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February 2001
Interim Intermediate Sanctions IRS Issues Temporary Excess Benefit Excise Tax Regulations
The Internal Revenue Service has released long-awaited regulations on intermediate sanctions, the excise tax on excess benefit transactions. Surprisingly, the regulations are classified as temporary. The most significant change from the proposed regulations [see NN 9/98, pg.1], is that initial contracts for fixed sums between an organization and a new hire, initially a non-disqualified person, are exempt from the rules. While the Service's application of intermediate sanctions to date have stretched the meaning of "intermediate" (the organizations involved also lost their exempt status [see NN 1/00, pg. 1]), the exempt organization community has given the new regulations a warm reception.
What the Regs Do
The basic motivation behind section 4958 excess benefit excise taxes was to provide a means for the Service to punish insiders and organization managers, short of revoking the charity's exempt status, for using charities to further private interests. The concern was that such a draconian remedy would either cause the Service to ignore inappropriate conduct, or, in the alternative, use the sledgehammer of status revocation against the fly of individual misconduct. Accordingly, the excise taxes were termed "intermediate sanctions."
The only significant opposition to the rules came from the Bishop Estate, a massive Hawaiian charity accused of being run largely for the benefit of its directors (who were just recently assessed with the tax). The real disagreements were, as usual, in the details.
How They Work
The Tax: The intermediate sanction excise taxes impose a tiered tax on the individual (the "disqualified person") receiving the excess benefit and a potential tax on the organization manager who approved the transaction. The individual receiving the excess benefit is subject to a 25 percent tax on the amount of the excess benefit over and above the tax imposed through inclusion in that person's taxable income. If the excess benefit is not corrected within the taxable period (generally the period between the transaction date and when the Service notices it), an additional 200 percent tax on the amount of the excess benefit is imposed. This 200 percent tax may be abated if the individual corrects the excess benefit by returning the funds or property plus interest within 90 days of the IRS notice of deficiency. The 25 percent tax may be abated if the IRS is satisfied that the transaction was corrected in the taxable period and was due to reasonable cause and not willful neglect.
Disqualified Persons: That tax schedule is imposed only on so-called disqualified persons: broadly, those individuals, typically insiders, or organizations, in a position of substantial influence over the organization. This category automatically includes voting members of the board of directors; presidents, CEOs and COOs and similar officers; treasurers and CFOs; and their families (extending up two and down three generations) and organizations in which such individuals or their families control 35 percent of the stock, beneficial interest or profit interest. Organizations, such as a management company, can be deemed disqualified persons, but notably, all 501(c)(3)s and 501(c)(4)s with respect other 501(c)(4)s are generally not. Other facts and circumstances may lead to a determination of disqualified person status. This category includes founders, substantial contributors, and persons with authority over substantial portions of the organization's budget or programs.
There are several exceptions. Independent contractors and those who have taken a vow of poverty are generally not disqualified persons. Further, employees making less than $85,000 (adjusted for inflation beginning 2001) who are not automatically disqualified by virtue of their position are not disqualified persons.
Excess benefit: An excess benefit under the regulations is any economic benefit provided directly or indirectly (see below) from the organization to the disqualified person exceeding the value of the consideration received by the organization for providing the benefit. In application, the definition follows the reasonableness requirements for business expense deductions, and functionally amounts to excessive salaries, sweetheart contracts and other deals in which the organization pays more than fair market value. Placing a cap on a bonus or revenue sharing arrangement is also a factor in determining whether the transaction is reasonable. It is important to note that the tax is assessed only on the difference between the fair market value and the benefit received by the disqualified person.
Tax on Managers: To provide an incentive for managers to resist the influence of disqualified persons in proposing excess benefit transactions, the statute imposes a 10 percent tax (subject to a $10,000 cap per transaction) on managers who knowingly participate in such transactions, unless it was not willful and due to a reasonable cause. Managers include officers and directors, and participation includes not vocally opposing the transaction at, for instance, a board meeting. "Knowing," under the rules, requires that the manager have actual knowledge of sufficient facts that would indicate an excess benefit transaction, is aware that the transaction may violate the rules, and negligently fails to make reasonable attempts to ascertain the nature of the transaction. Helpfully, there are some important safe harbors (see below).
