Alliance for Children and Families, October 01, 2002
It’s Time to Get Serious About Intermediate Sanctions
SITUATION: Following a meeting of the executive committee,the board chair recommends a new compensation package for your executive director. The package is described in general terms and quickly approved. As he’s closing his file at the end of the meeting, you overhear him telling another director, “I sure hope no one finds out how much we’re paying her, because I’m sure she’s being paid more than any other nonprofit director in town. It could really backfire on us.”
SITUATION: You find out that your new development director “suggested” to the banquet company that they hire your largest contributor’s wife to manage your annual banquet—the organization’s largest fundraising event of the year. After it is over, you find out that not only was she on the payroll of your event, but she was paid a substantial bonus that was then charged back to your organization.
SITUATION: Your executive director has just purchased a new agency car for himself and asked the CFO to sell his used vehicle to the board chair’s daughter. The CFO agrees, and sells the late-model, fully-loaded car to the 20-year-old for $1,500. The vehicle’s blue book value is $15,000. A bill of sale is quietly buried in the finance office and the car is removed from the agency’s fleet.
In the good old days, shady deals that benefited a tax exempt organization’s insiders rarely led to governmental enforcement action—and for good reason. The IRS had only one weapon—its ability to revoke the organization’s tax-exempt status. We call this the “atom bomb approach” in regulation, because the only penalty available to correct the evil would most certainly annihilate the agency.
In the mid 1990s, Congress adopted what we call “intermediate sanctions.” This new enforcement tool offers the IRS a way to get at the wrongdoers without having to penalize the organization. The sanctions are found at Section 4958 of the Internal Revenue Code.2 Implementing regulations became final this year.3
There are a number of key terms that must be absorbed in order to understand how intermediate sanctions work. What I have presented in this article are only the most general definitions [see page 20] and descriptions. If you want to know how these sanctions work in more detail, I suggest that you download two very helpful documents from the IRS Web site called “Easier Compliance is Goal of New Intermediate Sanction Reg- ulations” and “Rebuttable Presumption Procedure is Key to Easy Intermediate Sanctions Compliance.” Steven Miller, IRS director of exempt organizations, authored both articles.4
How They Work
First, the scheme requires self-reporting. You may not have noticed this, but your Form 990 annual information return now has the following question:
“Line 89b: 501(C)(3) AND 501(C)(4) ORGANIZATIONS. – – Did the organization engage in any section 4958 excess benefit transaction during the year? If “Yes,” attach a statement explaining each transaction.”
Line 89c requires you to enter the “Amount of tax imposed on the organization managers or disqualified persons during the year under sections . . . 4958.” If you have not noticed these additions, please review your most recent Form 990. I am guessing that you answered “no” to the Line 89b question.5
Second, the scheme penalizes the disqualified person (DP) who received the excess benefit and the organization man- ager(s) who knowingly approved it. The disqualified person must do two things as his/her tier-one tax: 1) pay the entire excess benefit back to the organization, and 2) pay an excise tax to the govern- ment of 25 percent of that amount. If the DP fails to pay the excess benefit back in a timely manner, the amount to be returned to the organization—the tier-two tax—increases to 200 percent. The organization managers who knowingly approved the transaction must pay 10 per- cent of the excess benefit as an excise tax, up to a maximum of $10,000.6
Third, intermediate sanctions are designed to be punitive, and they are. Because an excess benefit may span a number of years (as when an executive director receives too much in compensation), the total of tier-one and tier-two taxes can quickly get into the tens, if not hundreds, of thousands of dollars. The same is true if assets are sold. In the first published opinion on intermediate sanctions, the taxes and penalties totaled in the millions.7 Their harshness is intended to encourage compliance, as no one will want to chance their imposition by failing to abide with the law.
Fourth, what constitutes “reasonableness” is a matter of judgment. That means that a transaction’s reasonableness will be based upon the validity of an appraiser’s valuation (of tangible or intangible assets), or a board’s decision as to what constitutes appropriate com- parables (for compensation arrangements). These are “facts and circumstances” tests and they can be very subjective. That is why use of the “rebuttable presumption procedure” is so important—it creates a safe harbor for organizations that use it properly.
What You Can Do
We believe that the IRS is focusing its initial enforcement actions in the health-care field where there have been clear violations of the inurement prohibition, and with egregious and notorious situations—the “low hanging fruit.” With these early cases, the IRS will refine its enforcement approach, further define ambiguous terms, get supportive decisions out of the courts, and generally prepare itself for a broader implementation initiative. Therefore, unless you have obvious excess benefit problems, you most likely will have some time to organize your operations so that you will comply with IRS requirements.
Information on the IRS “Rebuttable Presumption Procedure” form is reproduced in modified format at the lower right of this page. When you read through it, you should begin to understand what the IRS is looking for. If your board has not already evaluated your senior executive’s salary using a format similar to this one, you should probably ask it to do so. The same should be done for any key staff where excess benefit questions might arise. Simi- larly, if there are transactions between any- one else that falls into the description of “disqualified person” (directors and officers, substantial contributors) and your organization, you should re-examine those transactions closely.
If you believe that an excess benefit transaction has occurred but are uncertain of whether or not the IRS would classify it as such, you should get a professional opinion on the issue. The IRS considers any of the following to be within this group: legal counsel (in-house or outside), certified public accountants or accounting firms, or independent qualified valuation experts.