Excess Benefit Transactions Under Section 4958 And Revocation Of Tax-Exempt Status by David A. Levitt When charities are generous to the wrong people, they risk losing their tax-exempt status. The InTernal revenue ServIce has issued final income tax regulations clarifying the substantive re- quirements for tax exemption under section 501(c)(3) of the Internal Revenue Code (all section references herein are to the Code) and the imposition of section 4958 ex- cise taxes on excess benefit transactions. In addition to excise taxes that may be imposed under section 4958, the Internal Revenue Service may also revoke the tax-exempt status of an organization in appropriate circumstances. This article reviews the final regulations, effective March 28, 2008, that provide the framework by which the IRS will determine whether one or more excess benefit trans- actions are sufficient grounds for revocation of a section 501(c)(3) charitable organization’s tax-exempt status. David A. Levitt David A. Levitt is a principal in the San Francisco Section 4958: intermediate SanctionS • law firm of Adler & Colvin. He is Co-Chair of the Section 501(c)(3) sets forth the requirements for qualifying Subcommittee on Intermediate Sanctions of as a tax-exempt charitable organization. The statute spe- the ABA Tax Section’s Exempt Organizations Committee and a member of the California cifically requires that “no part of the net earnings of [the Association of Nonprofits Policy Council. organization] inure to the benefit of any private share- holder or individual....” This prohibition on private inure- ment is interpreted by the IRS to mean that a tax-exempt charitable organization may not improperly transfer its financial resources to any insider of the organization. The Practical Tax Lawyer | 13 14 | The Practical Tax Lawyer Spring 2009 Before the addition of section 4958, the only disqualified Persons penalty the IRS could impose upon discovering “Disqualified persons” are persons who are, or instances of private inurement was revocation of in the previous five years before the transaction in an organization’s tax-exempt status. Revocation question have been, in a position to exercise sub- is a harsh outcome for any charity and may not stantial influence over the organization’s affairs. be appropriate under the circumstances. In addi- The definition includes the organization’s directors tion, when a charity’s tax exemption is revoked, as well as certain officers and key employees. Dis- ultimately it is the charity and its beneficiaries that qualified persons also include such persons’ family members (e.g., spouses, children, grandchildren, suffer, rather than the insiders who improperly ben- ancestors, brothers, and sisters) and an entity that efited. is more than 35 percent controlled by disqualified Section 4958 provides the IRS with a less dra- persons. Other persons may also exercise substan- conian alternative to revocation of exempt status, tial influence over the charity’s activities based on the ability to impose intermediate sanctions on any the facts and circumstances. Such persons could in- “excess benefit transaction” between an applicable clude the founder of the charity, a substantial con- exempt organization and an insider of that orga- tributor to the charity, a person with managerial nization. Applicable exempt organizations include authority over the charity’s operations, or a person section 501(c)(3) charitable organizations, other with control over a significant portion of the char- than private foundations (which are subject to their ity’s budget. own self-dealing rules under section 4941), and sec- tion 501(c)(4) social welfare organizations (which Penalty taxes are not addressed by the new regulations). Section Section 4958 creates a two-tier excise tax on ex- 4958 penalizes those individuals who have improp- cess benefit transactions. A disqualified person who erly benefited from transactions with an applicable benefits from an excess benefit transaction with an organization and, in certain cases, the officers or applicable tax-exempt organization is liable for a directors who have approved the transaction. tax of 25 percent of the excess benefit. The “excess benefit” is the amount by which the value of the excess Benefit transaction consideration provided to the disqualified person An “excess benefit transaction” provides an ex- exceeds the economic benefit provided by the dis- qualified person to the organization in return. If cessive economic benefit to an insider of the orga- the 25 percent tax is imposed on an excess benefit nization, defined under the Code as a “disqualified transaction and the disqualified person does not person.” An excess benefit occurs when the value correct the excess benefit within a certain amount of the benefit provided by the organization