Tuesday April 16, 2024
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7.1.2 Intermediate Sanctions
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Intermediate Sanctions
Excess Benefit Transaction: An excess benefit transaction occurs when a charity engages in any transaction with a "disqualified person" whereby the disqualified person receives a direct or indirect benefit from the charity for which he or she did not pay.
Disqualified Person: A disqualified person for purposes of applying intermediate sanctions is any person or family member of a person (including his or her brothers and sisters) who at anytime during the five years up to and including the date of the excess benefit transaction is in a position to exercise substantial influence over the public charity.
Compensation Safe Harbor: A charity may pay reasonable compensation to its officers and directors (or other disqualified persons); but if compensation is unreasonable, the difference between the reasonable and unreasonable compensation is an excess benefit.
Automatic Excess Benefit Transactions: The newest development in the area of excess benefit transactions relates to the identification of "automatic" excess benefit transactions.
Intermediate Sanctions Excise Tax: Intermediate sanctions take the form of an excise tax imposed upon the disqualified person who engages in an excess benefit transaction with the public charity and, in some cases, upon managers of the public charity (such as officers, directors or trustees) who knowingly participate in the excess benefit transaction.
Relationship Between Operational Test and Intermediate Sanctions: The identification of excess benefit transactions and application of intermediate sanctions does not supersede or replace the traditional private inurement prohibition.
Charitable Tax Shelter Penalty Tax: In Notice 2007-18, Treasury explained to nonprofits the potential penalties for becoming involved in tax shelter transactions.
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Prior to July 30, 1996, the only way to punish a charity that did not engage primarily in activities to accomplish its charitable purpose was to revoke the charity's tax-exempt status. This consequence was often drastic and harsh, especially in cases where the charity's conduct was not willful, was a one-time only occurrence subsequently corrected by the charity or was seen as insignificant in view of the charity's operations as a whole.
On July 30, 1996, "Intermediate Sanctions" was added as an alternative to revoking the tax-exempt status of a charity that violates the operational test. Intermediate sanctions take the form of an excise tax imposed on "excess benefits" that are given by a charity to a private individual who has a close relationship with the charity.
Excess Benefit Transaction
An excess benefit transaction occurs when a charity engages in any transaction with a "disqualified person" whereby the disqualified person receives a direct or indirect benefit from the charity for which he or she did not pay. Sec. 4958. Excess benefits can be triggered many ways, including below-market loans by a public charity to a disqualified person or the payment of unreasonable compensation by a charity to a disqualified person.
In October 2005, the IRS and the Treasury Department issued proposed regulations that further clarify excess benefit transactions. Reg. 111257-05 will trigger revocation of an organization's tax-exempt status if the organization is operating for a private rather than a public benefit, even in the absence of any excess benefit transactions set forth in Sec. 4958. If an organization is formed for designated individuals, the creator or his family, shareholders of the organization or persons controlled directly or indirectly by private interests, then it is considered operating for a private benefit. Reg. 1.501(c)(3)-1(d)(1)(ii).
Revocation of the organization's tax-exempt status will occur only where the transactions are so extensive as to create questions regarding the organization's overall purpose and operations. Furthermore, if the organization has created safeguards to detect and prevent excess benefit transactions, the IRS is less likely to revoke the organization's tax-exempt status.
Example 7.1.2A
Art museum exhibits only art created by local artists. Pieces are for sale and museum receives a 10% commission to cover operating costs. The artists, who are not related to the board of trustees, receive the remaining 90% of the sale price. Because the artists directly benefit from the exhibition of their work and the benefit is substantial, the museum is operated for a private benefit and not exempt under Sec. 501(c)(3).
Example 7.1.2B
An educational organization has the sole purpose of studying the history and immigration of one family and plans to publish a history of the family documenting the pedigree of the family members. The organization solicits members from only that particular family because one of the organization's primary objectives is to locate living descendents and enable them to become acquainted. Because the organization's research activities primarily serve the private interests of one family, the organization is operated for the benefit of private interests and is not exempt under Sec. 501(c)(3).
Disqualified Person
A disqualified person for purposes of applying intermediate sanctions is any person or family member of a person (including his or her brothers and sisters) who at anytime during the five years up to and including the date of the excess benefit transaction is in a position to exercise substantial influence over the public charity. Reg. 53.4958-3. Whether a person is in a position to exercise substantial influence is determined by the facts of the situation. Certain people, however, such as those who serve on a public charity's governing body and are entitled to vote, are per se disqualified persons.
