Volunteer Legal Handbook Supplement  Excess Benefits Transaction - The Regs

The IRS has issued proposed regulations implementing 26 U.S.C. Section 4958. The proposed regulations were issued on August 4, 1998 in the Federal Register at Volume 63, page 41486. The comment period for the regulations closed on November 2, 1998.

Because these regulations are only proposed and not final, they have not been physically incorporated into the Volunteer Legal Handbook. But please see discussion of the "Excess Benefit Transactions" statute.

Note that because there is a "reach back" under 26 U.S.C. Section 4958 to September 14, 1995, if the proposed regulations are adopted they will apply to transactions you have already undertaken and are taking today.

The proposed regulations and commentary are 20 pages long and fairly complex. A few of the more important issues are addressed here.

1. Kinds of Transactions that Are Regulated
   1. Identiying a Disqualified Person
   2. Identifying an Excess Benefit
2. Finding the "Safe Harbor"
3. Excise Taxes on Violators
   1. Excise Tax on Disqualified Persons
   2. Excise Tax on Organization Managers
4. Required Returns and Statutes of Limitation

1. Kinds of Transactions That Are Regulated.

The excise tax is imposed on "excess benefits" given directly or indirectly to "disqualified persons." So there are two initial issues here: who is a "disqualified person" and what is an "excess benefit."

(a) Identifying a "disqualified person"

A wide variety of persons are identified as "disqualified persons" under the proposed regulations:

Note that many of these criteria are subjective and not objective, so that it can be extremely difficult to determine at the time if the person involved is a "disqualified person." In addition, many of the criteria involve information or issues that may be incapable of determination at the time the board of directors of a nonprofit corporation is acting. For example, it might be impossible to determine in January whether in December a person involved in a transaction that is under scrutiny is a "substantial contributor" under §507(d)(2).

The examples in the proposed regulations demonstrate just how difficult the determination whether a person is a "disqualified person" can be.

Example 7. X is a radiologist employed by U, a large acute-care hospital that is an applicable tax-exempt organization for purposes of section 4958. X has no managerial authority over any part of U or its operations. X gives instructions to staff with respect to the radiology work X conducts, but X does not serve as supervisor to other U employees. X's total compensation package includes nontaxable retirement and welfare benefits and a specified amount of salary. X's compensation is greater than the amount of compensation referenced for a highly compensated employee in section 414(q)(1)(B)(i) in the year benefits are provided. X is not related to any other disqualified person of U. X does not serve on U's governing body or as an officer of U. Although U participates in a provider-sponsored organization (as defined in section 1853(e) of the Social Security Act), X does not have a material financial interest in that organization. Whether X is a disqualified person is determined by all relevant facts and circumstances. X did not found U, and although X makes a modest annual financial contribution to U, the amount of the contribution does not make X a substantial contributor within the meaning of section 507(d)(2). X does not receive compensation based on revenues derived from activities of U that X controls, and has no authority to control or determine a significant portion of U's capital expenditures, operating budget, or compensation for employees. Under these facts and circumstances, X does not have substantial influence over the affairs of U, and therefore X is not a disqualified person with respect to any transaction involving U that provides economic benefits to X directly or indirectly.

Example 8. W is a cardiologist and head of the cardiology department of the same hospital U described in Example 7. W does not serve on U's board and does not serve as an officer of U. W does not have a material financial interest in the provider-sponsored organization (as defined in section 1853(e) of the Social Security Act) in which U participates. W is compensated personally with a salary and retirement and welfare benefits fixed by a three-year renewable employment contract with U. W's annual amount of compensation exceeds the amount referenced for a highly compensated employee in section 414(q)(1)(B)(i). Whether W is a disqualified person is determined by all relevant facts and circumstances. W has managerial authority for the cardiology department. The cardiology department is a principal source of patients admitted to U and consequently a major source of revenue for U. W also has authority to allocate the budget for that department, which includes authority to distribute incentive bonuses among cardiologists according to criteria that he has authority to set. The pool for the bonuses is funded by a portion of U's revenues attributable to the cardiology department. Because of the importance of the cardiology department to U and W's managerial control over that segment of U, W is in a position to exercise substantial influence over the affairs of U. Therefore W is a disqualified person with respect to any transaction involving U that provides economic benefits to W directly or indirectly.

It may prove to be extremely difficult to determine whether a party to a transaction is a "disqualified person" in a specific case.

