On March 27, 2008, the U.S. Department of the Treasury released the long-awaited final regulations regarding 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 final regulations is to provide guidance on the specific factors that the Internal Revenue Service (IRS) will consider in determining whether a Section 501(c)(3) organization jeopardizes its tax exempt status by engaging in one or more excess benefit transactions. In other words, these regulations address this question: if an exempt organization is found to have engaged in an excess benefit transaction (such as by paying unreasonable compensation), when might the organization’s tax-exempt status also be at risk? The final regulations also adopt the examples set forth in the proposed regulations that describe when an organization operates for private rather than public benefit, thereby precluding Section 501(c)(3) status.
As described below, the changes in the final regulations should cause organizations to pay even greater attention to their board-level process of reviewing and approving executive compensation (and also to certain physician compensation arrangements, in the case of exempt hospitals). Further, it is more important than ever that this process be designed to result in the rebuttable presumption, and that the market data being used by the board or board-appointed committee be “appropriate comparability data.” A strong process led by the board or board-appointed committee, and one in which the data comparison is appropriate for the organization, will be the strongest defense against intermediate sanctions and also against a threat to exempt status.
Revocation Standards – to Revoke or Not to Revoke
While the final regulations largely adopt the provisions contained in the proposed regulations, certain additions and clarifications provide meaningful guidance as to how the IRS may approach a variety of exemption issues in the future. In the proposed regulations, the IRS provided a series of factors that it will consider in determining whether a 501(c)(3) organization that engages in an excess benefit transaction may continue to be described in Section 501(c)(3). The factors included: (1) the size and scope of the organization’s regular exempt activities; (2) the relationship between the size and scope of the excess benefit transaction(s) and the organization’s regular exempt activities; (3) whether the organization has a history of engaging in “repeated” excess benefit transactions; (4) whether the organization has adopted compliance measures intended to prevent the occurrence of future intermediate sanctions violations; and (5) whether the excess benefit transaction has been corrected (or the organization has made a good faith effort to seek correction). Factors 4 and 5 have greater weight in favor of continuing to maintain exemption if the organization discovers the excess benefit transaction and takes corrective action before the IRS discovers the excess benefit transaction.
For the most part, the final regulations adopted the above factors without major revisions. One meaningful change, however, relates to the third factor above. In the final regulations, the IRS has changed the word “repeated” to the word “multiple." Accordingly, the third factor now reads, “whether the organization has been involved in multiple excess benefit transactions with one or more persons.” In making this change, the IRS noted that that the term “multiple” has two senses: an organization may engage in repeated instances of the same excess benefit transaction, and/or the organization may have more than one type of excess benefit transaction involving one or more persons. The effect of this change is an increase in the circumstances in which revocation may be considered by the IRS. As in the proposed regulations, the final regulations provide 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 most significant change set forth in the final regulations is the inclusion of a new example that focuses on how the above factors will be applied by the IRS. In the example, the IRS determines that a particular organization, Organization O, paid excessive compensation to a senior executive and that such excessive compensation constituted both a proscribed excess benefit transaction and inurement of net earnings; yet, based on the facts and circumstances, the IRS did not revoke the organization’s tax-exempt status. Key facts from this new Example 6 are as follows:
- In Year 1, Organization O’s board of directors adopted written procedures for setting executive compensation modeled on the procedures for establishing a rebuttable presumption of reasonableness. The board appointed an independent compensation committee to gather data on compensation levels paid by similarly situated organizations for functionally comparable positions. Based on its research, the compensation committee recommended a range of reasonable compensation for several of O’s existing “Top Executives.” On the basis of the committee’s recommendations, the board approved new compensation packages for the Top Executives and documented the basis for its decision in board minutes.
- During a subsequent IRS examination, the IRS found that, while the compensation committee relied exclusively on compensation data from organizations that performed services similar to those of O, the organizations relied upon were not similarly situated because they served substantially larger geographic regions and were larger than O in terms of annual revenues, total operating budget, number of employees and number of beneficiaries served. (Note, however, that the IRS does not state in Example 6 how much larger the comparator organizations were when compared to O.) Accordingly, the IRS concluded that the compensation committee did not rely on “appropriate data as to comparability” and failed to establish the rebuttable presumption of reasonableness. After comparing the Top Executives of O to organizations of the same size, the IRS concluded that the Top Executives’ compensation packages for Year 1 were excessive (again, the basis for this conclusion is unknown) and, accordingly: (1) constituted excess benefit transactions and (2) violated the proscription against inurement under Section 501(c)(3) of the Code.
