I. Introduction
This Article argues that, in light of the availability of intermediate sanctions, termination of exempt status generally is an inappropriate sanction for charities that have permitted inurement to insiders. Rather, except in unusual circumstances, use of intermediate sanctions should be the exclusive remedy in such cases. As will be shown, this Article’s argument is not unduly controversial having been in good part accepted by the Treasury Department, the Internal Revenue Service (Service), and other commentators.
The first three parts of this Article contain reflections on three distinct but closely-related notions in the Internal Revenue Code and the Treasury Regulations. All concern charities described in section 501(c)(3) but two also impact other types of tax-exempt organizations. Two are creatures of the statute; the other is a child of the Treasury Regulations. Two are of fairly ancient lineage whereas the third is not yet three decades old. Taken together, they police the quintessential characteristic of charities: that they operate for the public benefit and do not permit their assets or activities to profit persons other than their intended beneficiaries.
The three doctrines are (1) the proscription against inurement (discussed in Part II below); (2) the proscription against more-than-incidental private benefit (discussed in Part III below); and (3) the rules imposing excise taxes on excess benefit transactions (discussed in Part IV below). This Article does not aspire to provide a comprehensive descrip-tion or analysis of any of the three doctrines. Rather, it contains selected observations stemming from the author’s teaching and writing in this area for many years. A secondary purpose of the first three parts of this Article is to recount some ancient history and capture some more current events. Part V of this Article sets forth the argument that use of intermediate sanctions rather than termination of exemption should almost always be the exclusive sanction when impermissible inurement is found. A conclusion follows in Part VI.
II. Inurement
Peril awaits anyone who attempts to understand the tax law without rigorously parsing the language of the Code. Many results, happy or foolish, turn on a microscopic and punctilious scrutiny of the words of that statute. It is tempting to carry that habit pattern forward into an under-standing of the inurement proscription contained in section 501(c)(3). In this case, however, the temptation should be avoided. This Part will demonstrate, in three steps, why the relevant statutory language is close to meaningless, making it necessary to resort to other sources to understand the scope of the inurement rules.
Step 1: The Legislative History. The template for all inurement provisions was designed in 1909. Section 38 of the legislation imposed a “special excise tax” on corporations. Several types of organizations were excepted, including “any corporation or association organized and operated exclusively for religious, charitable, or educational purposes, no part of the net income of which inures to the benefit of any private stockholder or individual.” The legislative history of this language should, one might hope, provide a rich source of enlightenment. One hopes in vain. A few weak beams of light emerge, but most of the important issues remain shadowed.
On the floor of the Senate, on July 2, 1909, Senator Augustus O. Bacon, from Georgia, offered an amendment to the then-pending bill. Among the amendment’s provisions was the following:
Provided, That the provisions of this section shall not apply to any corporation or association organized and operated for religious, charitable, or educational purposes, no part of the profit of which inures to the benefit of any private stockholder or individual, but all of the profit of which is in good faith devoted to the said religious, charitable, or educational purpose.
Although the amendment was then laid on the table, that is, it was defeated, the amendment re-emerged several days later.
Senator Bacon moved his amendment again, in exactly the same language, on July 6, 1909. This time it was successful, but not before some interesting debate. Senator Clark of Wyoming first challenged Senator Bacon, asking whether the amendment would exempt the Trinity Church Corporation of New York City. Senator Clark said that Trinity Church took in hundreds of thousands of dollars each year as rents, and he thought it should be subject to taxation despite its lack of stockholders. After some discussion by various Senators (not including Senator Bacon) about the nature and size of the activities of Trinity Church, Senator Bacon replied:
[I]f it be true that there are features in the business of that [Trinity Church] corporation which are not strictly religious, educational, or benevolent, they would not be screened by this amendment; and if they are all of them religious, benevolent, and educational, the fact of their magnitude would not, in my opinion, be any reason why we should exclude them from the beneficial provisions of this amendment.
. . . [T]he corporation which I had particularly in mind as an illustration at the time I drew this amendment is the Methodist Book Concern, which has its headquarters in Nashville, which is a very large printing establishment, and in which there must necessarily be profit made, and there is a profit made exclusively for religious, benevolent, charitable, and educational purposes, in which no man receives a scintilla of individual profit.
Senator Flint from California then joined the fray, asking Senator Bacon whether the exemption amendment was necessary, given that the taxing language only applied in the first instance to organizations which were “for profit.” Senator Bacon replied that the amendment was indeed required:
I gave the illustration of the Methodist Book Concern for that reason. It is organized for profit, but it is not organized for individual profit. It is organized to make a profit to extend religious work and to extend benevolent work, charitable work, and educational work. It is organized for profit, and does make a profit. That is the very reason why I think the words of the amendment with reference to a corporation tax are not sufficient.
Senator Bacon then proceeded to make a change in his own suggested exemption language by inserting “exclusively” after “organized and operated.” That change, he opined, “would make it as complete as it is possible to do.”
After some far-ranging debate about other aspects of the amendatory language, concerning building and loan associations, labor unions, and the like, the amendment was finally approved. Thus, as the Bill emerged from the Senate, the exemption language read as follows:
Provided, however, that nothing in this section contained shall apply to . . . any corporation or association organized and operated exclusively for religious, charitable, or educational purposes, no part of the profit of which inures to the benefit of any private stockholder or individual, but all of the profit of which is in good faith devoted to the said religious, charitable, or educational purposes.
The quoted anti-inurement language was later changed in two ways prior to enactment: the word “profit” was changed to “net income” and the final clause (beginning “but all of the profit of which”) was deleted. The conference committee that adopted those two final changes did not provide, nor can one find from any other source, any explanation of its reasoning, so one is left to wonder whether any change in substance was intended.
