit transactions under the intermediate sanctions rules will not cause the loss of an organization’s tax exemption unless they are so extensive as to create questions about the organization’s overall purposes and operations. Moreover, organizations that have procedures in place to detect and prevent transactions benefiting insiders, and that act on their own initiative to discover and correct such transactions, are unlikely to have their tax exemption revoked by the IRS even if they engage in excess benefit transactions. IRS officials and practitioners have predicted that the IRS would take this common-sense approach to enforcement but the proposed regulations are the first authoritative statement of this principle. Accordingly, the proposed regulations indicate specific steps exempt organizations can take to protect their tax-exempt status.
The proposed regulations clarify the relationship between the substantive requirements for tax exemption under Section 501(c)(3) and the imposition of intermediate sanctions excise taxes under Section 4958. The purpose of the proposed regulations is to provide guidance on the specific factors that the IRS will consider in determining whether a Section 501(c)(3) organization may jeopardize its tax exempt status as a result of engaging in one or more excess benefit transactions. The proposed regulations also provide examples of when an organization operates for private rather than public benefit, thereby precluding Section 501(c)(3) status. These examples, described below, illustrate the broad nature of activities that can jeopardize exemption – these activities can involve non-economic benefits, payments that are reasonable in amount, and transactions that would not constitute excess benefit transactions.
The purpose of the "intermediate sanctions" excise taxes under Section 4958 is to punish insiders who benefit from their control over an exempt organization while not penalizing the organization itself. However, we have long known of the Congressional and IRS position that the imposition of intermediate sanctions excise taxes does not foreclose the ability of the IRS to revoke tax-exempt status. The IRS had previously indicated its intent to publish guidance regarding the factors it will consider in determining whether to revoke Section 501(c)(3) status where excise taxes also have been imposed, but to wait with such guidance until the IRS has gained sufficient experience in administering Section 4958. The release of these proposed regulations suggests that the IRS now has such experience.
The proposed regulations indicate that the IRS will apply a "facts and circumstances" test in determining whether to revoke tax-exempt status when an organization has engaged in one or more excess benefit transactions. The facts and circumstances include:
- The size and scope of the organization’s regular exempt activities;
- The relationship between the size and scope of the excess benefit transaction(s) and the organization’s regular exempt activities;
- Whether the organization has a history of engaging in excess benefit transactions;
- Whether the organization has adopted compliance measures intended to prevent the occurrence of future intermediate sanctions violations; and
- Whether the excess benefit transaction has been corrected (or the organization has made a good faith effort to seek correction).
The proposed regulations provide that all factors will be considered in combination with each other. Depending on the particular situation, the IRS may assign greater or lesser weight to some factors. Significantly, factors 4 and 5 will weigh more strongly in favor of continuing to maintain exemption if the organization discovers the excess benefit transaction(s) and takes corrective action, before the IRS discovers the excess benefit transaction. In addition, the proposed regulations make clear that simply correcting the intermediate sanctions transaction after the IRS has discovered the transactions will not be, by itself, a sufficient basis for maintaining exemption.
The proposed regulations provide five examples that illustrate the facts and circumstances analysis. All of the examples address fairly clear-cut situations in which the excess benefit is either an overwhelming and continuous, or de minimis and isolated, part of the organization’s activities. The examples, however, provide useful illustrations of the importance of process in the IRS’s analysis. For instance, Example 3 addresses an educational organization headed by its founder. Beginning in the organization’s fifth year, the founder-president diverted significant amounts of the organization’s funds to pay his personal expenses, significantly reducing the funds available to conduct educational programs. The board of directors did not authorize the payment of these personal expenses; some directors knew that they were occurring but took no action. The president claimed that the amounts spent were loans, but no loan documentation existed. The analysis in the example is that the organization has been involved in repeated significant excess benefit transactions, has not implemented any safeguards to prevent future diversions, and has not made good faith efforts to seek correction. Accordingly, the organization is no longer exempt as of the beginning of its fifth year.
By contrast, in Example 4, the organization entered into a construction contract with a company owned by its chief executive officer at a price substantially in excess of fair market value. The board approved the contract but did not perform due diligence that could have made it aware that the price was excessive. Later, but before any IRS examination, the board determined that the price was excessive. The board promptly removed the chief executive officer, terminated his employment, and engaged legal counsel to recover the excess payments to the construction company. In addition, the organization adopted a conflicts of interest policy and significant new contract review procedures designed to prevent future recurrences. In this example, the organization retains its tax exemption. Although the excess benefit transaction was significant in relation to the organization’s activities, it was a one-time occurrence and the organization implemented safeguards reasonably calculated to prevent future violations. The organization took corrective action before the IRS began an audit of the organization and made a good faith effort to seek correction.
The proposed regulations also add examples to the portion of the existing regulations governing Section 501(c)(3) organizations that requires these organizations to be operated for a public rather than a private purpose. These examples are drawn from cases decided by the Tax Court. The examples are:
- An educational organization studies history and immigration but focuses its research on the genealogy of only one family. One objective of its research is to identify and locate descendants of that family so that they can become acquainted. The proposed regulation concludes that the organization’s activities primarily serve the interests of members of that family, rather than the public, and the organization is not exempt.
- An organization’s sole activity is exhibiting art created by unknown local artists. All of the art is for sale on a consignment basis, with the artist receiving 90 percent of the selling price and the organization 10 percent. The proposed regulation concludes that, because the artists directly and substantially benefit from the exhibition and sale of their art, and 90 percent of the proceeds from the organization’s sole activity goes to the individual artists, the organization is operated for the artists’ private benefit and is not exempt.
- An organization’s sole activity is to train individuals in a program developed by its president. The program is owned by the president’s for-profit company, which licenses the organization to teach the program in return for royalty payments and sets the fees to be charged by the organization. Upon termination of the license, any new course materials developed by the organization must be turned over to the for-profit company and the organization then has a two-year non-compete. The proposed regulation concludes that, regardless of whether the royalty payments the organization makes are reasonable, the organization is operated for the benefit of the president and the for-profit company and is not exempt.
None of these examples involve unreasonable economic benefit to insiders and thus would not constitute excess benefit transactions. The preamble to the proposed regulations notes that these examples show that non-economic benefits or reasonable economic benefit can still endanger tax exemption even if the intermediate sanctions excise taxes would otherwise not apply.
In summary, the proposed regulations place a premium on effective tax compliance activity (potentially increasing the scope of responsibilities of the corporate compliance office). The proposed regulations highlight, perhaps more emphatically than in the past, that in certain situations there may indeed be an (extraordinarily severe) organizational penalty associated with violation of the intermediate sanctions rules. In other words, they "raise the stakes" to the tax-exempt organization for engaging in and failing to discover and correct situations involving private inurement or private benefit.