November 01, 2000

Intermediate Sanctions for Estate Planners (2000, 14:06)

William H. Caudill

Intermediate Sanctions for Estate Planners

Probate and Property, November/December 2000, Volume 14, Number 6

William H. Caudill
William H. Caudill is a partner with Fulbright & Jaworski, L.L.P. in Houston, Texas.

As part of the Taxpayers Bill of Rights 2, Pub. L. No. 104-168, 110 Stat. 1452 (1996), Congress enacted the "intermediate sanctions" legislation in the form of new Code § 4958. Code § 4958 governs certain transactions between public charities and related individuals or entities.

Before the enactment of Code § 4958, the IRS had few options in punishing public charities that engaged in questionable transactions with related individuals. The private foundation rules found in Code §§ 4940 through 4946 did not apply to public charities by definition. The IRS had no enforcement mechanisms short of revocation of exemption. Therefore, if a public charity engaged in a single questionable transaction, the IRS could either ignore the transaction or revoke the charity's tax-exempt status. "Intermediate sanctions" legislation provides the IRS with the ability to police these improper financial transactions, referred to as "excess benefit transactions," while not resorting to the ultimate punishment of revoking tax-exempt status.

Congress passed Code § 4958 on July 30, 1996, effective retroactively to all excess benefit transactions occurring on or after September 14, 1995. On August 4, 1998, the IRS issued proposed regulations under Code § 4958. This new Code section and its accompanying regulations should be reviewed by any estate planner who is advising a client or public charity on a financial transaction with a related person-such as leasing space or purchasing supplies from a family office or employing a family member.

Disqualified Persons

The intermediate sanctions rules only apply to transactions between public charities and "disqualified persons." Code § 4958(f)(1)(A) defines a disqualified person as any person who, within a five year period ending with the date of an excess benefit transaction, was in a position to exercise substantial influence over the affairs of the organization. A person will be considered to exert substantial influence over an organization if he or she serves on the organization's governing body, is an officer or serves in the capacity of an officer regardless of title, or has or shares ultimate responsibility for implementing the decisions of the governing body. Prop. Treas. Reg. § 53.4958-3(c).

Even if a person is not specifically described in the proposed regulations as a disqualified person, that individual may still be treated as a disqualified person considering all of the facts and circumstances. Control over a discrete segment of the organization may be sufficient to show that the person exercised substantial influence. Prop. Treas. Reg. § 53.4958-3(e). This test, however, is not automatic. For example, a regular subscriber who is a substantial contributor to an organization and receives preferential treatment is not a disqualified person unless he or she is otherwise involved in the organization's administrative affairs. Prop. Treas. Reg. § 53.4958-3(f), Ex. 10.

The definition of a disqualified person also includes certain members of the family of another disqualified person, as defined with reference to the private foundation rules in Code § 4946. Under Code § 4946, a person's family includes his or her spouse; ancestors; children; grandchildren; great-grandchildren; and spouses of children, grandchildren and great-grandchildren. In addition, Code § 4958(f)(4) includes siblings and spouses of siblings as members of the family, although it does not include nieces and nephews. Finally, an entity is a disqualified person if it is a corporation, partnership, trust or estate in which disqualified persons (including their family members) own 35% of the voting power, profits interest or beneficial interest. Code § 4958(f)(3). This includes both the actual ownership as well as constructive ownership under Code § 267(c).

Excess Benefit Transactions

Code § 4958(c)(1)(A) defines an "excess benefit transaction" as "any transaction in which an economic benefit is provided by an applicable tax-exempt organization [a public charity or a Code § 501(c)(4) entity] directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit."

The most common transaction that Code § 4958 affects is the payment of compensation for services rendered by a disqualified person. In general, a compensation package must be reasonable considering all of the facts and circumstances. Compensation is reasonable if it is no more than the amount that would ordinarily be paid for like services by like enterprises under the circumstances at the time that the contract or payment is made. Prop. Treas. Reg. § 53.4958-4(b)(3)(i).