While the debates provide some useful background to the develop-ment of the statutory language, the debates do not sufficiently explain why the words “profit,” “net income,” “private stockholder,” or “individual” were selected or rejected. The present version of the anti-inurement language contains two further changes: “net income” has become “net earnings,” and “stockholder” has become “shareholder.” Once again, it is impossible to discern any rationale for the verbal variations. As will be shown below, the words—if taken literally—would pose a number of important puzzles and problems. Given all of this opaque history, however, it seems wiser to treat the anti-inurement language as evocative rather than precise.
Step 2: A Comparison of the Words. Anti-inurement language appears in ten separate paragraphs of section 501(c) and in at least thirteen other places in the Code. Although the tune is fairly clear, the notes vary.
The language is identical in five paragraphs of section 501(c). It varies trivially, and in ways which seem immaterial, in two others. In two further cases, the inurement language is modified to permit certain types of intended benefits to flow to intended beneficiaries. In one case, however, the language is inexplicably different: the anti-inurement prohibition for social clubs applies to “any private shareholder,” but does not extend, as in all of the other cases, to any “individual.” Lacking any precedent or text explaining this distinction, one could reason in one of two ways:
- Language in the Code is important, so social clubs may retain tax-exempt status even if they permit inurement to the benefit of an individual, or
- Language in this instance is not very important, so one should not expect the scope of the anti-inurement prohibition to differ when applied to social clubs.
The latter seems correct.
Although most of the anti-inurement rules are codified in the statute, one—dealing with labor, agricultural, and horticultural organizations—is found only in the regulations. The current regulation was proposed in 1956 and adopted in 1958. Its language is closely similar to the statutory proscriptions: it provides that qualifying entities must “[h]ave no net earnings inuring to the benefit of any member.” Similar language has appeared in the regulations under section 501(c)(5)’s predecessors since at least 1924, but the language prior to 1958 referred to “net income” rather than “net earnings.” Consistent with the arguments made above, that verbal distinction is probably without legal significance.
Step 3: Deconstruction of the Words. The statutory language prohibits the inurement of “net earnings” to the benefit of “any private shareholder or individual.” A moment’s thought exposes so many problems with those words that it seems clear they cannot be read literally. For example, as one trenchant commentator put it, “[l]iterally, this could apply to any individual regardless of his or her connection with the organization” and “[t]he statute’s reach obviously cannot be this broad.” All relevant precedent agrees. To hammer the nail firmly into place, nevertheless, each of the relevant words and phrases will be examined in more detail.
Should the proscription against inurement of “net earnings” be read to permit, without sanction, the inurement of gross earnings? Or “revenue”? Or “assets”? Certainly not. One early decision stated that the phrase may include “more than the term net profits as shown by the books of the organization or than the difference between gross receipts and disburse-ments in dollars.” In 1974, the Sixth Circuit Court of Appeals quoted that decision with approval and added that “[e]arnings may inure to an individual in ways other than through the distribution of dividends.” Other courts have agreed. The Service has said that “the inurement prohibition, while stated in terms of the net earnings of an organization, applies to any of [an organization’s] charitable assets. It applies to more than just the net profits shown on the books of the organization or the surplus of gross receipts over disbursements in dollars.” It must be concluded that the words “net earnings” neither well describe nor well circumscribe the target.
We next turn to the phrase “private shareholder.” It is puzzling at the outset to ponder the meaning of the adjective: is there some difference intended, perhaps, between a “private” shareholder and some other type of shareholder, for example, a “public” shareholder? The more serious puzzle is: under what circumstances need we be concerned about inure-ment to any sort of “shareholder”? The Service will not generally permit a corporation to qualify as a charitable organization unless it is formed as a not-for-profit entity, that is, unless it totally lacks shareholders. Thus, virtually no corporate charities have any shareholders (although they may indeed have members). The only known exceptions involve situations in which the entity, while formed under for-profit statutes for some special legal reason, has taken steps to denude the shares of any rights to dividends or other distributions both during its continued existence and upon liquidation. The number of such exceptions is so miniscule that one cannot believe it should have been important to single out “shareholders” as a meaningful class of potential recipients of inurement.
The statute also says that no benefits may inure to any private “individual.” It has already been noted that reading the word broadly would produce absurd results because individuals are almost always the intended and perfectly acceptable beneficiaries of charity. As the Tax Court has said, “[T]o equate an ‘insider’ with potentially the whole community would so gut the insider test as to transmogrify it from a test of some precision . . . to a test of such general application as to be useless.”
Is the language also too narrow? For example, reasoning by negative implication, should the statute be read as permitting benefits to inure to partnerships or corporations? The relevant regulations define “private shareholder or individual” to include “persons,” which should be taken to invoke the Code definition: “The term ‘person’ shall be construed to mean and include an individual, a trust, estate, partnership, association, company or corporation.” The Service has opined that “a labor union . . . is a ‘person’ to whom the inurement proscription applies.” In a Service issued General Counsel Memorandum (G.C.M.) numbered 39,414, the Service stated: “In our opinion, a section 501(c)(3) organization may not loan its funds to private individuals or corporations for use in a business context without violating the statutory prohibition against private inurement.”
A leading commentator wrote that “[t]he private inurement proscription may apply not only to individuals . . . but also to corporations, industries, professions, and the like.”