- Based on the IRS’s findings, O’s board added new members to the compensation committee who had expertise in compensation matters, and also amended its written procedures to require the compensation committee to evaluate a number of specific factors, including size, geographic area and population covered by the organization, in assessing the comparability of compensation data. In addition, O’s board renegotiated the Top Executives’ contracts in accordance with the recommendations of the newly constituted compensation committee on a going-forward basis. To avoid potential liability for damages under state contract law, O did not seek to void the Top Executives’ employment contracts retroactively to Year 1 and did not seek correction of the excess benefit amounts from the Top Executives. O did not terminate any of the Top Executives.
- In determining that the excess payments did not warrant revocation of tax-exempt status in the above example, the IRS took the following factors into consideration. First, O engaged in regular and ongoing activities that furthered exempt purposes both before and after the excess benefit transactions occurred. Second, the size and scope of the excess benefit transactions, in the aggregate, were not significant in relation to the size and scope of O’s activities that furthered exempt purposes. Third, while O engaged in multiple excess benefit transactions, O had implemented written procedures for setting the compensation of its top management that were reasonably calculated to prevent the occurrence of excess benefit transactions prior to entering into these excess benefit transactions. O followed these written procedures in setting the compensation of the Top Executives for Year 1. Despite the board’s failure to rely on appropriate comparability data, the fact that O implemented and followed these written procedures in setting the compensation of the Top Executives for Year 1 was a factor favoring continued exemption. That O amended its written procedures to ensure the use of appropriate comparability data and renegotiated the Top Executives’ compensation packages on a going-forward basis were also factors favoring continued exemption, even though O did not void the Top Executives’ existing contracts and did not seek correction from the Top Executives. Based on the application of the factors to these facts, the IRS determined that O continued to be a 501(c)(3) organization.
Private Benefit – Getting to Exemption in the First Place
As noted above, the final regulations also address the issue of when an organization operates for private rather than public benefit, and thereby does not even qualify for Section 501(c)(3) status. In the proposed regulations, the IRS added examples (drawn from Tax Court decisions) to the portion of the then existing regulations governing Section 501(c)(3) organizations that requires these organizations to be operated for a public rather than a private purpose. The examples were as follows:
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 agreement. 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.
The final regulations adopt the language in the proposed regulations without meaningful change.
Beyond the Final Regulations
In addition to their obvious significance from an excess benefit transaction and exemption perspective, the final regulations are significant from a corporate governance perspective for three principal reasons. First, the board has an obligation (stemming from its duty of care) to be aware of the circumstances under which excess benefit transactions can jeopardize tax exempt status. Second, the board, and especially the compliance committee, should be attentive to the importance attributed by the IRS to the establishment of certain safeguards in connection with excess benefit transactions. These safeguards could include, but would not necessarily be limited to, confirming that tax law compliance is included within the scope of the corporate compliance plan and that the rebuttable presumption of reasonableness is satisfied whenever possible. Third, the board, and especially its compensation committee, should review the new example contained in the regulations addressing reasonable compensation and consider the implication for the process now being used to review and approve compensation.
Takeaways from the Final Regulations.
- As may be gleaned from Example 6 in the final regulations, the IRS will consider strongly whether an organization has relied on objectively reasonable internal controls and procedures, such as the process for qualifying for the rebuttable presumption of reasonableness, in determining whether revocation of exemption is warranted. Even if the process ultimately fails and an excess benefit transaction occurs, the fact that the process was objectively designed to result in the rebuttable presumption is a significant favorable factor in avoiding a challenge to an organization’s exempt status.
- In the course of conducting compensation or fair market value reviews, specific focus should be given to: (1) the use of appropriate industry comparables; (2) satisfaction (as a basic board practice) of all requirements for satisfaction of the rebuttable presumption; (3) the importance of good faith efforts to remediate excess benefit transactions before IRS intervention; (4) transparency with the full governing board of compensation issues and transactions with related parties; and (5) periodic board audits of compensation decisions and the compensation review and approval process.
- Good faith efforts to seek correction of an excess benefit transaction is a favorable factor toward protecting tax-exempt status. If correction is not pursued, the organization must review and document the basis for not seeking correction.
- Correction of an excess benefit transaction need not include removal of the individual involved in the excess benefit transaction (as a strategy to preserve tax-exempt status).
- While not specifically referenced in the final regulations, proper reporting of compensation and benefits on Form 990 may be a favorable factor in the IRS analysis of whether revocation of exemption is warranted in the event of an excess benefit transaction.