Example 7.1.2C
A building was donated to Charity and Charity wants to sell the building. The sister of the Charity's President would like to buy the building but is not able to pay the Charity's selling price. If the Charity sells her the building for less than fair market value, the sale is an excess benefit transaction; the difference between the sale price and the building's fair market value is the "excess benefit."
Compensation Safe Harbor
A charity may pay reasonable compensation to its officers and directors (or other disqualified persons); but if compensation is unreasonable, the difference between the reasonable and unreasonable compensation is an excess benefit. This is one of the most difficult areas because what is reasonable generally is determined based upon the facts and circumstances of each situation. For instance, it may be reasonable for one charity to pay its President $200,000 per year while another charity jeopardizes its operations by paying its President the same amount.
A charity can avoid excess benefit transactions when paying compensation to disqualified persons by taking advantage of an IRS "safe harbor." Specifically, a charity's payment of compensation will be presumed reasonable if:
- Terms of the compensation are approved by a disinterested board of directors;
- The disinterested board of directors obtains and relies upon appropriate comparability data (three to five comparisons, depending upon the charity's size); and
- The board documents in writing the terms of the compensation, date of approval, information regarding the comparability data obtained and relied on and how the data was obtained and names of the board members who participated in the approval prior to the next board meeting.
Automatic Excess Benefit Transactions
The newest development in the area of excess benefit transactions relates to the identification of "automatic" excess benefit transactions. Specifically, certain transactions, if not properly documented at the outset, will be automatically treated as excess benefit transactions regardless of whether or not they are reasonable.
Compensation is the area where this "automatic" excess benefit transaction is first defined. Any payment from a public charity to or for the benefit of a disqualified person must be documented in writing. If the payment is not for a loan, expense reimbursement or similar exchange of benefits, and if it is not characterized as part of compensation in writing at the time it is paid, the payment will be treated as an "automatic" excess benefit transaction without regard to whether it was reasonable (either alone or in the context of all other compensation received). This means that if a charity pays for a benefit - such as life insurance coverage - for a disqualified person and does not document in writing the nature of that payment (as compensation) when the payment is made, the payment will automatically be treated as an excess benefit.
Intermediate Sanctions Excise Tax
Intermediate sanctions take the form of an excise tax imposed upon the disqualified person who engages in an excess benefit transaction with the public charity and, in some cases, upon managers of the public charity (such as officers, directors or trustees) who knowingly participate in the excess benefit transaction. The excise tax is calculated based upon the amount of the "excess benefit" - the difference between what the public charity provided to the disqualified person and what is received in return. The initial excise tax imposed upon the disqualified person is 25% of the excess benefit and the initial excise tax imposed upon a manager of the public charity who knowingly participated is 10%, with a maximum of $10,000 per manager. If the excess benefit transaction is not subsequently corrected, or undone to the extent possible, an excise tax of 200% of the amount of the excess benefit is imposed upon the participating disqualified person. Reg. 53.4958-1.
Relationship Between Operational Test and Intermediate Sanctions
The identification of excess benefit transactions and application of intermediate sanctions does not supersede or replace the traditional private inurement prohibition, public benefit requirement and prohibition on lobbying and candidate electioneering. Instead, they require an additional analysis. There is often overlap between these requirements and excess benefit transactions. Both work to identify a problem with a charity's activity, and revocation of tax-exempt status and intermediate sanctions may, therefore, both be available to address the same problem. While both revocation and intermediate sanctions may be available, focus in recent years primarily has been on intermediate sanctions because it provides an "intermediate" consequence - something less than loss of tax-exempt status - to charities that fail to engage primarily in activities that accomplish their charitable purposes.
Example 7.1.2D
If a charity gives opera tickets worth $10,000 to a substantial contributor, the charity has not engaged primarily in charitable purposes - thereby failing the operational test - both by violating the prohibition on private inurement and by engaging in an excess benefit transaction. The charity could, therefore, lose its tax-exempt status (due to violation of the operating test's private inurement prohibition), have its board and substantial contributor subject to monetary penalties (due to the imposition of intermediate sanctions) or both.