Even the word “inurement” is problematical. It is, of course, perfectly clear that it cannot be read to prohibit the conferring of any benefit on an insider: G.C.M. 39,862 concedes (and all authorities agree) that “[t]he inurement proscription does not prevent the payment of reasonable compensation for goods or services.” In its search for a touchstone, G.C.M. 39,862 suggests that the word “is aimed at preventing dividend-like distributions of charitable assets or expenditures to benefit a private interest.” Even that suggestion, however, cannot be accepted. For example, if the organization lacked earnings and profits, it nevertheless would be susceptible to violating the anti-inurement rules. As noted previously, one court properly observed that “[e]arnings may inure to an individual in ways other than through the distribution of dividends.” As the Tax Court confirmed, however, inurement cannot occur without the intentional participation of the charity—theft by insiders at least sometimes does not constitute inurement.
There is so little content, then, in the words of the anti-inurement language that the scope of the prohibition must be sought elsewhere. The anti-inurement phrases should be recognized as Code-speak rather than English. Brain cells should be cauterized against any temptation to resort to the words for meaning. Reference, instead, should be to the various cases and other precedents which have interpreted the proscription. Although it is outside the scope of this Article to analyze the precedents, several observations are in order:
- The determination is inherently fact specific.
- Despite a fairly large number of precedents, helpful guidance is scarce. As one court put it, more than sixty years after the anti-inurement language first appeared in the Code, “[t]here is very little material by way of guidance to this Court in the regulations or in any case law as to the application and meaning of that sentence.”
- It is often fairly easy to decide what is and what is not prohibited, even though it is quite daunting to try to describe the test. As the Service’s then-Associate Chief Counsel (Employee Benefits and Exempt Organizations) put it: “In my view, the definition of inurement isn’t the problem—most practitioners and most agents know it when they see it.”
- As discussed in Part IV of this Article, the impact of the inurement proscription has been and will be significantly affected by the adoption of section 4958.
III. Private Benefit
Precedent interprets the regulations under section 501(c)(3) as creating a separate test—the more-than-incidental-private-benefit test—for tax-exempt charitable status. Prior to the late 1980s, there was little guidance on the differences between the inurement and private benefit doctrines; indeed, many earlier precedents seem muddled on this point, and the lines drawn, if any, seem indistinct and confused. Subsequently, however, various cases and Service pronouncements have sharpened the edges of the distinctions between the two.
The first clear exposition of the tests came in G.C.M. 39,862. It set forth two sorts of distinctions:
- First, while the inurement proscription applies only to benefits received by “insiders,” the private-benefit proscription applies to benefits received by anyone, including wholly disinterested persons.
- Second, the receipt of any benefit by an “insider,” no matter how trivial, is fatal, whereas purely “incidental” benefits received by others will not violate the private-benefit restriction.
The G.C.M 39,862 concludes that “[the] private benefit prohibition applies to all kinds of persons and groups, not just to those ‘insiders’ subject to the more strict inurement proscription,” and “the absence of inurement does not mean the absence of private benefit. Inurement, then, may be viewed as a subset of private benefit.”
The Service’s later-issued “Audit Guidelines for Hospitals” contain the following succinct summary of these distinctions:
Although the requirements for finding inurement or private benefit are similar, inurement and private benefit differ in two key respects. The first is that even a minimal amount of inurement results in disqualification for exempt status, whereas private benefit must be more than quantitatively or qualitatively incidental in order to jeopardize tax exempt status. The second is that inurement only applies to ‘insiders’ (individuals whose relation-ship with an organization offers them an opportunity to make use of the organization’s income or assets for personal gain), whereas private benefit may accrue to anyone.
Thus, prior to the enactment of intermediate sanctions, the inurement rules required the finding of an “insider” and were then trigger happy; the private benefit rules applied to any recipient of a private benefit but required a balancing of benefits to the public against the benefits to the recipient. After enactment of intermediate sanctions, however, those distinctions no longer apply as clearly, as Part V of this Article will demonstrate.
It follows from the distinctions between the inurement and excess-private-benefit proscriptions that “insider” status for purposes of the former should not be determined by reference to the amount of the benefit received. If receipt of a sizeable benefit transforms the recipient into an “insider,” the inurement prohibition would threaten to subsume the excess-private-benefit rule. It is clear, however, that the two are distinct, and that—if anything—the inurement regime is a subset of the private benefit prohibition.
An argument to the contrary exists. The argument should be, and has proved to be, unsuccessful. The argument derives from the notion that the existence of “control” can be discerned from the ability to obtain a benefit from the controlled entity. For example, the section 482 regulations provide as follows:
Controlled includes any kind of control, direct or indirect, whether legally enforceable or not, and however exercisable or exercised, including control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose. It is the reality of the control which is decisive, not its form or the mode of its exercise. A presumption of control arises if income or deductions have been arbitrarily shifted.
The first two sentences seem apposite even to the inurement test because they correctly would not limit the definition of “insider” to those holding titles, and they would permit the inurement prohibition to extend to any persons actually having the control necessary to abuse the charitable status of the organization. The last quoted sentence, however, seems inappropriate in the inurement context because its use would tend to blur or even obliterate the separate excess-private-benefit rule.
A 1992 New York State Bar Association Tax Section Report made this point. There is some indication that it has been accepted by the Service. The Associate Chief Counsel of the Service, addressing the American Bar Association Tax Section’s Exempt Organizations Committee in early 1993, referred to the New York State Bar Association’s Report as follows:
The Report recommended that the Service clarify that “insider” status is not attained automatically, solely by the receipt of a benefit from an otherwise charitable organization. I agree. The Service has never taken such a position. We never intended to suggest that receipt of a benefit should cause treatment as an insider. Insider status follows from a person’s relationship to the charitable organization.
