Excerpts From Proposed I.R.S. Rules on Excess Compensation at Charities

Following are excerpts from the Internal Revenue Service’s explanation of its proposal to carry out a 1996 federal law that allows the agency to impose penalties on charity officials, trustees, and others who receive overly lucrative financial benefits through their association with charitable organizations. The explanation defines who is covered by the law — referred to in the law as “disqualified persons.”

Taxes onexcess-benefit transactions

The proposed regulations describe the three taxes imposed under Section 4958 on excess-benefit transactions between an applicable tax-exempt organization and a disqualified person. Two of the taxes are paid by certain disqualified persons who benefit economically from a transaction, and the other tax is paid by certain organization managers who participate in the transaction knowingly, willfully, and without reasonable cause.

A disqualified person who receives an excess benefit from a transaction is liable for a tax equal to 25 per cent of the excess benefit. If the excess benefit is not corrected within the taxable period, that disqualified person is then liable for a tax of 200 per cent of the excess benefit. “Taxable period” is defined as the period beginning on the date the transaction occurs and ending on the earlier of the date of mailing a notice of deficiency for the 25-per-cent tax or the date on which the 25-per-cent tax is assessed.

“Correction” is defined in the proposed regulations as undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person had been dealing under the highest fiduciary standards. Correction of the excess benefit occurs if the disqualified person repays the applicable tax-exempt organization an amount of money equal to the excess benefit, plus any additional amount needed to compensate the organization for the loss of the use of the money or other property during the period commencing on the date the excess-benefit transaction occurs and ending on the date the excess benefit is corrected. Correction may also be accomplished, in certain circumstances, by returning property to the organization and taking any additional steps necessary to make the organization whole. If the excess-benefit transaction consists of the payment of compensation for services under a contract that has not been completed, termination of the employment or independent contractor relationship between the organization and the disqualified person is not required in order to correct. However, the terms of any ongoing compensation arrangement may need to be modified to avoid future excess-benefit transactions. If the excess benefit is corrected within the correction period, then under the rules of Section 4961 the 200-per-cent tax under Section 4958(b) is not assessed. If the excess benefit is corrected within the correction period and it is established to the satisfaction of the Secretary [of the Treasury] that the excess benefit transaction was due to reasonable cause and not to willful neglect, then under the rules of Section 4962 the 25-per-cent tax under Section 4958(a)(1) will be abated.

Each organization manager who participated in the excess-benefit transaction, knowing that it was such a transaction, unless such participation was not willful and was due to reasonable cause, is liable for a tax equal to 10 per cent of the excess benefit, not to exceed an aggregate amount of $10,000 with respect to any one excess-benefit transaction. An organization manager is, with respect to any applicable tax-exempt organization, any officer, director, or trustee of such organization, or any individual having powers or responsibilities similar to those of officers, directors, or trustees of the organization. Independent contractors, acting in a capacity as attorneys, accountants, and investment managers and advisers, are not officers. Any person who has authority merely to recommend particular administrative or policy decisions, but not to implement them without approval of a superior, is not an officer. An individual who is not an officer, director, or trustee, yet serves on a committee of the governing body of an applicable tax-exempt organization that is invoking the rebuttable presumption of reasonableness (described later in this section) based on the committee’s action, however, is an organization manager for purposes of the 10-per-cent tax.

The definitions provided in the proposed regulations for the terms participation, knowing, willful, and due to reasonable cause with respect to organization managers for Section 4958 purposes parallel the definitions of those terms used with respect to foundation managers in the Section 4941 regulations. If an organization manager, after full disclosure of the factual situation to legal counsel (including in-house counsel) relies on the advice of such counsel expressed in a reasoned written legal opinion that a transaction is not an excess-benefit transaction under Section 4958, that manager’s participation in such transaction will ordinarily not be considered knowing or willful, and will ordinarily be considered due to reasonable cause, even if the transaction is subsequently held to be an excess-benefit transaction.

