• Factors for Revocation of Tax-exempt Status for Engaging in Excess Benefit Transactions
  • May 8, 2008
  • Law Firm: Hinshaw & Culbertson LLP - Rockford Office
  • Under Section 4958 of the Code, the IRS may impose excise taxes on a transaction between a tax-exempt social welfare organization or public charity, such as a hospital or other health care provider, and a person who is in a position to exert substantial control over the organization, if the transaction results in an excess benefit to the person. An applicable tax-exempt organization pays an excess benefit when the value it pays to a disqualified person exceeds the value of goods or services it receives in return. A disqualified person is an individual in a position to exercise substantial influence over the affairs of the organization, a family member of such an individual, or an entity in which such an individual owns more than a 35 percent interest. The excise taxes are imposed on the disqualified person who benefited from the transaction and any organization managers who participated in the transaction knowing it was improper. The disqualified person is subject to an initial tax equal to 25 percent of the excess benefit and the organization managers who participated in the transaction knowing it was prohibited are subject to a tax equal to 10 percent of the excess benefit up to $20,000. If there is no correction of the excess benefit within a certain period of time, the disqualified person is subject to an additional tax equal to 200 percent of the excess benefit.

    The final regulations clarify that the substantive requirements for tax-exemption under Section 502(c)(3) of the Code still apply to tax-exempt public charities and social welfare organizations whose disqualified persons or organization managers are subject to excise taxes. Thus, an organization may lose its tax-exempt status if, due to the excess benefit transaction, it is no longer organized and operated primarily to serve an exempt purpose. The regulations set forth five factors that the IRS considers, in addition to all relevant facts and circumstances, in determining whether to revoke an organization’s tax-exempt status:

    • the size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after the excess benefit transaction occurred;
    • the size and scope of the excess benefit transaction in relation to the size and scope of the organization’s regular and ongoing activities that further exempt purposes;
    • whether the organization has been involved in multiple excess benefit transactions with one or more persons;
    • whether the organization has implemented safeguards that are reasonably calculated to prevent excess benefit transactions; and
    • whether the excess benefit transaction has been corrected or the organization has made good faith efforts to seek correction from the disqualified person who benefited from the excess benefit transaction.

    The last two factors weigh more heavily in favor of continued recognition of tax-exemption if the organization takes action before the IRS discovers the excess benefit transaction. However, simply correcting the excess benefit transaction after the IRS has discovered it is by itself never a sufficient basis for maintaining tax exemption. The IRS provides in the regulations six examples that demonstrate how the factors apply to certain situations. The regulations do not provide any “best practices” to improve governance and prevent prohibited transactions.