Intermediate Opinions

Charities give preliminary thumbs-up to proposed IRS regulations on financial abuses, but wait for further clarification

The reviews are in: Charities and their lawyers say that the Internal Revenue Service wrote a good first draft of new rules designed to punish people who receive overly generous financial benefits through their involvement with non-profit groups. But the charity representatives have urged the service to do a better job when it issues the final version of the rules.

One of the biggest concerns about the I.R.S.’s proposed regulations is that they could affect the way small charities reach decisions on compensation. Another worry is over how the proposal could affect the relationship between charities and their professional solicitors.

The new rules are designed to carry out a law Congress enacted in 1996 to allow the service to levy fines on charity officials who receive inappropriately high salaries or perquisites, as well on trustees who authorize the arrangements (The Chronicle, August 13). Sweetheart deals involving charity trustees and officers could also lead to financial penalties. The law generally applies to transactions that occurred after September 13, 1995.

The statute’s penalties are often referred to as “intermediate sanctions” because until the law was passed, the I.R.S. had only one way to punish abuses: revoke a charity’s tax exemption. Because that penalized an entire organization and the people who benefited from its services, the agency rarely took that step.

Under the statute’s provisions, the I.R.S. is allowed to force charity officials to pay fines, called excise taxes, equal to 25 per cent of the portion of the compensation or other benefits found to be excessive. If such officials failed to pay the penalties or return the portion of the compensation considered excessive, they could face fines of up to 200 per cent of the money they received improperly. Board members who approved excessive benefits could be subject to a 10-per-cent tax, up to $10,000.

The I.R.S.’s proposed regulations define the terms used in the law, provide examples of how the rules would be applied, and explain the detailed steps that charities could take to head off trouble.

The government received more than four dozen letters with comments, most of which offered detailed legal analyses. The revenue service soon is expected to schedule a public hearing to discuss the matter before it releases final regulations sometime in the next year or so.

Many of those offering comments commended the government’s proposal but asked the I.R.S. to make significant changes. “The proposed regulations are not sufficiently detailed to illustrate or exemplify acceptable norms of behavior for affected persons,” wrote Amber Wong Hsu and William J. Lehrfeld, lawyers in Bethesda, Md.

“While the intermediate-sanction regulations represent a good start in the right direction, they need to provide more protection to tax-exempt organizations that may become the target of unnecessary investigations by revenue agents,” they said. Most charities have “extremely limited funds to spend on lawyers,” added Ms. Hsu and Mr. Lehrfeld. “Their funds should be devoted toward educational or charitable programs, rather than on conflicts with the Internal Revenue Service.”

Many comments received by the I.R.S. focused on a part of the government’s proposal that has implications for all charities: a road map that organizations could follow to stay out of trouble when they set the compensation of top officials.

By following certain steps, organizations would be allowed to establish a so-called rebuttable presumption with the government. The I.R.S. would presume such pay to be reasonable — and not an “excess benefit” — if it was 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 non-profit and for-profit organizations and used them to determine salaries. The government does not spell out how many other groups a charity should compare itself to, but it does say that charities with gross receipts of less than $1-million annually would only have to obtain data from five other “comparable organizations in the same or similar communities.”

* “Documented adequately” the steps it took. For example, if the board decides “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.”

In an example provided in its proposal, the I.R.S. said that a university’s board could be penalized if it set a president’s salary by relying on a national survey of compensation for presidents that did not “divide its data by any measure of university size or other criteria,” and if the board members did not have particular expertise in academic compensation.

The I.R.S. said that it was unlikely that the smallest organizations — those with annual gross receipts of less than $100,000 — would choose to follow the procedures to obtain a rebuttable presumption and thus would not be affected by the added “record-keeping burden” that others would face by trying to meet the standards.

But Barnaby Zall, a lawyer in Rockville, Md., told the revenue service he believes that small groups will feel pressured to comply because their volunteers and donors — as well as I.R.S agents — will expect them to. The rebuttable presumption “will become the standard of performance for exempt organizations,” he wrote.

One way out, said Mr. Zall, is for the I.R.S. to decide not to require small groups to go through all the steps required of larger ones.

“Congress intended to deter and capture those who looted affected organizations,” wrote Mr. Zall. “It did not intend to require smaller organizations to spend their scarce resources on self-protection (comparability studies, legal opinions, and precious board time on reviewing smaller transactions).”

Others also asked the I.R.S. to make changes in its proposal on the rebuttable presumption.

The District of Columbia Bar’s Section of Taxation pointed out that it can be expensive for a charity to follow the service’s guidelines, especially to obtain the necessary data on comparable salaries. To reduce that cost, the I.R.S. should allow charities that follow the procedures to set pay for senior executives to rely on the presumption for five years, “as long as no significant change occurs in the terms and conditions of employment,” wrote Cynthia M. Lewin and Barbara L. Kirschten, officials of the Section of Taxation.

The government was encouraged by Independent Sector, a national coalition of charities and foundations, to allow groups with gross receipts of up to $5-million — rather than the proposed $1-million — to take advantage of the option to obtain data from only five other comparable groups.

“We believe that the $1-million threshold is too low,” Independent Sector said. “It will fail to capture, based on the experience of our members, relatively small tax-exempt organizations that lack the extra resources to hire an independent compensation firm but [which] would be compelled to engage such a firm in order to satisfy this requirement.” The coalition said that the problem is compounded by the fact that for some types of organizations, such as museums, publicly available salary surveys simply do not exist.

Independent Sector also suggested that the threshold be adjusted for inflation in future years.