exceeds of time, a second tier tax of 200 percent of the ex- the value of what the disqualified person provides cess benefit is imposed on the disqualified person. the organization in return. Excess benefit transac- For example, if a section 501(c)(3) organization was tions often involve compensation of disqualified found to have paid $150,000 to a disqualified per- persons, but also can involve the sale or other trans- son in a transaction for which $100,000 was fair fer of property between a charity and a disqualified market value, the disqualified person would have to person, loans between a charity and a disqualified pay a tax of 25 percent of $50,000, or $12,500 to person, or the use by a disqualified person of a the IRS. In addition, the disqualified person would charity’s assets, including intellectual property. have to return the excess benefit of $50,000 to the Excess Benefit Transactions | 15 organization, or be subject to the added 200 per- nization that engages in one or more excess benefit cent penalty tax ($100,000). transactions will continue to be exempt under sec- Organization managers who participate in an tion 501(c)(3). The final regulations apply with re- excess benefit transaction knowingly, willfully, and spect to excess benefit transactions occurring after without reasonable cause, are liable for a tax of 10 March 28, 2008. 73 Fed. Reg. 16519. percent of the excess benefit. The tax for which In determining whether to continue to recog- all participating organization managers are liable nize the tax-exempt status of a charitable organi- cannot exceed $20,000 for any one excess benefit zation described in section 501(c)(3) that engages transaction. in one or more excess benefit transactions, the final regulations state that the IRS will consider all rel- revocation evant facts and circumstances, including, but not Any transaction resulting in an excess benefit to limited to, the following: a disqualified person is likely also to violate the pro- • The size and scope of the organization’s regu- hibition on private inurement under section 501(c) lar and ongoing activities that further exempt (3). Regardless of whether a particular transaction purposes before and after the excess benefit is subject to tax under section 4958, the existing transaction or transactions occurred; regulations confirm that substantive requirements • The size and scope of the excess benefit trans- for tax exemption under section 501(c)(3) still ap- action or transactions (collectively, if more than ply. The legislative history to section 4958 provides one) in relation to the size and scope of the or- that “intermediate sanctions...may be imposed...in ganization’s regular and ongoing activities that lieu of, or in addition to, revocation of an organi- further exempt purposes; zation’s tax-exempt status.” H. Rep. No. 104-506, • Whether the organization has been involved in 104th Cong., 2d Sess., at 59 (1996). In the pream- multiple excess benefit transactions with one ble to the 2001 temporary regulations interpreting or more persons (in the final regulations, this section 4958, the Service stated that it would ex- factor was revised to substitute the term “mul- ercise its administrative discretion in enforcing the tiple” for the word “repeated.” The Service requirements of section 4958 and section 501(c)(3) clarifies in the preamble that “multiple” refers in accordance with the legislative history and that to both repeated instances of the same or sub- it would publish guidance regarding the factors it stantially similar excess benefit transaction and would consider as it gained more experience in ad- the presence of more than one excess benefit ministering section 4958. 66 Fed. Reg. 2155. We transaction, regardless of whether the transac- now have that additional guidance. tions are the same or substantially similar, and in both cases regardless of whether they involve excISe TaxeS vS. revocaTIon: The the same or different persons); new regulationS • In September 2005, • Whether the organization has implemented the IRS released proposed regulations addressing safeguards that are reasonably calculated to whether revocation of charitable tax-exempt sta- prevent excess benefit transactions; and tus is appropriate when section 4958 excise taxes • Whether the excess benefit transaction has also apply. The final regulations, which add a new been corrected, or the organization has made paragraph (f) to Treas. Reg. §1.501(c)(3)-1, provide good faith efforts to seek correction from the guidance on factors that the IRS will consider in disqualified person(s) who benefited from the determining whether a charitable tax-exempt orga- excess benefit transaction.
Pages to are hidden for
"Excess Benefit Transactions Under Section 4958 And Revocation Of"Please download to view full document