(b) Identifying an "Excess Benefit"

The proposed regulations also provide some guidance in identifying what is or is not an "excess benefit," although as in the case of a "disqualified person" those standards are distressingly subjective. While broadly an "excess benefit" occurs "when the value of the economic benefit provided exceeds the value of the consideration," §53.4958-4(a), it’s a test that can be exceptionally difficult to apply. Consider the protracted hearings and trials that arise in a well-settled area of the law like property condemnation, where the fair market value is an issue. The task is made more complex still because the economic benefit given must include both direct and indirect benefits.

Certain kinds of economic benefits are not ever treated as "excess benefits" as a matter of regulation and law:

2. "Safe Harbor" for Certain Kinds of Transactions.

The proposed regulations implement the expressed intent of Congress to create a kind of limited "safe harbor" for certain kinds of transactions that would otherwise be impermissible excess benefits transactions. While the requirement of a "safe harbor" was described in the legislative history, it was not described in the statute itself. A "safe harbor" means that the transaction involved does not constitute an "excess benefits transaction" unless the IRS provides information to the contrary; a rebuttable presumption is created in favor of the nonprofit corporation that the transaction does not constitute an improper, excess benefits transaction.

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A "rebuttable presumption" is a rule of evidence. In this case, if the requirements for the "safe harbor" are met, it means the IRS must come forward with evidence to establish that there was an excess benefit, rather than your organization being required to prove there was no such thing.

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Your nonprofit corporation should attempt to satisfy the "safe harbor" requirements in every material transaction, whether it is a salary for a management employee or a transaction involving something other than a routine, minimal purchase. Because it can be impossible to tell with certainty in advance whether the transaction involves an "excess benefit" paid to a "disqualified person," you should assume you may need the rebuttable presumption created by the "safe harbor." To qualify for the "safe harbor," the nonprofit corporation must meet the following requirements:

(a) The compensation arrangement or terms of transfer are approved by the nonprofit corporation’s governing body or a committee of the governing body composed entirely of individuals who do not have a conflict of interest with respect to the transaction (§53.4958-6(d)(1));

(b) The governing body or committee obtained and relied upon appropriate data as to comparability prior to making its determination (§53.4958-6(d)(2)); and

(c) The governing body or committee adequately documented the basis for its determination concurrently with making that determination (§53.4958-6(d)(3)).

The requirements for each element are moderately detailed. For example, a person who has a conflict of interest with regard to the transaction in question may be present when the transaction is under consideration, only to answer questions; that person must recuse themselves from the meeting during both debate and voting on the transaction.

Example: If you are considering the salary for your nonprofit corporation’s executive director, the executive director cannot participate in the salary evaluation, and can appear before the board of directors or committee only to answer questions, and then must leave the room during debate and voting. The minutes of the board of directors or committee must reflect these things.

Perhaps the most troubling issue presented is the requirement that the decision-maker must have "obtained and relied upon appropriate data" as to comparability. In the case of "small organizations" &endash; nonprofit corporations with annual gross receipts of less than $1 million, based on a rolling average over the last three years &endash; you can get by if you have "data on compensation paid by five comparable organizations in the same or similar communities for similar services." For many nonprofit corporations, this requirement will impose a very significant burden.

The requirements for nonprofit corporations with annual receipts in excess of $1 million are much more burdensome, requiring information sufficient to determine whether under the standards at §53.4958-4(b) a compensation arrangement will result in the payment of reasonable compensation or a transaction will be for fair market value. Note in many situations that is a very vague guideline. To meet those requirements, a nonprofit corporation must have "relevant information," which may include:

It’s not at all clear that nonprofit corporations in Alaska, for example, can get the information required of them. While information services will likely meet the needs in larger metropolitan areas, the proof requirements are likely to present grave problems, particularly for mid-sized nonprofit corporations.

And finally, the regulations plainly demonstrate the importance for nonprofits of keeping accurate and comprehensive minutes and records. The requirement is to have "adequately documented" the basis for its determination concurrently with making that determination. The regulations require not only "adequate documentation," they also require the minutes be "concurrent."

There are pretty detailed requirements for the requirement of "adequate documentation." Those requirements include:

Records may be written or electronic.

3. Who’s Liable for Excess Benefits Transactions?

Remember, two sorts of persons are liable for the excise tax imposed under these rules, as described in the Handbook at pages 62-63: the person receiving the "excess benefit" and the person(s) conferring the excess benefit. The extent of liability and the analysis to determine liability are entirely different for the two kinds of persons.

(a) "Disqualified Persons" Receiving "Excess Benefits"

A disqualified person who receives an excess benefit is subject to an initial tax of 25% of the excess benefit conferred. If more than one person received the excess benefit, the liability is joint and several.