The Seventh Circuit Court of Appeals, reversing the Tax Court, also clearly rejected the notion that the receipt of even very significant benefits from a charity automatically makes the recipient an “insider.” In United Cancer Council v. Commissioner, the outside fundraiser got $26.5 million as compensation out of a total of $28.8 million raised for the charity. The appellate court declined to accept the Tax Court’s view that this caused the fundraiser to become an “insider,” holding that “the ratio of expenses to net charitable receipts is unrelated to the issue of inurement.” It concluded that the fundraiser “did not, by reason of being able to drive a hard bargain, become an insider . . . .” Judge Posner did agree, however, that the more-than-incidental-private-benefit doctrine might apply, even though the inurement proscription did not, and remanded the case to the Tax Court to decide that question. The later-issued regulations, under the so-called “intermediate sanctions” provisions of section 4958, responded to the United Cancer Council decision by adding an initial-contract exception to the definition of an excess benefit transaction.
IV. Excess Benefit Transactions
Following a discussion of the history of the development of the so-called intermediate sanctions rules in the Code, this Part will analyze (1) the congruence between the scope of the prohibition against inurement and the scope of the new intermediate sanctions provision, and (2) certain tax consequences of “correcting” an excess benefit transaction.
A. History
The history of the enactment of section 4958 is interesting:
Prior to 1969, the only sanction for a tax-exempt organization’s serious transgressions was termination of tax-exempt status. As early as 1965, one state bar association [the New York State Bar Association] commented that an ‘all or nothing sanction’ could lead to a ‘breakdown of enforcement’ because the harshness of the remedy could deter the IRS from invoking it and the courts from decreeing it . . . . The 1969 legislation affecting private founda-tions put in place, for the first time, a more measured regimen of sanctions: tiers of excise taxes to be imposed on various sorts of sins. It applied, however, only to private foundations, thus leaving other charitable organizations under the pre-existing all-or-nothing system.
The problems of an all-or-nothing regime were also noted by Congress. For example, the legislative history of the Omnibus Budget Reconciliation Act of 1987 observed that the Service might “hesitate to revoke the exempt status of a charitable organization . . . in circumstances where that penalty may seem disproportionate.”
Between 1969 and the early 1990s, there were occasional expressions of interest in applying some form of “intermediate sanctions” to public charities. For example, a 1989 report of an IRS Task Force on Civil Tax Penalties contains an extensive discussion of the private-foundation rules, including a policy analysis of the reasons why some or all of the chapter forty-two rules might be applied to public charities. Its recommendations include this sentence: “The types of sanctions imposed on private foundations should be extended to some or all public charities with respect to self-dealing, excess business holdings, jeopardy investments, and taxable expenditures.”
In his opening statement at a June 15, 1993, hearing on public charities, Congressman J.J. Pickle, then-Chairman of the Oversight Subcommittee of the House Ways and Means Committee, made clear that he intended to consider legislation which would establish intermediate sanctions on public charities. In her testimony at that hearing, then-Service Commissioner Margaret Richardson said in part:
The lack of a sanction short of revocation of exemption in cases in which an organization violates the inurement standard or one of the other standards for exemption causes the Service significant enforcement difficulties. Revocation of an exemption is a severe sanction that may be greatly disproportional to the violation in issue. For example, assume that an examination of a large university reveals that the university is providing its president with inappropriate benefits. The university may be paying the president a salary that appears excessive in comparison to that paid to presidents of comparable universities. Alternatively, the university may have provided the president with a substantial interest-free loan. It may have paid for costly and luxurious amenities in the president’s official residence. Each of these facts would raise serious inurement questions. Revoking the university’s exemption, however, may be an inappropriate penalty. Revocation could adversely affect the entire university community—employees, students, and area residents. Moreover, even if the organization’s exemption were revoked, the president would be able to retain the benefits inappropriately received from the university. In short, the Service may be faced with the difficult choice of revoking an organization’s exemption or taking no enforcement action as long as the compensation in question has been reported accurately on the individual’s income tax return.
The example given is compelling. Revocation would punish the innocent, disrupting many important relationships and expectations. It would have little or no impact on the recipient of the inurement. Commissioner Richardson concluded that “it would be useful to provide the Service with a sanction short of revocation to address violations of these standards.”
Shortly after the June 15, 1993 hearing, the nonprofit sector acted aggressively to become involved in the process. In part that was due to the perception that Chairman Pickle appeared to be ready to move things forward; better to join (and attempt to influence) the course of the march than to be left standing at the starting line. Another important motive, however, was more expansive and less self-defensive: some of the major umbrella organizations—Independent Sector in particular—believed that more accountability was desirable for the long-run health of the field, and that some form of intermediate sanctions would make that possible. As early as July of 1993, IS publicly stated that it “supports establishing intermediate sanctions, such as perhaps a 5% excise tax applicable to organizations and individuals, for acts of inurement or private benefit, provided that clear and reasonable definitions are developed for those acts.”
Sometime between the middle of August and early September of 1993, counsel for IS had his first conversation on this topic with an Attorney Advisor in the Treasury Department’s Tax Legislative Counsel’s office. IS counsel stated the view that the private foundation self-dealing rules were not an appropriate model for public charity intermediate sanctions and urged the use of an arms-length standard instead. The quick agreement to that principle by the Attorney Advisor paved the way to an ongoing constructive dialogue with the Treasury.
