LEGAL SERVICES BULLETIN
Gwen Dayton, Vice President and General Counsel March 2001, Volume 1, No. 1
IRS Issues Temporary
Rules on Excess Benefits

On January 10, 2001, the Internal Revenue Service took an unexpected step and published temporary regulations implementing a system of special punitive taxes on transactions involving excessive benefits paid by tax-exempt 501C(3) organizations. The rules took effect immediately and will cease to apply on January 9, 2004.

In 1996, Congress sought to rein in tax-exempt organizations that were providing excessive compensation or benefits to organization insiders by enacting an intermediate sanction rule to the Internal Revenue Code. Prior to 1996, the only sanction available to the IRS in these circumstances was to revoke the organization's tax-exempt status, an extreme step the IRS generally did not want to take. The new regulations allow the IRS to impose excises taxes on certain people who engage in "excess benefit" transactions with section 501C(3) and 501C(4) organizations. The taxes apply to individuals and entities who are "disqualified persons" within the meaning of the regulations and also to organization managers such as directors, trustees and officers.

Who is Affected? The regulations apply to an "excess benefit transaction" between a 501C(3) or 501C(4) tax-exempt organization and any "disqualified persons." Government entities that have obtained 501C(3) or 501C(4) status are not subject to the regulations. The rules also do not apply to 501C(3) organizations that are private foundations.

Disqualified persons. Disqualified persons are people in a position to exercise substantial influence over the tax-exempt organization during the five-year period before the transaction, including the following:

• Persons who qualify by virtue of their position, such as voting members of an organization's governing body, presidents, chief executive officers, treasurers and CFOs.
  
  
• Certain members of their families, and organizations at least 35% controlled by these persons.
  
  
• Any person with a material financial interest in a provider-sponsored organization that includes a tax-exempt hospital.
  
  
• Others who do not qualify by virtue of their position but qualify because the facts and circumstances indicate they exert substantial influence over the organization. A person who manages a discrete segment or activity of an organization that represents a substantial portion of the organization's activities is likely a disqualified person.

Certain persons are specifically identified as not being in a position to exercise substantial influence and therefore not disqualified persons:

• Specified other tax-exempt organizations.
  
  
• Employees who are not highly compensated (under $85,000 annually)

Excess Benefit Transactions. An excess benefit transaction means a transaction in which a covered organization provides an economic benefit to a disqualified person and receives less than the value of the benefit in return.

Multi-entity organizations need to pay particular attention to these regulations as they also include "indirect" transactions. Indirect transactions include transactions through entities that are controlled by the tax-exempt entity or that serve as an intermediary. The regulations also include transactions through intermediaries not controlled by the organization in certain circumstances:

• Where the organization provides an economic benefit to the intermediary;
  
  
• The intermediary provides economic benefits to a disqualified person; and
  
  
• There is evidence of an understanding that the intermediary will transfer property to the disqualified person or the intermediary lacks a significant purpose of its own to make the transfer.

Examples of an excess benefit transaction include:

• Unreasonable compensation or bonuses, including all forms of cash and non-cash compensation.
  
  
• Excessive travel expenses or other benefits.
  
  
• Incentive compensation plans that allow a disqualified person to improperly benefit from the organization's revenues (see “Revenue Sharing”).

Working condition fringe benefits generally are not considered an excess benefit transaction. These benefits include:

• Directors and officers liability insurance premiums.
  
  
• Reimbursement for reasonable expenses of attending board meetings. ("Luxury" travel and the expenses of a spouse's travel would not be disregarded, however.)

Exceptions

• "First bite at the apple." Sanctions do not apply to an initial transaction between a person and an organization. This exception applies only to payments that are fixed at the time of the initial contract. Any bonus payments provided for in the initial contract that require discretion by the organization at a later date may be scrutinized as a possible excess benefit. This exception may be important to hospitals that are recruiting new physicians to the staff.
  
  
• Revenue sharing. The statute passed by Congress provides that "excess benefit transaction" includes a transaction in which the benefit provided to a disqualified person is based partly or in whole on revenue of the organization. The temporary regulations, however, do not address the topic, instead reserving it pending additional review. Until final regulations are issued, revenue sharing arrangements will be evaluated under the general excess benefit transaction rules. Such transactions may be subject to sanction if they result in a disqualified person receiving economic benefit that exceeds the value that the person provides to the organization

Rebuttable Presumption of Reasonableness

Under the regulations, a transaction will be presumed to be reasonable if all the following conditions are met:

1. The compensation arrangement or other transaction is approved in advance by an authorized body of the organization (such as the board or a committee);
   
   
2. The authorized body obtained and relied upon "appropriate data as to comparability" prior to making a decision; and
   
   
3. The authorized body adequately documented the basis for its decision at the time that it was made.

The rules clarify that large organizations (annual gross receipts of more than $1 million) are also allowed to compile their own comparability data without retaining compensation consultants.

Penalties

Both the disqualified person and the tax-exempt organization may be penalized for engaging in an excess benefit transaction.

A disqualified person who benefits from an excess benefit transaction is subject to an initial tax of 25% of the excess benefit. If the person does not correct the transaction by restoring the excess benefit to the organization, the IRS may impose an additional tax of 200% of the excess benefit. "Correction" means "undoing" the excess benefit transaction by, in most cases, paying the organization an amount equal to the excess benefit plus interest.

Organization managers, such as officers, directors and those who exercise general authority on behalf of an organization, may be liable for a tax of 10% of the excess benefit, to a maximum of $10,000.

The regulations allow organization managers to protect themselves from the 10% excise tax by relying on the written, reasoned opinion of legal counsel as well as CPAs, accounting firms and independent valuation experts that a transaction is reasonable.

The above discussion is a summary of the new temporary regulations. The IRS expects to issue final regulations prior to the expiration of these regulations.

Please feel free to contact Gwen Dayton, Vice President and General Counsel, gdayton@oahhs.org, with questions or suggestions for future Legal Services Bulletins.