With respect to any specific excess-benefit transaction, if more than one person is liable for any of the taxes imposed by Section 4958, all persons with respect to whom a particular tax is imposed are jointly and severally liable for that tax. For instance, if more than one disqualified person benefits from the same transaction, all the benefitting disqualified persons are jointly and severally liable for the respective Section 4958(a)(1) or (b) taxes on that transaction. Where an organization manager also receives an excess benefit from an excess-benefit transaction, the manager may be liable for both taxes imposed by Section 4958(a).

Except as otherwise provided in the proposed regulations, a transaction occurs on the date on which a disqualified person receives an economic benefit from the applicable tax-exempt organization for federal-income-tax purposes. In the case of payment of deferred compensation, the transaction occurs on the date the deferred compensation is earned and vested.

The proposed regulations cross-reference Sections 6501(e)(3) and 6501(l) and the regulations thereunder, as amended, for statute-of-limitations rules for Section 4958 excise taxes. Thus, the statute of limitations for imposition of tax under Section 4958 generally begins to run as of the date the applicable tax-exempt organization files its return (Form 990) for the year in which the excess-benefit transaction occurred.

The proposed regulations provide that the taxes imposed on excess-benefit transactions apply to transactions occurring on or after September 14, 1995. However, these taxes do not apply to a transaction pursuant to a written contract that was binding on September 13, 1995, and at all times thereafter before the transaction occurred. A written binding contract that is terminable or subject to cancellation by the applicable tax-exempt organization without the disqualified person’s consent is treated as a new contract as of the date that any such termination or cancellation, if made, would be effective. If a binding written contract is materially modified (including situations in which the contract is amended to extend its term or to increase the amount of compensation payable to the disqualified person), it is treated as a new contract entered into as of the date of the material modification.

Definition of applicable tax-exempt organization

The proposed regulations generally define an applicable tax-exempt organization as any organization that, without regard to any excess benefit, is or would have been described in Sections 501(c)(3) or (4) and exempt from tax under Section 501(a) at any time during a five-year period ending on the date of an excess-benefit transaction (the lookback period). In the specific case of any transaction occurring before September 14, 2000, the lookback period begins on September 14, 1995, and ends on the date of the transaction.

To be described in Section 501(c)(3) for purposes of Section 4958, an organization must meet the requirements of Section 508 (subject to any applicable exceptions provided by that section). A private foundation as defined in Section 509(a) is not an applicable tax-exempt organization for Section 4958 purposes. An organization that has applied for and received recognition of exemption as an organization described in Section 501(c)(4) is an applicable tax-exempt organization for Section 4958 purposes. In addition, an organization that has sought to take advantage of Section 501(c)(4) status by filing an application for recognition of exemption under Section 501(c)(4) with the I.R.S., filing an information return as a Section 501(c)(4) organization under the [Internal Revenue] Code or regulations promulgated thereunder, or otherwise holding itself out as being described in Section 501(c)(4), is an applicable tax-exempt organization for Section 4958 purposes.

A foreign organization that receives substantially all of its support from sources outside of the United States is not an applicable tax-exempt organization for Section 4958 purposes. Section 4948(b) generally states that Chapter 42 taxes, including Section 4958 taxes on excess-benefit transactions, do not apply to any foreign organization that has received substantially all of its support from sources outside the United States. Definition of disqualified person

The proposed regulations define a disqualified person as a person who, with respect to any transaction with an applicable tax-exempt organization, at any time during a five-year period beginning after September 13, 1995, and ending on the date of such transaction, was in a position to exercise substantial influence over the affairs of the organization. Certain persons are statutorily defined to be disqualified persons under Section 4958(f), including certain family members of disqualified persons (spouse, brothers, or sisters, by whole or half blood; spouses of brothers or sisters, by whole or half blood; ancestors; children; grandchildren; great-grandchildren; and spouses of children, grandchildren, and great-grandchildren), and 35-per-cent controlled entities (a corporation in which a disqualified person owns more than 35 per cent of the combined voting power; a partnership in which a disqualified person owns more than 35 per cent of the profit’s interest; or a trust or estate in which a disqualified person owns more than 35 per cent of the beneficial interest).

