IRS Issues Final Rules Telling How to Avoid Penalties for Improper Financial Dealings

The Internal Revenue Service has released final regulations on how it will enforce a federal law that is designed to crack down on people who receive improper financial benefits through their involvement with nonprofit groups.

The final regulations spell out in detail how the IRS will enforce the so-called intermediate-sanctions law, enacted in 1996. They define the terms used in the law, provide examples of how the rules will be applied, and explain the detailed steps charities can take to head off trouble.

The final rules replace temporary guidelines that the IRS issued last year and are generally similar to the previous version.

Among the few changes, the final rules broaden the definition of crimes that the revenue service may prosecute under the law to include theft from or fraud against a charity.

More generally, the law allows the revenue service to levy fines on charity officials who receive inappropriately high salaries or excessively generous perquisites, as well as on trustees who authorize those arrangements.

The penalties included in the law apply to employees and officers who have a substantial influence over the charity, such as top executives and board members. Also covered are the family members of those employees and officers, as well as any businesses in which an employee or officer controls at least 35 percent of the assets.

Officials who get excessive salaries or perquisites can be forced to pay fines, known as excise taxes, equal to 25 percent of the portion of the compensation or other benefit found to be excessive. If the officials who received the excessive salaries or benefits fail to pay the penalties and return the portion of the compensation considered excessive, they could face fines of up to 200 percent of the money they receive improperly.

Board members who approve excessive benefits could be subject to a 10 percent tax on the amount of the excessive benefits they approved, up to $10,000.

Until the law’s passage, the revenue service could punish charitable abuses only by revoking an organization’s tax exemption, a step the IRS was reluctant to take because it would penalize the charity as a whole and the recipients of its services.

Under the final rules, the IRS will presume that a charity official’s pay or perquisites are reasonable if they were approved by a charity board that:

• Was composed entirely of people who did not have a conflict of interest with the person receiving the compensation or other benefits;
• Collected compensation figures for similar nonprofit and for-profit organizations and used them to determine salaries; and
• Maintained written documentation of its analysis.

Some observers contend that the IRS has failed to address an important issue in the rules. Like last year’s temporary guidelines, the final regulations ignore “revenue-sharing transactions” in which an executive’s pay is based in whole or in part on the charity’s income. The IRS eliminated proposed rules governing such transactions after a number of people complained that the requirements were confusing.

However, without rules, executives who receive such incentive compensation run a greater risk of having such arrangements challenged by the IRS because they can’t be sure the arrangements are acceptable, according to Barnaby Zall, a lawyer in Rockville, Md., who specializes in nonprofit issues.

The broadening of the intermediate-sanctions law to include theft and fraud as well as embezzlement is perhaps the most significant change from the temporary guidelines.

Before enactment of the intermediate-sanctions law, it was up to state and local governments to prosecute people who received improper benefits from nonprofit groups. The law changed that by permitting the IRS to prosecute “financial irregularities,” leaving it to the revenue service to define the term. The temporary rules allowed the revenue service to prosecute only embezzlement.

Among other changes from the temporary guidelines is language that more clearly exempts from the intermediate-sanctions law government entities that have received charitable status from the IRS, such as state colleges or hospitals.

The final regulations, which went into effect January 23, appear in the Federal Register. They can be found online at http://www.access.gpo.gov/su_docs/fedreg/a020123c.html, under the heading of the Internal Revenue Service.