On September 20, 1993, then-head of the IS Government Relations function, Bob Smucker, met with Beth Vance, then-Staff Director of the Subcommittee on Oversight, to discuss intermediate sanctions legislation. In a September 29 letter following up on that meeting, Mr. Smucker confirmed IS’s support for such legislation, and set forth five principal characteristics it should have:
Graduated penalty taxes should apply to unreasonable compensation and non-fair-market-value transactions involving public charities;
Intermediate sanctions should not adopt the self-dealing or mandatory payout rules from the 1969 private foundations legislation;
What is reasonable compensation should be determined under “the market-driven standard of current law”;
The sanctions should be imposed on the individual malefactors rather than the public charities, but officers and directors should also be sanctioned if they “knowingly and willfully approve a prohibited transaction . . . .”; and
Appropriate safe harbors and de minimis rules should be adopted “to ensure that [the new sanctions] are not unduly burdensome, particularly to smaller charities.”
A copy of the letter was sent to the Assistant Secretary of the Treasury for Tax Policy.
By early November of 1993, IS had prepared draft legislation and a twenty-two-page explanation. These were shared with relevant officials on the Staff of the Joint Committee on Taxation. At the same time, efforts were taken to enlist the support of other nonprofit groups. For example, on January 10, 1994, the President of the Council on Foundations wrote to Chairman Pickle, on behalf of the Council, to endorse the proposal for intermediate sanctions as drafted and submitted by IS.
It seems fair to conclude, then, that the ultimate enactment of section 4958 was due in large part to the energetic efforts of the nonprofit sector itself, acting through some of its major umbrella organizations. It is easy to confirm this. Assistant Secretary of the Treasury Leslie B. Samuels testified on March 16, 1994, at the third hearing on intermediate sanctions before the Oversight Committee. He explicitly recognized the contribution of IS in the development of the legislation:
These types of [abuse] cases have shaken the public’s confidence in charitable organizations. Consequently, charities should be interested in reducing the occurrence of abuses, to prevent the further erosion of the reputation of the charitable community as a whole. In recognition of this fact, at least one large coalition of nonprofit organizations, INDEPENDENT SECTOR, has made proposals to improve the performance and accountability of public charities.
B. Interpretation of section 4958
Given the policy behind section 4958, it should be interpreted so far as possible to be precisely congruent with the scope of the inurement proscription. Whenever prohibited inurement can occur without violating section 4958, the only sanction continues to be revocation of tax-exempt status. It was exactly that undesirable situation that led to the enactment of intermediate sanctions. The legislative history can be read to confirm the view that section 4958 should duplicate the reach of the anti-inurement rules. The report of the House Ways and Means Committee first states that section 4958 may be applied either “in lieu of (or in addition to) revocation of an organization’s tax-exempt status.” The accompanying footnote, however, goes on to say:
In general, the intermediate sanctions are the sole sanction imposed in those cases in which the excess benefit does not rise to the level where it calls into question whether, on the whole, the organization functions as a charitable or other tax-exempt organization. In practice, revocation of tax-exempt status, with or without the imposition of excise taxes, would occur only when the organization no longer operates as a charitable organization.
If, as the footnote urges, section 4958 generally displaces the inurement prohibition, that section also should aspire to cover the same transactions; otherwise, lacunae will occur.
The argument here is not for precise overlap of section 4958 with the anti-inurement rules. The statute unfortunately will not permit that construction. Rather, the suggestion is for congruent interpretation so far as possible. This proposition will be analyzed in three steps:
First—Certain types of transfers, although potentially subject to the anti-inurement regime, will not be caught by the new intermediate-sanctions provisions. The easiest example involves a payment of excess benefits to an “insider” by a private foundation. Because private foundations are explicitly excluded from the coverage of section 4958, inurement transactions involving them will escape its claws.
Another example has been suggested. It rests on some statements in G.C.M. 39,862 to the effect that all doctors (and indeed all employees) are, for purposes of the inurement doctrine, “insiders” of the hospital where they work. If those statements are correct, excessive payments to such doctors or employees would fall afoul of the anti-inurement doctrine even if the recipients were not “in a position to exercise substantial influence over the affairs of the organization.” Such payments would not, however, be subject to section 4958 sanctions because the recipients would not be “disqualified persons” as defined. It seems clear, however, that those statements from G.C.M. 39,862 are wrong. In its report on G.C.M. 39,862, the New York State Bar Association Tax Section argued that a janitor, for example, should not be treated as an insider. Subsequently, then-Associate Chief Counsel of the Service, referring to that portion of the Bar Association Report, said, “I understand the concern. We intend to clarify that issue in an upcoming G.C.M.”
The legislative history of section 4958 also casts doubt on those over-broad statements from G.C.M. 39,862:
The IRS has issued a general counsel memorandum indicating that all physicians are considered ‘insiders’ for purposes of applying the private inurement proscription. The Committee intended that physicians will be disqualified persons only if they are in a position to exercise substantial influence over the affairs of an organization.
Furthermore, the Service has acknowledged that the over-broad statements in G.C.M. 39,862 are inaccurate. In its so-called physician-recruitment ruling, it stated:
The physicians described in the following recruiting transactions do not have substantial influence over the affairs of the hospitals that are recruiting them. Therefore, they are not disqualified persons as defined in § 4958, nor do they have any personal or private interest in the activities of the organizations that would subject them to the inurement proscription of § 501(c)(3).
This ruling also confirms that employees and doctors who lack actual influence will not be treated as insiders.
The most definitive rejection of the overbroad statements in G.C.M. 39,862 came in the regulations under section 4958. Certain employees of an applicable tax-exempt organization are explicitly excluded from the class of disqualified persons. It follows that the second example, above, of inurement rules applying when section 4958 does not is incorrect. It is clear that the overbroad statements from G.C.M. 39,862 were wrong.
