Excess Benefit Transactions Under Section 4958 And Revocation Of by xdi18574


									               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

                                                      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
                                                          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.

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