Board Liability Under Intermediate Sanctions

1
Board Liability UnderIntermediate Sanctions

• Presented by
• Deborah Z. Read
• July 29, 2002

2
What Are Intermediate Sanctions?

• Intermediate level of penalty
• In the form of excise taxes imposed by the IRS
• Apply when certain tax exempt organizations
  engage in transactions that provide excess
  benefits to insiders

3
Why Have Intermediate Sanctions?

• Prior to intermediate sanctions, the only stick
  the IRS had was revocation of exempt status
• An intermediate penalty facilitates enforcement
• More enforcement of exempt organization
  principles results in more self-policing the law
  has more credibility
• Revoking a charitys exempt status for
  transactions that result in improper benefits to
  insiders penalizes the wrong person

4
When do Intermediate Sanctions Apply?

• You need three elements for intermediate
  sanctions to apply
• An excess benefit transaction
• An applicable tax exempt organization
• A disqualified person
• When an applicable tax exempt organization
  engages in an excess benefit transaction with a
  disqualified person, the IRS can invoke
  intermediate sanctions

5
What is an Excess Benefit Transaction?

• A transaction in which an applicable tax exempt
  organization provides an economic benefit to a
  disqualified person and the value of the economic
  benefit provided exceeds the value of the
  consideration received
• Must take into account
• All consideration and benefits
• Whether exchanged by or with the applicable tax
  exempt organization or any entity that
  organization controls

6
What is an Applicable Tax Exempt Organization?

• An IRC 501(c)(3) public charity
• Does not include a private foundation
• Does not include governmental entities not
  subject to tax
• Does not include public colleges and universities
• An IRC 501(c)(4) social welfare organization

7
Who is a Disqualified Person?

• Any person in a position to exercise substantial
  influence over the affairs of an applicable tax
  exempt organization at any time during the
  five-year period ending on the date of the
  transaction

8
Who is a Disqualified Person?

• The statute identifies certain per se
  disqualified persons and certain persons deemed
  not to be disqualified persons
• Classification of anyone else as a disqualified
  person is based on all the facts and circumstances

9
Who is a Disqualified Person?

• Examples of per se disqualified persons
• Voting members of the organization's governing
  body
• Presidents
• CEOs
• COOs
• Treasurers
• CFOs
• Any person holding the powers, responsibilities,
  or interests of someone in these positions

10
Who is a Disqualified Person?

• A family member of a disqualified person, e.g.,
  the spouse of the president
• Corporations, if more than 35 of the voting
  rights are owned by disqualified persons
• Partnerships, if more than 35 of the profits
  interests are owned by disqualified persons
• Trusts or estates, if more than 35 of the
  beneficial interests are owned by disqualified
  persons

11
Who is not a Disqualified Person?

• Another tax exempt charity
• Non-highly compensated employees of an applicable
  tax exempt organization, i.e., employees making
  less than approximately 80,000 per year (if not
  otherwise described as a disqualified person)

12
Who is a Disqualified Person?

• Generally a person who is (or was during the
  five-year look back period) in a position to
  exercise substantial influence over the
  organizations affairs
• Facts and circumstances govern
• Regulations contain guidance on the specific
  facts and circumstances that tend to show
  substantial influence and those that do not

13
Who is a Disqualified Person?

• Factors tending to show that a person is a
  disqualified person
• The persons compensation is based primarily on
  revenues derived from activities of the
  organization, or of a particular department or
  function of the organization, that the person
  controls
• The person has authority to control or determine
  a substantial portion of the organizations
  capital expenditures, operating budget, or
  compensation for employees

14
Who is a Disqualified Person?

• Factors tending to show that a person is a
  disqualified person
• The person manages a discrete segment or activity
  of the organization that represents a substantial
  portion of the activities or income/expense of
  the organization