Second—Conversely, there will be cases in which only section 4958, and not the inurement proscription, will apply. As one example, section 4958(f)(1)(A) defines a “disqualified person” to include anyone who had the requisite control “at any time during the 5-year period ending on the date of such [excess-benefit] transaction.” No known precedent invokes any such look-back rule for purposes of the anti-inurement provisions. Other examples could easily be provided. For instance, by application of the attribution or affiliation rules in section 4958, a limited partnership in which a stepbrother of an insider’s spouse owns a 36% “silent” profits interest automatically becomes a disqualified person for purposes of section 4958, even if there is no evidence whatsoever of that partnership (or the stepbrother) being in a position to exercise any control over the nonprofit organization in question and even if the stepbrother is in fact hated by both the insider and the spouse-sibling.
A final possible example of the reach of section 4958 exceeding that of the anti-inurement doctrine involves attempts to justify certain types of apparent excess benefit as being merely reasonable compensation for services performed by the insider. The statute and the regulations are explicit that, for purposes of the excess-benefit regime, any such justification must be shown by contemporaneous—rather than ex post—written evidence. By contrast, it is possible, albeit not certain, that an ex post argument, attempting to justify an apparent inurement transaction as constituting reasonable compensation for services rendered, might be accepted by the courts.
Third—Thus, in conclusion, while the provisions overlap, each also has its own independent area of effectiveness; neither is a subset of the other. The argument, then, is that the section 4958 rules should cover inurement situations as much as possible, that is, as few lacunae as possible should exist where the inurement doctrine applies but section 4958 does not.
The examples, above, of non-overlap cases involve either the status of the recipient of the proscribed benefit or the status of the charity transferring it. In the first example, the charity was a private foundation, explicitly excluded from the operation of the intermediate sanctions legislation. In the second example, the recipient was a person who, while not an actual “insider” for purposes of the inurement prohibition, was explicitly included within the “disqualified person” category of section 4958 as a result of its attribution or affiliation rules. The argument for common interpretation, then, comes to this: the substance of a transaction—whether it constitutes inurement or an excess benefit—should be interpreted identically for purposes of both doctrines, even though the status issues, that is, the status of either the person benefited or the charity making that payment, may have to be interpreted differently.
At first glance, it might seem that there would be little incentive to argue for section 4958 not being co-extensive with the scope of the inurement proscription: why would any organization risk loss of exempt status rather than the imposition of a fine on its disqualified persons? The litigation posture, however, will be different than that. Section 4958 imposes its sanctions on the individual beneficiaries of excess benefit transactions, not on the entity involved. They will argue against the imposition of excise taxes, perhaps caring little whether the exemption of the charitable organization in question would be put at risk. It might be tempting for diligent government litigators to assert parallel claims—one against the individuals under section 4958 and another against the organization under section 501(c)(3). The temptation should be resisted in most instances. Succumbing to it would violate the Congressional intention that section 4958 usually be the exclusive remedy, and it would needlessly create litigation costs (both time and money) for the public charity. The Service should adopt and publicly announce a policy of using only section 4958 to police inurement violations except in extreme cases.
Although the Treasury Department had indicated, in the preamble to the 1998 Proposed Regulations under section 4958, that this would be the position taken in the final regulations, the Temporary Regulations promulgated in early 2001 took a slightly different tack. They backed off the earlier undertaking, saying instead:
The temporary regulations do not foreclose revocation of tax-exempt status in appropriate cases. The IRS and the Treasury Department believe that to do so would effectively change the substantive standard for tax-exempt status under sections 501(c)(3) and (4). Accordingly, the IRS intends to exercise its administrative discretion in enforcing the requirements of sections 4958, 501(c)(3) and 501(c)(4) in accordance with the direction given in the legislative history. The IRS will publish guidance concerning the factors that it will consider in exercising its discre-tion as it gains more experience administering the section 4958 regime.
Final regulations were adopted on March 28, 2008. They confirm that revocation of tax-exempt status may occur even in some cases in which section 4958 excise taxes have been applied. The final regulations say that the Service “will consider all relevant facts and circumstances” in deciding whether revocation is appropriate, and they set forth five specific factors that, among others, may be taken into account in making that decision. Six helpful examples are provided, in four of which tax-exempt status is not revoked despite an excess benefit transaction having occurred.
In the first case decided under section 4958, the Service argued for both the imposition of intermediate sanctions and revocation of exempt status. The Tax Court sustained the imposition of excise taxes on the disqualified persons, but it declined to accept the revocation argument. The Tax Court first noted that “[a]lthough the imposition of § 4958 excise taxes as a result of an excess benefit transaction does not preclude revocation of the organization’s tax-exempt status, the legislative history indicates that both a revocation and the imposition of intermediate sanctions will be an unusual case.” The court then refused to revoke the organization’s tax exemption for three reasons: (1) the excess benefit transaction in question was a “single transaction,” (2) the charities—since the transaction in question—had not “been operated contrary to their tax-exempt purpose,” and (3) there was “some credence in petitioners’ suggestion that maintenance of the tax exemption may enable them to utilize the correction provisions made available in sections 4961 through 4963.” Despite the Caracci court’s decision, however, the Service continues to assert revocation of exemption together with section 4958 sanctions in at least some situations, although there are several Service Private Letter Rulings to the contrary.
A later decision appears to involve the reverse situation: permitting the imposition of section 4958 sanctions despite the organization’s tax exempt status having been revoked. Neither the Tax Court nor the Circuit Court addressed the question of whether revocation of exemption was appropriate in conjunction with the imposition of intermediate sanctions, presumably because the revocation appears to have preceded the taxpayer’s claim for relief from section 4958 and thus that issue was not before the courts. While there is good reason to avoid revocation in most situations where intermediate sanctions are being or have been applied, it is hard to make any reasonable argument that intermediate sanctions should not be imposed when excess benefit transactions are involved just because revocation has preceded such imposition.