The proposed regulations state that a revenue-sharing transaction may also constitute an excess benefit transaction under certain circumstances. A revenue-sharing transaction will constitute an excess benefit transaction if the benefit permits a disqualified person to receive additional compensation without providing a proportional benefit to the organization. The proposed regulations provide an example of an appropriate revenue-sharing transaction. A university professor may receive a percentage of patent royalties on inventions produced by his or her research if the university owns and controls the patent, the professor shares the royalties proportionately with the university, the professor has no control over the revenue stream and the professor has no incentive or opportunity to act contrary to the university's interests. Prop. Treas. Reg. § 53.4958-5.

A disqualified person's compensation package includes not only salary or wages but also all incidental or fringe benefits provided to a disqualified person from a public charity, such as retirement benefits and insurance. Prop. Treas. Reg. § 53.4958-4(b)(3)(ii). Reimbursements for reasonable expenses of attending meetings of a public charity's governing body will generally be disregarded. The proposed regulations specifically state that such reasonable expenses do not include luxury travel or spousal travel. Prop. Treas. Reg. § 53.4958-4(a)(3)(i). Economic benefits provided to a disqualified person solely as a member or volunteer of the organization will be disregarded if the benefit is provided to members of the general public in exchange for a membership fee of $75 or less per year. Prop. Treas. Reg. § 53.4958-4(a)(3)(ii). The payment of premiums for directors' and officers' liability insurance covering the taxes imposed by Code § 4958 or the indemnification for such taxes will not constitute an excess benefit transaction if the premium or the indemnification is treated as compensation to the disqualified person when paid and the total compensation is reasonable. Prop. Treas. Reg. § 53.4958-4(a)(4).

For a benefit to be treated as part of a reasonable compensation package, an organization must clearly indicate its intent to treat the benefit as compensation at the time that the benefit is provided. The proposed regulations require an organization to establish this intent by clear and convincing evidence. Prop. Treas. Reg. § 53.4958-4(c)(1).

An organization can establish this intent by appropriately reporting the benefits for income tax purposes. An organization will have appropriately reported a benefit as compensation if it does so on its original or amended federal tax filings for the payment (such as Forms W-2 or 1099) or for the organization (such as Form 990), filed before the organization receives written notification of an IRS examination. Reporting will also have occurred if the recipient disqualified person reports the benefit as income on his or her Form 1040 for the year in which the benefit is received. In the absence of appropriate income tax reporting, the organization can be treated as having provided clear and convincing evidence of the requisite intent if the failure to report was due to reasonable cause. Other methods can also be used to establish the intent to treat a benefit as compensation, so long as such evidence is clear and convincing. Prop. Treas. Reg. § 53.4958-4(c)(2).

Rebuttable Presumption of Reasonableness

The IRS will presume that payments of compensation, transfers of property or other transactions between a public charity and a disqualified person are reasonable if the organization follows certain procedures. The organization's governing body (or a duly constituted and authorized committee thereof) composed entirely of individuals with no conflicts of interest regarding the transaction must approve the transaction in question. In approving the transaction, the governing body must obtain and rely on appropriate data as to comparability before approving the transaction. Finally, the governing body must adequately document the basis for its determination concurrently with making that determination. If the public charity satisfies these requirements and the rebuttable presumption is established, the IRS may rebut this presumption by additional information showing that the transaction was not reasonable. Prop. Treas. Reg. § 53.4958-6(a).

A member of the governing body does not have a conflict of interest if that member is not a disqualified person and is not related to any disqualified person participating in or economically benefiting from the transaction being considered. In addition, a member of the governing body may not be employed or subject to the direction and control of any disqualified person benefiting from the transaction and may not receive compensation or other payments subject to the approval of a disqualified person. The member must not have any material financial interest that will be affected by the transaction and may not approve a transaction with the expectation that a similar transaction will be approved in turn for his or her benefit. Prop. Treas. Reg. § 53.4958-6(d)(1)(ii).