The proposed regulations specifically identify certain persons as having substantial influence over the affairs of an applicable tax-exempt organization. These specified persons include any individual who serves as a voting member on the governing body of the organization; any individual or individuals who have the power or responsibilities of the president, chief executive officer, or chief operating officer of an organization; any individual or individuals who have the power or responsibilities of treasurer or chief financial officer of an organization; and any person who has a material financial interest in certain provider-sponsored organizations in which a hospital that is an applicable tax-exempt organization participates.

The proposed regulations deem two categories of persons not to have substantial influence over the affairs of an applicable tax- exempt organization. The first category comprises other applicable tax-exempt organizations described in Section 501(c)(3). The second category comprises any employee who, for the taxable year in which the benefits are provided, receives economic benefits, directly or indirectly from the organization, of less than the amount of compensation referenced for a highly compensated employee in Section 414(q)(1)(B)(i), who is not a statutorily defined disqualified person and not specifically identified by the regulations as having substantial influence, and is not a substantial contributor to the organization within the meaning of Section 507(d)(2).

The proposed regulations provide that except as specified in the categories set forth in the statute or the preceding parts of the regulation, the determination of whether a person has substantial influence over the affairs of an organization is based on all relevant facts and circumstances. A person who has managerial control over a discrete segment of an organization may nonetheless be in a position to exercise substantial influence over the affairs of the entire organization. Facts and circumstances tending to show that a person has substantial influence over the affairs of an organization include, but are not limited to, the following: that the person founded the organization; that the person is a substantial contributor (within the meaning of Section 507(d)(2) ) to the organization; that the person’s compensation is based on revenues derived from activities of the organization that the person controls; that the person has authority to control or determine a significant portion of the organization’s capital expenditures, operating budget, or compensation for employees; that the person has managerial authority or serves as a key adviser to a person with managerial authority; or that the person owns a controlling interest in a corporation, partnership, or trust that is a disqualified person.

Facts and circumstances tending to show that a person does not have substantial influence over the affairs of an organization include but are not limited to, the following: that the person has taken a bona fide vow of poverty as an employee, agent, or on behalf of a religious organization; that the person is an independent contractor, such as an attorney, accountant, or investment manager or adviser, acting in that capacity, unless the person is acting in that capacity with respect to a transaction from which the person might economically benefit either directly or indirectly (aside from fees received for the professional services rendered); and that any preferential treatment a person receives based on the size of that person’s donation is also offered to any other donor making a comparable contribution as part of a solicitation intended to attract a substantial number of contributions.

In the case of multiple organizations affiliated by common control or governing documents, the deter mination of whether a person does or does not have substantial influence will be made separately for each applicable tax-exempt organization. Excess-benefit transaction

The proposed regulations state that an excess-benefit transaction is any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to, or for the use of, any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit. An excess-benefit transaction also includes certain revenue-sharing transactions (described later in this section). A benefit can be provided indirectly if it is provided through one or more entities controlled by or affiliated with the applicable tax-exempt organization.

Certain economic benefits provided by an applicable tax-exempt organization to a disqualified person are disregarded for purposes of Section 4958. These include paying reasonable expenses for members of the governing body of an applicable tax-exempt organization to attend meetings of the governing body of the organization, not including expenses for luxury travel or spousal travel; an economic benefit provided to a disqualified person that the disqualified person receives solely as a member of, or volunteer for, the organization, if the benefit is provided to members of the public in exchange for a membership fee of $75 or less per year; and an economic benefit provided to a disqualified person that the disqualified person receives solely as a member of a charitable class the applicable tax-exempt organization intends to benefit.

The proposed regulations provide that the payment of a premium for an insurance policy providing liability insurance to a disqualified person to cover any taxes imposed under this section or indemnification of a disqualified person for such taxes by an applicable tax-exempt organization is not an excess-benefit transaction if the premium or the indemnification is treated as compensation to the disqualified person when paid, and the total compensation paid to the disqualified person is reasonable.