Although section 4958 was signed into law on July 30, 1996, it was retroactively effective: it applies generally to excess benefit transactions occurring on or after September 14, 1995. It has thus been in force for nearly thirty years. Regulations were first proposed in 1998; Temporary Regulations were adopted in January of 2001; and final Regulations were adopted in January of 2002. In addition to the one litigated case discussed above, the excess-benefit rules have been successfully applied in several other instances. The Service can and should continue to assert these excess-benefit excise taxes vigorously in appropriate cases. Doing so will help to develop more coherent and rational legal precedents dealing with issues of inurement. However, as discussed in Part V below, the Service should rarely seek termination of exemption when such intermediate-sanction remedies are available.
C. Tax Consequences of “Correction”
Two penalty excise taxes are imposed on an insider who receives an excess benefit: a first-tier tax of 25% of the amount of the benefit, and—if the transaction is not timely “corrected”—a second-tier tax of 200% of the amount of the benefit. For this purpose, “correction” means “undoing 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 were dealing under the highest fiduciary standards . . . .” Thus, the statute inflicts some pain to punish the infraction and much more severe pain if it is not reversed.
It is perfectly clear that the insider may take no deduction for either the first- or second-tier excise taxes. It is less clear what the tax treatment is of any amounts returned to the organization as “correction.” Several possibilities exist:
- The amounts might be deductible,
- The amounts might be subject to the special beneficial rules of section 1341, or
- The amounts might be nondeductible.
The proper treatment of correction amounts depends on the nature of the excess benefit transaction.
If the excess benefit occurs as the result of theft or fraud, for example, through embezzlement, it is clear that the disqualified person is entitled to a deduction when the funds are returned. It is equally clear that the special mitigating relief provisions of section 1341 are not available because one of the preconditions to the applicability of that section—that the funds were originally received under some claim of right—cannot be met.
On the other hand, if the excess benefit occurs as the result of a more benign transgression, such as overly-generous compensation, in most cases, under existing precedent, no deduction will be available for payments in “correction.” That is because “[d]eductions for repayment of amounts received under claim of right have been denied in cases where the repayment is not required by either express contractual provisions or applicable legal principles.” In such cases, section 1341 relief will also be unavailable.
There are, however, three legal theories that possibly might permit a deduction for returned excess compensation in section 4958 situations. First, an argument can be made that the looming threat of a 200% second-tier excise tax creates the equivalent of a legal obligation to repay the excess benefit. If that argument is accepted, a deduction would be available and the provisions of section 1341 might also apply. Second, an argument can be made that, in the absence of legal compulsion, the return of the excess benefit constitutes a charitable contribution. This second argument (1) is inconsistent with the compulsion theory of the first argument, (2) may fail the test of the regulations that a charitable contribution must have been intended, and (3) even if successful would produce a more limited deduction than the first argument. Third, it may occasionally be possible to argue for a deduction if the taxpayer’s motive for making the payments was to protect his job.
A self-help method exists for ameliorating these harsh results: the charitable entity may adopt a legally-enforceable by-law, or enter into a contract with the taxpayer receiving compensation, prior to the transaction obligating the disqualified person to return any amounts determined to constitute an excess benefit. Such a by-law or contract creates an enforceable obligation to repay such amounts, and that legal obligation makes a deduction available. The Service has taken the view, however, that—even when such a contract is in place—the special mitigating relief provisions of section 1341 are not available, but at least one court has disagreed. Consideration should be given to adopting such a by-law or entering into such agreements covering all excess benefit transactions with all disqualified persons. The existence of a deduction, and perhaps the additional benefit of section 1341 treatment, will make it even more likely that excess benefits are returned to the organization in question, which is the fundamental policy behind the intermediate sanctions in section 4958. There does not appear to be any “downside” to the adoption of such plans, which suggests that an appropriate by-law or contract ought to be adopted routinely by organizations to which the intermediate sanction provisions apply.
V. Reconsidering Termination of Exempt Status for Inurement
The 1993 testimony of then-Commissioner Richardson described circumstances in which revocation of exempt status was a harsh and “inappropriate remedy,” caused cruel consequences to innocent bystanders, and was impotent to sanction the recipient of the impermissible inurement. In other circumstances, revocation may be too little and too late, for example, when the charitable entity has already been drained of assets via inurement so that termination of its exempt status is meaningless. Whether too painful or too puny, revocation is always a blunt weapon and always impacts the charity rather than those who have abused it. Intermediate sanctions provide a far better tool to deal with such cases—a tool that is crafted to recapture impermissible benefits from the person who received them and to restore those assets to the charity itself.
No doubt it was for these reasons that the legislative history stated section 4958 would be the exclusive sanction for inurement unless “the organization no longer operates as a charitable organization.” Although the regulations say that the sanction of revocation remains available even if section 4958 applies, they set forth five factors that (in addition to other undescribed “relevant facts and circumstances”) the Commissioner will consider “[i]n determining whether to continue to recognize the tax-exempt status of an applicable tax-exempt organiza-tion . . . that engages in one or more excess benefit transactions . . . that violate the prohibition on inurement . . . .” The enumerated factors can be grouped under three heads—proportionality, multiplicity, and contrition:
- Proportionality: the first two factors compare “[t]he size and scope of the organization’s regular and ongoing [charitable] activities” to “[t]he size and scope of the excess benefit transaction or transactions.” One might visualize this as creating a fraction the numerator of which is the excess benefit transactions and the denominator of which is the charitable activities of the organization. The regulations provide no guidance about either (1) how to quantify the numerator or denominator or (2) what ratio the fraction would have to exceed to suggest revocation rather than continuing recognition of exempt status.