Highlights of Important Provisions
There are some important provisions in the temporary regulations that should be examined.
Initial Contract Exemption: Following the 7th Circuit's decision in United Cancer Council [see NN 3/99, p.1], the temporary regulations exempt fixed payments pursuant to an initial contract with a person or organization who is not at that time a disqualified person. For example, if an organization hires an executive director with a contract to pay her $1 million a year, and she had no prior dealings with the organization, neither the executive director nor the board would be liable for excess benefit excise taxes, regardless of the comparability data. The payment must be fixed, or, if bonuses and cost-of-living-adjustments are included, they must be capped for this exemption to take effect. It must be stressed, however, that such an organization runs the risk of finding its tax-exempt status revoked for operating for private benefit.
Similarly, an initial, fixed contract with a fundraising organization or similar service provider will be excused from the provisions of these regulations so long as the vendor substantially performs the services under the contract.
Rebuttable Presumptions: Transactions, either compensation or transfers of property, are presumed in advance not to be excess benefit transactions under the regulations if the organization follows appropriate procedures. First, the transaction needs to be approved by an authorized body composed of individuals with no conflict of interest in the proposed transaction. Second, the authorized body must obtain and rely upon data as to comparability (a fair market value analysis) prior to making the decision. Finally, the authorized body must document the basis for its determination.
Effectively, if the decision-making body has no conflicts, researches the market and keeps records of doing so, the Service will be hard pressed to find that an excess benefit transaction has occurred. The particular facts and circumstances may nevertheless rebut that presumption and result in an imposition of the tax.
Comparability and the Safe Harbor for Small Organizations: Undoubtedly, the most difficult part of achieving the rebuttable presumption is assembling the comparability data on a particular transaction or compensation package. Ordinarily, an organization needs to consider a number of factors when evaluating a compensation package including compensation paid by similarly situated and functionally comparable organizations, availability of similar services in a relevant geographic labor market, current compensation surveys, and written offers obtained by job candidates. For property and other transactions, independent appraisals or a competitive bid process should serve.
Organizations with less than $1 million in annual gross receipts (current or averaged over the prior three fiscal years) can perform adequate compensation surveys by calling three comparable organizations in the same or similar communities for similar services. Note that this safe harbor does not apply to property transfers or other transactions.
Managers' Safe Harbor for Transactions: Under the temporary regulations, managers cannot be held to have knowingly participated in an excess benefit transaction, and are thus shielded from the 10 percent excise tax, if they relied on a reasoned opinion (even an incorrect one) of legal counsel, CPAs and accounting firms with experience in the area, or independent valuation experts who hold themselves out as such. The opinion must be written and state the qualifications of the writer, and must be based on a full disclosure of the facts.
Indirect Excess Benefits: In this iteration, the Service has expanded the scope of an excess benefit to include indirect economic benefits to a disqualified person. Indirect economic benefits include payments made to a disqualified person-controlled entity (e.g., he owns more than 50 percent of the stock, profits or votes) or through an intermediary where there is evidence of an oral or written agreement that the intermediary will pass the benefits on to the disqualified person.
"D and O" Insurance: In a special rule, when calculating the amount of excess benefit, the regulations will include intermediate sanctions liability insurance premiums (for both recipients and compliant managers) and unreasonable reimbursements related to court proceedings arising from the transaction. The effect of this rule is to make it virtually impossible to indemnify managers against the excise taxes, although it is possible to pay their reasonable defense expenses if they are successful.
While including D&O premiums as compensation for purposes of maxing an excess benefit calculation, the regulations also clarified a long-running question. Reasonable regular premiums paid by an organization for directors' and officers' liability insurance can be excluded from the recipients' gross income under the de minimis fringe benefit rules.
Why Temporary?
Given the reasonably widespread support intermediate sanctions enjoy in the exempt organization community, the question remains why the Service decided to issue these in temporary form. Some commentators speculated that the stumbling block was revenue sharing arrangements, a matter reserved in the regulations for future determination. More likely, however, the decision to allow time for additional comments was a manifestation of the kinder, gentler IRS. As a result, these regulations will expire on January 9, 2004, if not replaced with final regulations before that date.