The proposed regulations provide that if the amount of the economic benefit provided by the applicable tax-exempt organization exceeds the fair market value of the consideration, the excess is the excess benefit on which tax is imposed by Section 4958. Rules concerning the excess benefit in certain revenue-sharing transactions are described later in this section. The fair market value of property is the price at which property or the right to use property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy, sell, or transfer property or the right to use property, and both having reasonable knowledge of relevant facts. Compensation

Compensation for the performance of services is reasonable only if it is an amount that would ordinarily be paid for like services by like enterprises under like circumstances. Generally, the circumstances to be taken into consideration are those existing at the date when the contract for services was made. However, where reasonableness of compensation cannot be determined based on circumstances existing at the date when the contract for services was made, then that determination is made based on all facts and circumstances, up to and including circumstances as of the date of payment. In no event shall circumstances existing at the date when the contract is questioned be considered in making a determination of the reasonableness of compensation. A written binding contract that is terminable or subject to cancellation by the applicable tax-exempt organization without the disqualified person’s consent is treated as a new contract as of the date that any such termination or cancellation, if made, would be effective. If a binding written contract is materially modified (which includes amending the contract to extend its term or increase the amount of compensation payable to the disqualified person), it is treated as a new contract entered into as of the date of the material modification. Examples illustrate whether the reasonableness of compensation can be determined based on circumstances existing at the time a contract for the performance of services was made. In accordance with the legislative history, the fact that a state or local legislative or agency body has authorized or approved a particular compensation package paid to a disqualified person is not determinative of the reasonableness of compensation paid for purposes of Section 4958 excise taxes. Under the proposed regulations, the fact that a particular compensation package is authorized or approved by a court also is not determinative of the reasonableness of compensation paid to a disqualified person.

Compensation for purposes of Section 4958 includes all items of compensation provided by an applicable tax-exempt organization in exchange for the performance of services by a disqualified person. These items of compensation include, but are not limited to, all forms of cash and non-cash compensation, including salary, fees, bonuses, and severance payments paid, and all forms of deferred compensation that is earned and vested, whether or not funded, and whether or not paid under a deferred compensation plan that is a qualified plan under Section 401(a). If deferred compensation for services performed in multiple prior years vests in a later year, then that compensation is attributed to the years in which the services were performed. Compensation also includes the amount of premiums paid for liability or any other insurance coverage, as well as any payment or reimbursement by the organization of charges, expenses, fees, or taxes not covered ultimately by the insurance coverage; all other benefits, whether or not included in income for tax purposes, including payments to welfare-benefit plans on behalf of the disqualified persons, such as plans providing medical, dental, life insurance, severance pay, and disability benefits, and both taxable and non-taxable fringe benefits (other than working condition fringe benefits described in Section 132(d) and de minimis fringe benefits described in Section 132(e) ), including expense allowances or reimbursements or foregone interest on loans that the recipient must report as income on his separate income-tax return; and any economic benefit provided by the applicable tax-exempt organization directly or indirectly through another entity, owned, controlled by, or affiliated with the applicable tax-exempt organization, whether such other entity is taxable or tax-exempt.

An economic benefit that an applicable tax-exempt organization provides to, or for the use of, a disqualified person is not treated as consideration for the performance of services unless the organization clearly indicates its intent to treat the benefit as compensation when the benefit is paid. An applicable tax-exempt organization will be treated as having intended to provide an economic benefit as compensation for services only if it provides clear and convincing evidence of having that intent when the benefit was paid. An applicable tax-exempt organization can provide clear and convincing evidence of such intent by reporting the economic benefit as compensation on original or amended federal-tax-information returns with respect to the payment (e.g., Form W-2 or 1099) or with respect to the organization (e.g., Form 990), filed before the commencement of an I.R.S. examination in which the reporting of the benefit is questioned. For purposes of Section 4958 and these proposed regulations, an I.R.S. examination of an applicable tax-exempt organization has commenced if the organization has received written notification from the Exempt Organizations Division of an impending Exempt Organizations examination, or written notification of an impending referral for an Exempt Organizations examination, and also includes having been under an Exempt Organizations examination that is now in Appeals or in litigation for issues raised in an Exempt Organizations examination of the period in which the excess-benefit transaction occurred. Reporting of an economic benefit to provide clear and convincing evidence of intent is also accomplished if the recipient disqualified person reports the benefit as income on the person’s Form 1040 for the year in which the benefit is received. If the amount of an economic benefit paid to a disqualified person is not reported and should have been reported on any information return issued by the applicable tax-exempt organization, and the failure to report was due to reasonable cause as defined under Section 6724 regulations, then the organization is deemed to satisfy the clear and convincing evidence requirement. To show that its failure to report an economic benefit that should have been reported on an information return was due to reasonable cause, the applicable tax-exempt organization must establish that there are significant mitigating factors with respect to its failure to report, or the failure arose from events beyond the organization’s control, and the organization acted in a responsible manner both before and after the failure occurred. If an organization fails to provide clear and convincing evidence that it intended to provide an economic benefit as compensation for services when paid, any services provided by the disqualified person will not be treated as provided in consideration for the economic bene fit. Transaction in which amount of economic benefit is determined in whole or in part by the revenues of one or more activities of the organization