A governing body has appropriate data on comparability if, given the board members' knowledge and expertise, it has information sufficient to determine whether a compensation arrangement will result in the payment of reasonable compensation or that a transaction is otherwise for fair market value. Relevant information would include compensation levels paid by similarly situated organizations (both taxable and nonprofit) for functionally comparable positions; the availability of similar services in the geographic area; independent compensation surveys compiled by third-party firms; actual written offers from similar institutions in competition for the services to be rendered; and independent appraisals of the value of property or services in question. Prop. Treas. Reg. § 53.4958-6(d)(2)(i). For organizations with annual gross receipts of less than $1 million, the governing body will be considered to have appropriate data on comparability if it has compensation data for five comparable organizations in the same or similar communities. The proposed regulations state that no adverse inference is intended by this list of potential information; circumstances falling outside of this safe harbor may satisfy the appropriate data requirement. Prop. Treas. Reg. § 53.4958-6(d)(2)(ii).

Adequate documentation requires that the governing body's records (written or electronic) reflect compliance with these procedures. The records must enumerate the terms of the transaction that was approved and the date of approval. They must list the members who were present during the debate on the transaction and those who voted. Adequate minutes should describe the comparability data on which the governing body relied and how it was obtained. Any conflicts of interest should be recited. Finally, the records should note the final action taken on the transaction.

If the compensation package or cost of the transaction is higher or lower than the range of the comparable data obtained, the minutes should reflect the reason for the discrepancy. For the records to be concurrent, they should be prepared by the next meeting of the governing body after the final action on the transaction is taken. The governing body must review and approve the records as reasonable, accurate and complete within a reasonable time after presentation for approval. Prop. Treas. Reg. § 53.4958-6(d)(3).

Imposition of Tax

If an excess benefit transaction has occurred, Code § 4958(a)(1) imposes an initial excise tax equal to 25% of the "excess benefit." This excise tax must be paid by any disqualified person or persons with respect to the transaction. Liability for the initial tax imposed on disqualified persons is joint and several. Code § 4958(d)(1). An additional excise tax is imposed on any organization manager who participates in the excess benefit transaction equal to 10% of the excess benefit unless the participation is not willful and is due to reasonable cause. Code § 4958(a)(2). The maximum initial tax shall not exceed $10,000. Code § 4958(d)(2). If the excess benefit transaction is not corrected within a prescribed time period, the IRS will impose an additional excise tax on the disqualified persons equal to 200% of the excess benefit. Code § 4958(b).

For purposes of imposing the tax, an organization manager is any officer, director or trustee or any individual having the powers or responsibilities of an officer, director or trustee regardless of title. Independent contractors such as lawyers, accountants and investment advisors are not officers and therefore are not organization managers for these purposes. Any individual who is not an officer, director or trustee but serves on the committee of the governing body that is responsible for the excess benefit transaction (such as a compensation committee deciding the reasonableness of a compensation package) will be treated as an organization manager. Prop. Treas. Reg. § 53.4958-1(d)(2)(ii).

Statute of Limitations

The return on which an exempt organization reports excess benefit transactions excise tax is Form 4720, which is attached to Form 990. Specific questions are asked on Form 4720 regarding excess benefit transactions. Filing Form 990 for the year in which the action (or failure to act) that gives rise to the liability occurred triggers the statute of limitations. A three year statute of limitations applies, except in the case of fraud. Potentially, a six year statute of limitations applies "if the transaction giving rise to the tax is not disclosed in a manner adequate to apprise the Secretary of the existence and nature of the item." Code § 6501(c)(3); Treas. Reg. § 301.6501(c)-1(c)(ii).


Sophisticated clients often include charitable organizations as part of their overall estate plans. With the advent of the intermediate sanctions legislation and subsequent regulations, using a public charity, such as a supporting organization, in this role may be more difficult. For example, an estate planner should be sure to review the intermediate sanction rules before transferring a family limited partnership interest to a public charity if the governing bodies overlap or if a disqualified person may be employed by the partnership or the public charity. With proper attention, adequate due diligence and appropriate documentation, most public charities can steer clear of the excess benefit excise tax.