15
What is the Penalty Tax?

• On the disqualified person
• First tier tax of 25 of the excess of the value
  of the benefit received over the consideration
  provided, i.e., the excess benefit
• Second tier tax of 200 of the excess benefit
• In addition, the excess benefit transaction must
  be corrected
• Second tier tax applies if the IRS issues a
  notice of deficiency for, or assesses, the first
  tier tax before the excess benefit transaction is
  corrected

16
What is the Penalty Tax?

• On the organization manager
• Imposed on any organization manager who knowingly
  participates in or approves an excess benefit
  transaction, unless participation is not willful
  and is due to reasonable cause
• Tax is personal liability to the organization
  manager
• Tax equals 10 of the excess benefit
• Maximum tax among all participating organization
  managers is 10,000 per transaction
• Each participating manager is jointly and
  severally liable
• An individual can be taxed as both a disqualified
  person and an organization manager

17
What Are Examples of Excess Benefit Transactions?

• Payment of excessive compensation
• Purchase of assets by a disqualified person from
  an applicable tax exempt organization at price
  below fair market value
• Purchase of assets by an applicable tax exempt
  organization from a disqualified person at a
  price above fair market value
• Transfer of ownership or use of assets without
  valid consideration

18
What Are Examples of Excess Benefit Transactions?

• Payment of large severance packages
• Below-market loans
• Spousal employment
• Payment of excessive service or transaction fees
  to entities owned by disqualified persons

19
Is There Any Relief?

• Initial contract exception
• Intermediate sanctions do not apply to any fixed
  payment made to a person under an initial
  contract
• Fixed payment amount of cash or property
  specified in the contract or determined by a
  fixed formula specified in the contract to be
  paid in exchange for specified services or
  property
• Initial contract binding written contract
  between an applicable tax exempt organization and
  a person who was not a disqualified
  person immediately before entering the contract

20
Is There Any Relief?

• Initial contract exception
• Material changes to the contract cause the
  contract to be treated as a new one as of the
  date of the material change
• Material change includes most extensions or
  renewals of the contract

21
Is There Any Relief?

• The rebuttal presumption
• Payments under a compensation arrangement or in
  exchange for property are presumed to be at fair
  market value if the following three conditions
  are satisfied
• The transaction is approved in advance by an
  authorized body comprised entirely of individuals
  who do not have a conflict of interest with
  respect to the transaction
• The authorized body obtained and relied on
  appropriate data as to comparability prior to
  making its determination and
• The authorized body contemporaneously documented
  the basis for its determination

22
Is There Any Relief?

• The rebuttal presumption
• If the three described conditions are met, the
  IRS can rebut the presumption only if it compiles
  sufficient contrary evidence to negate the
  probative value of the comparability data relied
  on by the approving body
• The presumption applies to all payments made
  under a contract authorized by the rebuttal
  presumption procedures
• Failure to follow the rebuttal presumption
  procedures creates no negative or positive
  inference about the transaction

23
Is There Any Relief?

• Reasoned written opinions
• Organization managers can avoid intermediate
  sanctions liability for approving transactions
  with disqualified persons if they rely on a
  reasoned written opinion of a professional when
  they approve the transaction
• Full disclosure of the facts of the transaction
  must be made to the opining professional
• The opinion must be within the professionals
  expertise
• The absence of a professional opinion creates no
  negative or positive inference about the
  transaction

24
What Can be Done to Avoid Intermediate Sanctions?

• Use the initial contract exception whenever
  practicable
• Consider longer term initial contracts to protect
  payments as long as practicable
• Use valuations or comparability studies before
  entering into transactions with disqualified
  persons
• Utilize the rebuttal presumption procedures
  whenever practicable or rely on written
  professional opinions
• Educate your board about the potential excise tax
  personal liability

25
What Can be Done to Avoid Intermediate Sanctions?

• Use caps or ceilings to prevent runaway benefits
• Structure compensation elements to achieve
  objectives for the organization
• Adopt and enforce a conflict of interest policy