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The IRS has issued final regulations (T.D. 9390) that clarify the interaction between the substantive requirements for tax exemption under Section 501(c)(3) of the Internal Revenue Code and the so-called “intermediate sanctions” that may be imposed under Code Section 4958 on individuals who engage in “excess benefit transactions” involving tax-exempt organizations. These final regulations replace proposed regulations that were issued in 2005.

An organization may elect to be exempt from federal income tax pursuant to Section 501(c)(3) of the code if it is organized and operated exclusively for religious, charitable, scientific or educational purposes. In addition to this “charitable purpose” requirement, no part of the net earnings of an exempt organization may inure to the benefit of any private individual, no substantial part of an exempt organization’s activities may include attempts to influence legislation, and an exempt organization may not intervene in political campaigns. Any organization that violates these operational rules could have its tax-exempt status revoked by the IRS.

Historically, when faced with an organization that violated any of the operational requirements for tax exemption imposed under Section 501(c)(3), regardless of how de minimus or isolated that violation may have been, the only sanction that could be imposed by the IRS was the revocation of the organization’s tax-exempt status. Since revocation of exempt status could be draconian in certain situations and harmful to the charitable, educational, religious or scientific purposes otherwise served by the organization, the IRS sought revocation of tax-exempt status only in the most egregious circumstances. Accordingly, there was no effective method for enforcing compliance with the requirements of Section 501(c)(3).

In response to this lack of calibrated sanctions, Section 4958 was added to the code by the Taxpayer Bill of Rights II in 1996. Section 4958 imposes excise taxes on transactions that provide excess economic benefits to “disqualified persons” with respect to tax-exempt organizations described in Section 501(c)(3) and Section 501(c)(4) (which organizations are organized as civic leagues). For purposes of these sanctions, an excess benefit is the amount by which the value of an economic benefit provided by a tax-exempt organization directly or indirectly to or for the use of a disqualified person exceeds the value of the consideration (including the performance of services) received by the organization. Typically, excess benefit transactions involve excessive or unauthorized payments of compensation or sales and leases of property for other than fair market value.

A disqualified person with respect to a tax-exempt organization is any person (and the members of that person’s family) who is in a position to exercise substantial influence or control over the affairs of the organization. An entity, more than 35 percent of which is owned or controlled by a disqualified person, will also be treated as a disqualified person.

Section 4958 imposes a 25 percent excise tax on disqualified persons who receive an excess benefit from an exempt organization. In addition, a 10 percent excise tax is imposed on the “manager” of an exempt organization who knowingly participates in an excess benefit transaction. For this purpose, a “manager” includes any officer, director or trustee of an exempt organization or any other person having powers or authority similar to that of an officer, director or trustee. Section 4958 imposes no sanctions directly on exempt organizations.

The legislative history of Section 4958 indicates that these “intermediate sanctions” for excess benefit transactions may be imposed by the IRS in lieu of (or in addition to) the ability of the IRS to revoke an organization’s tax-exempt status. The final regulations continue this approach and indicate that the determination of an organization’s tax-exempt status and the determination of the existence of an excess benefit transaction subject to the excise taxes under Section 4958 are separate determinations, often involving distinct parties, different legal elements and separate processes, even though they may relate to the same facts.

The final regulations provide that in making the determination whether to revoke the tax-exempt status of an organization that engages in one or more excess benefit transactions that violate the prohibition on private inurement or to simply impose the excise taxes under Section 4958 (while preserving the organization’s exempt status), the IRS will consider all relevant facts and circumstances, including but not limited to, the following:

The size and scope of the organization’s regular and ongoing activities that further its exempt purpose before and after the excess benefit transaction occurred;

The size and scope of the excess benefit transaction or transactions in relation to the size and scope of the organization’s regular and ongoing activities that further its exempt purpose;

Whether the organization has been involved in multiple excess benefit transactions with one or more persons;

Whether the organization has implemented safeguards that are reasonably calculated to prevent excess benefit transactions; and

Whether the excess benefit transaction has been corrected or the organization has made good faith efforts to seek correction.

The final regulations state that all of the above factors will be considered in combination with each other and, depending on a particular situation, the IRS may assign greater or lesser weight to some factors than to others. Finally, the regulations state that the factors will weigh more heavily in favor of continuing to recognize the tax-exempt status of an organization where the organization discovers the excess benefit transaction and initiates corrective action before discovery by the IRS.

The final regulations contain six examples of excess benefit transactions and indicate which transactions only give rise to sanctions under Section 4958 and which transactions, based upon the factors listed above, will also result in the revocation of tax-exempt status. These examples involve unreasonable compensation, unauthorized compensation, sales by an exempt organization to a disqualified person for less than fair market value, and business arrangements designed to provide other economic benefits to disqualified persons.

The final regulations addressing the interplay between Sections 501(c)(3) and 4958 highlight both the requirements for tax- exempt status and the various ways these requirements may be violated. In addition, the regulations clarify, to a certain degree, when revocation of exempt status will be deemed appropriate and when the “intermediate” sanctions of Section 4958 may be imposed either together with or in lieu of the revocation of exempt status. Finally, the final regulations emphasize the importance of a well-documented compliance program and voluntary self-correction as a safeguard against loss of tax-exempt status.

MARK L. SILOW is the administrative partner and chief operating officer of Fox Rothschild. Silow formerly was chairman of the firm’s tax and estates department. Silow’s work involves a broad range of commercial and tax matters including business and tax planning, corporate acquisitions and dispositions, real estate transactions, estate planning and employee benefits.

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