The Service is particularly seeking comments on how or whether to treat donors as disqualified persons with respect to donor-advised funds, but other comments are welcome. Send comments to: Internal Revenue Service, CC:M&SP:RU (REG- 246256-96), Room 5226, PO Box 7604, Ben Franklin Station, Washington, D.C. 20044. Alternatively, you can use the web site at http://www.irs.ustreas.gov/prod/tax_regs/comments.html
By Doug Smith
Out with the Old, In with the New: Federal Laws Limit Former Government Employees' Activities
Last month's issue of the Navigator described some of the political and fundraising restrictions that the Hatch Act levies on current federal government employees. But with the replacement of the Clinton administration by the Bush administration, many former high-level executive and legislative branch employees are flooding the private sector looking for work. Exempt organizations and others eager to hire former government employees should be aware that there are several statutory prohibitions that restrict their activities.
Former government employees face different restrictions depending on their level of seniority and prior involvement in particular matters. Bans range from one-year to permanent prohibitions, and almost all apply only if the former employee is making a communication to a specific person or persons on behalf of anyone other than the United States, such as an individual or organization.
The most severe statutory restriction applies to all former executive branch employees, including those from independent federal agencies. This restriction permanently prohibits former employees from attempting to influence, on anyone's behalf, any United States department, agency, or court on a matter involving specific parties in which the former employee participated "personally and substantially" while employed by the government. The United States or the District of Columbia must be one of the parties or must have a "direct and substantial" interest. The restriction also applies to former District of Columbia executive branch employees who influence any D.C. departments or agencies under similar circumstances.
Another restriction, effective for only two years after leaving office, prohibits former federal employees from influencing a United States department, agency, or court on matters that were pending under their official responsibility during their last year of government service. All former executive branch employees also are prohibited for one year from representing, aiding, or advising anyone other than the United States in trade or treaty negotiations in which they participated personally and substantially during their last year of government service.
Senior-level executive branch employees face additional restrictions on their post-government communications. They are prohibited for one year from attempting to influence their former agency on behalf of another person or entity who seeks official action on the part of the agency. All senior-level employees also are forbidden for one year from representing a foreign individual or corporation before an agency of the U.S., and from aiding or advising a foreign entity. There is also a one-year restriction applicable solely to very senior former employees, such as cabinet members, who cannot influence any officials in their former department or agency, or executive branch appointees.
As for former employees of the legislative branch, former members of Congress, staffers, and committee members are also subject to one-year bans on communications made on behalf of others. Former members of Congress cannot attempt to influence current members of Congress, officers, or employees of either House of Congress or any other legislative office, while former elected officers cannot contact anyone in the House of Congress in which they served. Former congressional staffers cannot communicate with their former employers or employers' staff on behalf of a third party, while former committee staff members are prohibited from influencing committee members or staff who currently serve or served on the same committee in the year before the former staff members left their positions. Similar one-year restrictions also affect former leadership staff and former employees of other legislative offices.
Despite these prohibitions, there are a number of statutory exceptions that some nonprofits may be able to take advantage of. With the exception of representing or aiding a foreign individual or corporation, none of the restrictions on legislative branch or senior executive branch personnel apply to former government employees employed by state or local governments or their agencies. Former federal employees employed by 501(c)(3) organizations that are accredited centers of higher education, hospitals, or medical research organizations are also allowed to make such communications on their behalf. In addition, the restrictions in the previous two paragraphs would not prevent a former employee from making a statement on a matter on which she has "special knowledge," as long as she does not receive compensation for doing so.
After taking office in 1993, former President Clinton issued an Executive Order extending many of these one-year bans on personnel in the executive branch to five-year bans. This order was revoked on December 28, 2000, so the statutory one-year bans are now back in place. Nonprofits that are in the process of hiring outgoing-but-still-employed government officials also should be aware that statutes and regulations prohibit federal employees from participating in any matter involving the financial interests of an organization with which they are negotiating or arranging future employment.
