The IRS Issues New Regulations to Enforce ‘Intermediate Sanctions’ Law

By ELIZABETH SCHWINN

More than two years after issuing provisional rules on the topic, the Internal Revenue Service has released more-detailed rules on how it will enforce a law designed to crack down on people who receive improper financial benefits through their involvement with nonprofit groups.

The regulations — which are set to expire in three years — include numerous changes from the provisional rules, made in response to comments by charity officials and others. Tax lawyers say that, in general, the changes will make it easier for nonprofit groups to comply with the law.

An I.R.S. spokesman says that the rules were issued in temporary form, rather than in final form as had been expected, to give people a chance to comment on the changes before the I.R.S. issues permanent ones.

The new rules spell out how the so-called intermediate sanctions law, which was enacted in 1996 and got its first provisional explanatory rules in 1998, will be enforced. Until the law’s passage, the I.R.S. could only punish charitable abuses by revoking a group’s tax exemption, a step the service was reluctant to take because it penalized not only the abusers but also the charity as a whole and the recipients of its services.

The law makes charity executives, board members, and other people closely associated with such organizations individually liable for any improper benefits they might receive. Under the statute, the revenue service may fine charity officials up to 25 percent of the portion of compensation or other benefits it deems excessive. Offenders who fail to repay promptly any amount found to be excessive by the I.R.S. could face a fine of up to 200 percent of the excess benefit. Board members who approved excessive compensation or benefits for others could be subject to a tax of 10 percent of the amount in question, up to $10,000.

More Examples

Marc Owens, who retired last year as director of the I.R.S.’s Exempt Organizations Division, says the changes to the rules should provide comfort to nonprofit groups because they clarify steps they must take to comply with the law and provide a greater number of examples than were found in the provisional version of the rules.

For example, government entities that have applied for and received charity tax status, such as state colleges or hospitals, are now explicitly exempted from the law.

Another change explicitly permits nonprofit officials who receive an overly generous benefit in the form of land, art, or other material goods to return a cash payment covering the portion of the gift that the I.R.S. deems excessive, rather than giving back the property or other items. The rules “eliminate potential difficulties with land titles,” explains Mr. Owens, who now practices law at a Washington firm.

In addition, the new rules now protect charities making a first-time arrangement with an outside consultant, such as a fund-raising company, from falling afoul of the excessive-payments rule. The law will not apply to fixed payments made under a first contract, regardless of whether the I.R.S. might otherwise consider the payment excessive. It will apply to flexible payments, and later contracts with the same party, even under the same terms, would not be covered by the protective rule.

The rule essentially incorporates a 1999 decision by the U.S. Court of Appeals for the Seventh Circuit in United Cancer Council v. Commissioner of Internal Revenue. The court ruled that an outside fund-raising consulting company could not be held liable for receiving overly generous benefits under an initial contract with a charity.

Relying on Consultants

Celia Roady, a Washington lawyer who represents nonprofit groups, says that one important change applies to a provision of the rules that exempts charity officials from paying penalties if they rely on outside help when determining whether the compensation and benefits they offer are reasonable. The provisional rules had said only that charities could rely on the opinion of outside lawyers in making such a determination.

But under the new rules, “You can rely on the opinion of your accountant or compensation consultant, not just on counsel,” Ms. Roady says. She cautions that charities that rely on such an opinion, however, will need to be sure the outside advisers they consult follow steps outlined in the new rules.

The I.R.S. has asked for further comment on specific aspects of the rules, including on whether the regulations should cover people who set up donor-advised funds. Such funds allow donors to obtain a tax deduction when they make gifts to a community foundation or similar charity, and then to recommend how to distribute the money in the future to other charities. In general, the I.R.S. is uncomfortable with the level of control some donors retain, Mr. Owens says.

Absent from the new rules are regulations that specifically deal with “revenue-sharing transactions” — when an employee or other person close to an organization is paid based in whole or in part on the charity’s income. The revenue service has asked for additional comment on the matter.

The rules took effect January 10 and will expire January 9, 2004. The regulations appeared in the January 10 issue of the Federal Register and are available at http://www.access.gpo.gov/su_docs/aces/aces140.html.