The proposed regulations apply a facts-and-circumstances test to assess whether a transaction in which the amount of an economic benefit provided by an applicable tax-exempt organization to or for the use of a disqualified person is determined in whole or in part by the revenues of one or more activities of the applicable tax-exempt organization (revenue-sharing transaction) results in inurement, and therefore constitutes an excess-benefit transaction. A revenue-sharing transaction may constitute an excess-benefit transaction regardless of whether the economic benefit provided to the disqualified person exceeds the fair market value of the consideration provided in return if, at any point, it permits a disqualified person to receive additional compensation without providing proportional benefits that contribute to the organization’s accomplishment of its exempt purpose. If the economic benefit is provided as compensation for services, relevant facts and circumstances include, but are not limited to, the relationship between the size of the benefit provided and the quality and quantity of the services provided, as well as the ability of the party receiving the compensation to control the activities generating the revenues on which the compensation is based.

The type of revenue-sharing transaction described in the proposed regulations constitutes an excess-benefit transaction if it occurs on or after the date of publication of final regulations. The excess benefit in such a transaction consists of the entire economic benefit provided. Any revenue-sharing transaction occurring after September 13, 1995, may still constitute an excess-benefit transaction if the economic benefit provided to the disqualified person exceeds the fair market value of the consideration provided in return. Before the date of publication of final regulations, however, the excess benefit shall consist only of that portion of the economic benefit that exceeds the fair market value of the consideration provided in return. Examples are provided of revenue-sharing transactions that do and do not constitute excess-benefit transactions. Rebuttable presumption that transaction is not an excess-benefit transaction

The proposed regulations provide that a compensation arrangement between an applicable tax-exempt organization and a disqualified person is presumed to be reasonable, and a transfer of property, a right to use property, or any other benefit or privilege between an applicable tax-exempt organization and a disqualified person is presumed to be at fair market value, if three conditions are satisfied. The three conditions are as follows: (1) the compensation arrangement or terms of transfer are approved by the organization’s governing body or a committee of the governing body composed entirely of individuals who do not have a conflict of interest with respect to the arrangement or transaction; (2) the governing body, or committee thereof, obtained and relied upon appropriate data as to comparability prior to making its determination; and (3) the governing body or committee adequately documented the basis for its determination concurrently with making that determination. The presumption established by satisfying these three requirements may be rebutted by additional information showing that the compensation was not reasonable or that the transfer was not at fair market value.

To the extent permitted under local law, the governing body of an applicable tax-exempt organization may authorize other parties to act on its behalf by following specified procedures that satisfy the three requirements for invoking the rebuttable presumption of reasonableness. An arrangement or transaction that is subsequently approved by the board’s designee or designees in accordance with those procedures shall be subject to the rebuttable presumption even though the governing body does not vote separately on the specific arrangement or transaction.