By Mark Sawchuk and Ann Peters
IRS Issues 2001 Inflation-Adjusted Rates
The IRS has released a number of inflation-adjusted figures for the 2001 tax year, which will be of interest to both individuals and nonprofit organizations.
"Low Cost Article"
The unrelated business taxable income of certain exempt organizations does not include proceeds from the distribution of "low cost articles" in connection with charitable solicitations. For tax year beginning in 2001, a "low cost article" is any article which costs $7.60 or less.
2000: $7.40;
2001: $7.60
Other Insubstantial Benefit
The IRS established guidelines in Rev. Proc. 90-13 to provide charitable organizations with help in advising their patrons of the deductible amount of contributions when the contributors are receiving something in return for their contributions. The value of benefits received by a donor in return for a fully-deductible charitable contribution may be disregarded if either: 1) for a contributions of $25 or more, the contributor did not receive something in return that costs more than $5 (the rate for a "low cost article" listed above); or 2) the fair market value of all of the benefits received in connection with the payment is not more than 2 percent of the payment or $50, whichever is less. The $5/$25/$50 schedule is annually adjusted for inflation and this year has been increased to $7.60, $38, and $76, respectively.
2000: $7.40 / $37 / $74;
2001: $7.60 / $38/ $76
Mileage
The standard mileage deduction rate for business use of an automobile has increased to 34.5 cents/mile. The figure for volunteer or charity work remains at the 14¢/mile rate in effect last year.
2000: 32.5¢/mile;
2001: 34.5¢/mile
Reporting Exception for Lobbying Expenditures
Rev. Proc. 98?19 set at $75 or less-annually adjusted for inflation-the amount of annual dues that social welfare organizations may receive without becoming subject to I.R.C. § 6033(e), which requires a tax?exempt organization that incurs nondeductible lobbying expenditures to notify its members, at the time the dues are assessed or paid, of its reasonable estimate of the portion of the dues that is allocable to those expenditures. In 2001, the annual dues limitation to qualify for the reporting exception regarding certain exempt organizations with nondeductible lobbying expenses is $81 or less.
2000: $78;
2001: $81
Non-Member Dues
In 2001, dues paid by an individual to 501(c)(5) agricultural and horticultural organizations and 501(c)(6) organizations will not be subject to UBIT provided they do not exceed $116.
2000: $112;
2001: $116
Annual Exclusion for Gifts
The first $10,000 of gifts to any person (other than gifts of future interests in property) is not included in the total amount of taxable gifts made during that year. The 1997 Taxpayer Relief Act allows this figure to be annually indexed for inflation (rounding down to the next lowest multiple of $1,000), but no increase is effective for 2001. This amount is expected to rise in future years.
2001: $10,000 (unchanged from 2000)
Itemized Deductions The income threshold for the overall limitation on itemized deductions, which rises slightly each year, has risen to $132,950, or $66,475 for married individuals filing separately. The allowable amount of deductions is reduced for taxpayers with adjusted gross income above that amount.
2000: $128,950;
2001: $132,950
By Mark Sawchuk
Mandatory Electronic Filing Now In Effect
Final regulations published last summer now require many political committees, organizations, and others subject to the Federal Election Campaign Act to file their campaign finance reports electronically with the Federal Election Commission [see NN 5/00].
As of the reporting period which begins January 1, most candidates, authorized political committees, party committees, non-connected committees, and separate segregated funds who make expenditures or receive contributions in excess of $50,000 in a calendar year will be subject to this filing requirement. Anyone who makes independent expenditures exceeding $50,000 will also be required to file disclosure reports electronically. Reports filed on paper by anyone required to file electronically will be ignored by the FEC, and the delinquent filer may be subject to FEC enforcement action. Senate campaign committees that file their reports solely with the Secretary of the Senate are not subject to these new regulations.
More information, as well as free filing software, is available at the FEC's web site at www.fec.gov/elecfil/electron.html. You can access the regulations directly at www.fec.gov/pdf/mandatoryeffinal.pdf.
By Mark Sawchuk
This publication is designed to provide accurate and authoritative information about the subject matter covered. It is not distributed with the intent to render legal, accounting, or other professional advice. The services of a competent professional should be sought if legal advice or other expert assistance is required.
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