- Multiplicity: the third factor asks whether the organization “has been involved in multiple excess benefit transactions with one or more persons.” 187 Obviously, proclivity or repetition weigh in favor of revocation.
- Contrition: the fourth and fifth factors look to “safeguards” implemented by the organization that “are reasonably calculated to prevent excess benefit transactions” and to whether the excess benefit transactions have been “corrected.” 188 These “will weigh more heavily in favor of continuing to recognize exemption where the organization discovers the excess benefit transaction or transactions and takes action before the Commissioner discovers [them].” Furthermore, “correction after the excess benefit transaction or transactions are discovered by the Commissioner, by itself, is never a sufficient basis for continuing to recognize exemption.”
The regulations provide six examples of how these factors should be applied. In four of them, revocation of exemption is abjured despite the presence of inurement. In none of them is any additional factor mentioned despite the regulations’ reference to “relevant facts and circumstances, including, but not limited to,” the five enumerated factors. Unfortunately, however, the proportionality tests are applied in a conclusory manner so no light is shed on (1) how to measure or quantify either the excess benefit transactions or the “size and scope of the organization’s regular and ongoing [charitable] activities,” or (2) what ratio of excess benefits to ongoing charitable activities is too great. Clearly, a mere scintilla of inurement is no longer, after enactment of intermediate sanctions, a sufficient reason for revocation of exemption. More guidance would be most welcome, however, on how to apply the facts-and-circumstances test of the regulations.
Since the effective date of section 4958, the Service has issued more than fifty Private Letter Rulings revoking a charity’s tax-exempt status in addition to applying intermediate sanctions. Most of the rulings recite that “multiple” or “numerous” or “repeated” excess benefit transactions were involved. That may suggest that the third factor in the regulations—whether the organization “has been involved in multiple excess benefit transactions”—carries the greatest weight in deciding that revocation should follow even when section 4958 sanctions are applied. In one case, the Tax Court confirmed that imposition of section 4958 sanctions was permissible in addition to revocation. But the existence of these more-than-fifty private letter rulings does not necessarily indicate that they are correct on the merits. In many circumstances, those controlling a bad and misbehaving charity may well decide to accept, rather than challenge, the Service’s revocation despite the imposition of section 4958 sanctions. Sometimes the revoked charity can simply transfer its remaining assets to a newly-created organization and the new organization can file a Form 1023-EZ to obtain tax-exempt status. The new organization can even adopt the same name as the prior, now-revoked organization either by incorporating in a different state or by having the prior organization amend its name to permit the new organization to use the old name when incorporating in the same state. Following such a path may be significantly less expensive than litigating the asserted revocation. Thus, in many cases revocation is fairly painless and not worth fighting even if a court might overrule the revocation if a party challenged the revocation.
Perhaps the Service should adopt a Goldilocks rule. For some charities, revocation of tax-exempt status would be catastrophic, for example, for a university that has students, faculty, staff, and tax-exempt bond holders who would be seriously damaged by revocation of its tax-exempt status. In most cases, the general rule should prevail that intermediate sanctions should be the exclusive remedy. For some other charities, revocation of tax-exempt status would be quite painless, for example, for a grant-making charity that could merely turn over its assets to a newly-formed entity that could quickly and easily qualify as tax exempt and then continue the prior activities. In most such cases, when revocation appears to be toothless, the Service could save staff time and energy by allowing intermediate sanctions to be the only remedy. In between those two polar examples may be cases in which the Service should impose revocation despite the assertion of intermediate sanctions. There is ample room, under the regulations, for the Service to consider where revocation falls on the scale from a catastrophic to a feeble sanction. Unless the impact is somewhere in the middle—between disastrous and meaningless—revocation should not be asserted.
Thus, the general rule remains that, except in the most unusual and tainted circumstances, when section 4958 sanctions are applied, the Service should not revoke the charity’s tax-exempt status. Several Service Technical Advice Memoranda concur.
Although intermediate sanctions under section 4958 do not apply to private foundations, an analogous issue arises when such a foundation engages in conflict-of-interest transactions subject to excise tax sanctions under section 4941. Should the imposition of such sanctions be the exclusive remedy, or should the foundation’s tax-exempt status also be subject to revocation? The Service takes the position that revocation may be appropriate despite the applicability of excise tax sanctions.
Once the Service rejects the old, mechanical, scintilla-of-inurement rule, and concepts of proportionality, multiplicity, and contrition become determinative, the prior-law differences between inurement and excess private benefit partially erode. What remains is only one of the two previous distinctions: the private benefit regime continues to apply not only to insiders but to any person. Finding inurement, however, is no longer sufficient by itself to cause revocation; instead, the Service must engage in the balancing of relevant facts and circumstances. It follows, therefore, that after the enactment of section 4958 inurement has become merely a subset of private benefit.
VI. Conclusion
Although the inurement proscription has been in the statute for more than a century, there is very little authority helpfully interpreting it. The specific statutory language is of almost no help in marking out the scope of the rule; indeed, this Article argues that the words should generally be disregarded rather than being rigorously parsed. To some extent, the paucity of precedent probably follows from the harshness of what long was the only available penalty: revocation of tax exemption. Because the intermediate sanctions legislation now provides a more measured remedy, and because the substantive scope of section 4958 should be interpreted to be closely identical to the anti-inurement doctrine, there is reason to hope that better guidance will emerge. That is a consummation devoutly to be wished because of the critical importance to this country of the work of its charitable community and the consequent importance of making sure that charity’s quintessential nature is protected and polished—that is, that charitable assets are deployed only for the benefit of the intended beneficiaries and not to other persons, and that this is also seen to be the case as the result of an appropriate level of scrutiny and accountability.