With respect to the first requirement, the proposed regulations provide that the governing body is the board of directors, board of trustees, or equivalent controlling body of the applicable tax-exempt organization. A committee of the governing body may be composed of any individuals permitted under state law to serve on such a committee, and may act on behalf of the governing body to the extent permitted by state law. However, any members of such a committee who are not members of the governing body are deemed to be organization managers for purposes of the tax imposed by Section 4958(a)(2) if the organization is invoking the rebuttable presumption based on the actions of the committee. A person is not included on an organization’s governing body or committee thereof when the governing body or committee is reviewing a transaction if that person meets with the other members only to answer questions, and otherwise recuses himself from the meeting and is not present during debate and voting on the transaction or compensation arrangement.

The proposed regulations provide that a member of the governing body, or committee thereof, does not have a conflict of interest with respect to a compensation arrangement or transaction if the member is not the disqualified person and is not related to any disqualified person participating in or economically benefiting from the compensation arrangement or transaction; is not in an employment relationship subject to the direction or control of any disqualified person participating in or economically benefiting from the compensation arrangement or transaction; is not receiving compensation or other payments subject to approval by any disqualified person participating in or economically benefiting from the compensation arrangement or transaction; has no material financial interest affected by the compensation arrangement or transaction; and, as prescribed in the legislative history, does not approve a transaction providing economic benefits to any disqualified person participating in the compensation arrangement or transaction, who in turn has approved or will approve a transaction providing economic benefits to the member. An arrangement or transaction has not been approved by a committee of a governing body if, under the governing documents of the organization or state law, the committee’s decision must be ratified by the full governing body in order to become effective.

With respect to the second requirement for the rebuttable presumption of reasonableness, the proposed regulations provide that a governing body or committee has appropriate data on comparability if, given the knowledge and expertise of its members, it has information sufficient to determine whether a compensation arrangement will result in the payment of reasonable compensation or a transaction will be for fair market value. Relevant information 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 geographic area of the applicable tax-exempt organization; independent compensation surveys compiled by independent firms; actual written offers from similar institutions competing for the services of the disqualified person; and independent appraisals of the value of property that the applicable tax-exempt organization intends to purchase from, or sell or provide to the disqualified person.

A special rule is provided for organizations with annual gross receipts of less than $1-million. Under this rule, when the governing body reviews compensation arrangements, it will be considered to have appropriate data as to comparability if it has data on compensation paid by five comparable organizations in the same or similar communities for similar services. No inference is intended with respect to whether circumstances falling outside this safe harbor will meet the requirements with respect to the collection of appropriate data.

For purposes of the third requirement of the rebuttable presumption of reasonableness under the proposed regulations, to be documented adequately, the written or electronic records of the governing body or committee must note the terms of the transaction that was approved and the date it was approved; the members of the governing body or committee who were present during debate on the transaction or arrangement that was approved and those who voted on it; the comparability data obtained and relied upon by the committee and how the data was obtained; and the actions taken with respect to consideration of the transaction by anyone who is otherwise a member of the governing body or committee but who had a conflict of interest with respect to the transaction or arrangement. If the governing body or committee determines that reasonable compensation for a specific arrangement or fair market value in a specific transaction is higher or lower than the range of comparable data obtained, the governing body or committee must record the basis for its determination. For a decision to be documented concurrently, records must be prepared by the next meeting of the governing body or committee occurring after the final action or actions of the governing body or committee are taken. Records must be reviewed and approved by the governing body or committee as reasonable, accurate, and complete within a reasonable time period thereafter.

If reasonableness of the compensation cannot be determined based on circumstances existing at the date when a contract for services was made, then the rebuttable presumption cannot arise until circumstances exist so that reasonableness of compensation can be determined, and the three requirements for the presumption subsequently are satisfied.

The fact that a transaction between an applicable tax-exempt organization and a disqualified person is not subject to the presumption described in this section shall not create any inference that the transaction is an excess-benefit transaction. Neither shall the fact that a transaction qualifies for the presumption exempt or relieve any person from compliance with any federal or state law imposing any obligation, duty, responsibility, or other standard of conduct with respect to the operation or administration of any applicable tax-exempt organization. The rebuttable presumption applies to all payments made or transactions completed in accordance with a contract provided that the three requirements of the rebuttable presumption were met at the time the contract was agreed upon.