The penalties included in the intermediate-sanctions law apply to employees and officers who have a substantial influence over the affairs of a charity, such as top executives and board members, who are called “insiders” by lawyers. Also covered by the statute: an insider’s family members and any businesses in which an insider has control of at least 35 per cent of the assets.

The I.R.S.’s proposed regulations were criticized for the way they spelled out what other kinds of people might have substantial influence over organizations.

The government said that it tends not to consider the following people as insiders: an employee who took a vow of poverty; an independent contractor, such as a lawyer, accountant, or investment manager (with some exceptions); and donors who gave significant sums and received preferential treatment from a charity, as long as the organization offered the same treatment to anyone who made a gift of similar size.

On the other hand, those that are considered to have substantial influence include voting members of governing bodies; presidents, chief executive officers, or chief operating officers; and treasurers and chief financial officers.

Others could also be considered insiders, the I.R.S. said, depending on relevant “facts and circumstances.” A person who tends to have “substantial influence” includes someone who founded an organization; is a major donor to a group; has managerial authority or serves as a key adviser to a person with that authority; has authority to control or determine a significant portion of the organization’s capital expenditures, operating budget, or compensation for employees; or received compensation based on revenue stemming from activities of the organization that the person controlled.

The provision on revenue-based pay alarmed the Free Speech Coalition, a McLean, Va., alliance of advocacy groups.

The I.R.S., in a “destructive” move, is trying to catch in its net many of the “outside fund raisers” that non-profit groups hire to help them bring in revenue, the coalition said in a letter submitted by Mark B. Weinberg and William J. Olson, the group’s legal co-counsel. Not every charity or advocacy group “has either the resources or a sufficiently broad focus to compete successfully for large foundation and government grants,” said the coalition. “The proposed regulations would seek to cut off alternative means of survival.”

Others saw the provision as a threat to the way that some charities now pay their own employees. “In large health-care organizations, incentive compensation plans based on individual or work-unit net revenues have been developed (in compliance with current I.R.S. guidance) for whole classes” of workers, said Randal B. Zickgraf of PennState Geisinger Health System. “The result of applying this regulation as it now reads would be that hundreds of employees could qualify [as insiders] merely by being employed by the organization under a compensation arrangement that they did not initiate.”

Several letters to the I.R.S. were concerned with a related part of the proposed rules that explains how some “revenue-sharing transactions” — when an insider’s pay was based in whole or in part on the charity’s income — could be considered improper. Problems could arise, the government said, if the insider could “receive additional compensation without providing proportional benefits that contribute to the organization’s accomplishment of its exempt purpose.”

In a hypothetical example, the I.R.S. said a charity employee who manages the group’s investment portfolio could properly receive a bonus that is based on the percentage of the increase in the value of the portfolio over a year. The reason: The bonus is “an incentive to provide the highest-quality service in order to maximize benefits and minimize expenses” to the charity, the I.R.S. said.

But in another example, the revenue service said that it would have problems if, among other things, a company that runs a charity’s gambling operations gave the charity a percentage of net profits. In this example, the I.R.S. said, the company “controls the activities generating the revenue on which its compensation is based,” as well as the amount the charity is charged for the company’s services. The deal does not provide the company “with an appropriate incentive to maximize benefits and minimize costs” to the charity, the government said, and the company will benefit “whether expenses are high and net revenues are low or expenses are low and net revenues are high.”

Kimberly S. Blanchard, a New York lawyer, wrote the I.R.S. that on this topic the proposed rules are confusing and need to be reworked. “On balance, it is unclear why Treasury believes that revenue-sharing transactions are inherently suspect,” Ms. Blanchard said.

Wrote the Greater Washington Society of Association Executives: “The examples provided do not seem to be particularly helpful. It seems that some further examples of improper arrangements other than bingo-game operators are needed for guidance.”

The Internal Revenue Service’s proposal describes in detail what kinds of compensation it considers to be acceptable and what is out-of-bounds.

Acceptable to the agency, for example, are the reasonable expenses that charities pay to trustees to attend board meetings. But reasonable expenses do not include “luxury travel or spousal travel,” according to the proposed regulations.

Some letters received by the I.R.S. asked the agency to specify as acceptable the reasonable costs of travel for a charity’s top executives — not just board members.

What’s more, the American Cancer Society asked that reimbursement of reasonable travel expenses for spouses of officials be allowed because non-profit groups sometimes “rely upon the development of social and professional relationships to garner donations,” wrote April Savoy-Lewis, associate chief counsel of the society. In these situations, she added, “the presence of executive staff members and their spouses at fund-raising events plays a key role in the development of social relationships and philanthropic efforts.”

Still others were concerned about what the I.R.S. meant by forbidding “luxury travel” without defining the term.

Paul Streckfus, a former revenue-service lawyer who is editor of the EO Tax Journal, said the government should specify an airline’s coach rate as the reasonable amount of reimbursement. “If a board member wishes to travel first class, the additional cost should be borne by the board member,” he wrote.

But the Pittsburgh law firm of Horty, Springer & Mattern suggested that the I.R.S. delete “luxury travel” from its proposal because the term could be construed to preclude anything more expensive than a “super saver” airline ticket or budget hotel. “Members of governing bodies of exempt organizations should not be forced to accept less adequate accommodations when serving exempt organizations than they would normally require for their own business or personal travel,” wrote the firm’s Daniel M. Mulholland. “To do so could discourage them from traveling on behalf of the exempt organization and therefore reduce their effectiveness as board members.”

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The proposed regulations were published in the August 4 issue of the Federal Register, Pages 41,486-506. The proposal can also be found by following the instructions for reading the Federal Register on a government World-Wide Web site at http://www.access.gpo.gov/su_docs/aces/aces140.html.