If a disqualified person "corrects" the excess benefit by putting the nonprofit corporation into the financial condition it would have been in but for the excess benefit, and does so within the "correction period," then any further tax is abated in the same manner as is the case under private foundation rules §§4961(a) and 4962(a). "Correction" is defined as

[U]ndoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person had been dealing under the highest fiduciary standards.

[§53.4958-1(c)(2)(ii)]

The "correction period" is the interval between the time of the excess benefits transaction and the earlier of mailing a notice of deficiency as to the initial tax or date of assessment of the initial tax.

If the disqualified person fails to correct the excess benefit within the correction period, then the disqualified person is subject to an additional excise tax amounting to 200% of the excess benefit.

(b) "Organization Managers" Conferring "Excess Benefits"

An "organization manager" is liable for an excise tax amounting to 10% of the excess benefit paid to the disqualified person. If more than one person was an "organization manager" with regard to the transaction, then the liability is joint and several. The maximum aggregate liability for any one transaction is $10,000.

An "organization manager" is any officer, director or trustee of an organization or any person having similar powers, regardless of title. A person is considered an organization manager whether they are named to it or whether they "regularly exercise general authority to make administrative or policy decisions on behalf of the organization." A person who has authority merely to make recommendations but not to implement them without approval of a superior is not an organization manager.

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Independent contractors acting in a capacity as attorneys, accountants, investment managers and advisors are not "organization managers." §53.4958-1(d)(2)(B)

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Organization managers are liable if they:

[K]nowingly participated in the excess benefit transaction, unless such participation was not willful and was due to reasonable cause.

[§53.4958-1(d)(1)]. There are at least four key concepts in that statement of liability: "knowingly," "participated," "willful" and "reasonable cause." Viewed the other way, if you are an organization manager and the IRS comes to call, these are your defenses to liability for the excise tax imposed on organization managers.

"Knowingly," includes, in addition to what you would expect, a negligent failure to make reasonable attempts to find out whether the transaction involves an excess benefit. It does not include simply having reason to know, but having reason to know is evidence of "knowingly." [§53.4958-1(d)(4)(ii)]. If you understand that distinction, perhaps you can explain it to me.

"Participated" includes silence or inaction where the organization manager is under a duty to speak or act. An organization manager must oppose the transaction in a manner that is consistent with the fulfillment of the manager’s responsibilities.

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A special note for this defense: you must be able to prove your opposition to the action. Simply voting against it may not be enough, even with a roll call vote, since as a fiduciary you may very well have a duty to disclose the knowledge you have. If you actually knew of the risk that the transaction might confer an "excess benefit," and didn’t tell the other directors, you might be breaching the duty to act consistent with the fulfillment of your duties. And you must be certain the minutes reflect these issues and actions.

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"Willful" means voluntary, conscious and intentional. It does not require that you have the motive of avoiding the restrictions on excess benefits. However, apparently actual knowledge that you are violating the excess benefits rules is not required. I interpret this requirement to mean that ignorance of the excess benefit transaction laws is not a defense, but that, after some level of due diligence, ignorance that the transaction under scrutiny confers an excess benefit is a defense. [§53.4958-1(d)(5)].

"Reasonable cause" is the "prudent person" standard; i.e., you have exercised your responsibility on behalf of the nonprofit corporation with ordinary business care and prudence. [§53.4958-1(d)(6)].

There is a kind of "mini-safe harbor" to the elements of "willful" and "reasonable cause" available where you rely upon the advice of legal counsel. However, to qualify, the "advice of counsel" must meet pretty rigorous standards.

• There must have been full disclosure of the fact situation to legal counsel, including in-house counsel.

• The opinion must be expressed in a written legal opinion, the opinion must address itself to the facts and the applicable law.

• The opinion must apply the facts at hand to the law. An opinion that merely recites the facts and that expresses a conclusion without addressing the application of the law to the facts will be insufficient.

No negative inference may be drawn from the absence of a written opinion of legal counsel by the IRS. [§53.4958-1(d)(7)].

4. What’s the Statute of Limitations for IRS Claims Under These Rules?

The statutes of limitations for IRS claims against the recipients and against organization managers are the general excise tax statutes of limitations. [§53.4958-1(f)]. The excise tax statutes of limitation are at IRC §6501. Under §6501(e)(3), the statute of limitations for IRS claims is six years where the tax return has been filed. However, as is the case with other excise taxes, where no return has been filed there is no statute of limitations. §6501(l).

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