Charitable Tax Shelter Penalty Tax
In Notice 2007-18, Treasury explained to nonprofits the potential penalties for becoming involved in tax shelter transactions.
Under Sec. 4965, a nonprofit may be subject to an excise tax if it is involved in a "prohibited tax shelter transaction." If the nonprofit did not know or did not have reason to know that it was participating in a prohibited tax shelter transaction, then it may be required to pay an excise tax based on 35% of the greater of (1) the nonprofit's net income "for the taxable year" attributable to the transaction or (2) 75% of the proceeds from the transaction. If the nonprofit knew or had reason to know the transaction was a prohibited tax shelter, the excise tax is 100% of the above formula. For managers with knowing participation, the excise tax on individual manager may be up to $20,000.
Treasury provides several examples of nonprofits that are subject to the excise tax on prohibited transactions. Generally, transactions before Aug. 16, 2006 and those that are not facilitated by the nonprofit's exempt status are exempt. However, payments received as a "party to a tax shelter" transaction after that date will subject the nonprofit to the excise tax. A nonprofit is a party if it uses its exempt status to facilitate the transaction, or it is identified in published guidance as a party.
The Sec. 4965 excise tax was passed after Congress was informed that tax shelter promoters were paying charities modest fees to participate in tax shelters. Tax shelter promoters were then using the credibility of the charity to facilitate sale of tax shelter interests.
With the excise tax and reporting requirements, nonprofits will be cautious about participating in or receiving gifted interests in tax shelters. If a gift strategy involves fraud, misstatement or gift overvaluation and the promoters of that strategy are later determined to be marketing a tax shelter, the charity could be subject to the Sec. 4965 excise tax.
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Case Studies on Intermediate Sanctions
Lucky Lucy Lindstrom's "Cousins' Scholarship" Plan:
Lucy Lindstrom finished college and headed west. She started as a financial analyst with a large company in Seattle. After just four years, she became a Registered Investment Advisor and began advising clients. Lucy also managed her own investments. With her keen insight into financial markets, Lucy soon began to move from traditional stocks and bonds into futures and commodities markets. Lucy was so successful in these markets that she now only manages her own large personal portfolio.
Somewhat late in life, Lucy discovered the wonderful world of philanthropy. She volunteered at her favorite charity and has learned that giving someone in need a helping hand is even more gratifying than making another million in the futures market.
Lucy had invested $1,000,000 in a "penny stock" company. Recently, the stock rose from the $1 per share that she paid to over $5 per share. Lucy thinks that this stock should be sold as soon as possible, but she would like to receive a charitable deduction this year. In addition, she thought that the $5,000,000 could be placed in a supporting organization with a community foundation to provide scholarships for students.
Lucy comes from a large family. She has 30 cousins, and many of their children are now entering college. Since her supporting organization will distribute $250,000 in scholarships each year, Lucy asked the community foundation's CEO if she could give scholarships to the children of her 30 cousins. She likes the concept of a "Cousins' Scholarship" program.
Would this plan work? Can the supporting organization fund scholarships for her cousins' children?
Lucky Lucy Lindstrom's "Personal Loan" Charity:
Lucky Lucy Lindstrom finished college and headed west. She started as a financial analyst with a large company in Seattle. After just four years, she became a Registered Investment Advisor and began advising clients. Lucy also managed her own investments. With her keen insight into financial markets, Lucy soon began to move from traditional stocks and bonds into futures and commodities markets. Lucky Lucy was so successful in these markets that she now only manages her own large personal portfolio.
Somewhat late in life, Lucy discovered the wonderful world of philanthropy. She volunteered at her favorite charity and learned that giving someone in need a helping hand is even more gratifying than making another million in the futures market.
Lucy had invested $1,000,000 in stock in a "penny stock" company. Recently, the stock rose from the $1 per share that she paid to over $5 per share. Lucy was delighted with her gain and decided to give the $5,000,000 to a supporting organization (SO) of her favorite charity.
For the first two years, the SO distributed grants for charitable purposes. However, in year three, Lucy made a major mistake in her personal commodities investing. She now wants to borrow $3,000,000 from the SO to "tide her over" through this difficult time. Since she needs all her assets to cover her leveraged obligations, Lucy would like to obtain a no-interest loan for two years from the SO. After all, she thinks, "I gave $5,000,000 to the SO, so it surely would be okay to borrow $3,000,000 at no interest for two years."
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