• IRS Proposed Regulations Clarify Link Between Excess Benefit and Tax-Exempt Status
  • October 11, 2005 | Author: Lisa B. Petkun
  • Law Firm: Pepper Hamilton LLP - Philadelphia Office
  • On September 8, 2005, the IRS released proposed regulations regarding standards the IRS will use to determine whether to revoke the §501(c)(3) status of an organization that has engaged in a transaction that constitutes both private inurement under §501(c)(3) of the Internal Revenue Code and an excess benefit transaction under the intermediate sanctions rules of §4958 of the Internal Revenue Code.

    An excess benefit transaction occurs when an organization exempt from federal tax under §501(c)(3) or (4) provides a benefit to an insider who is a leader (an officer, director, executive or manager with significant control over a major segment of the organization) that exceeds fair market value or is otherwise commercially unreasonable. When an excess benefit transaction occurs, the disqualified person who benefited must correct the transaction or repay the amount by which the benefit exceeded fair market value. Additionally, the disqualified person and the organization's leaders who knowingly participated in the transaction are subject to excise taxes.

    In determining whether to revoke the organization's tax-exempt status, the IRS will consider the following facts and circumstances:

    • the size and scope of the organization's regular and ongoing exempt purpose activities before and after the excess benefit transaction
    • the size and scope of the excess benefit transaction in relation to the size and scope of the organization's regular and ongoing exempt purpose activities
    • whether the organization has been involved in repeat excess benefit transactions
    • whether the organization has implemented safeguards that are reasonably calculated to prevent future violations
    • whether the excess benefit transaction has been "corrected" (repaid, plus interest), or the organization has made good faith efforts to seek correction from the insiders who benefited from the excess benefit transaction.

    All of these factors will be considered in combination. Depending on the particular situation, the IRS may assign some factors greater or lesser weight than others.

    The proposed regulations permit correction of violations if they are uncovered by the organization before they are discovered by the IRS. Under the proposed regulations, even substantial private inurement will not result in revocation of tax-exempt status if, after discovery of the inurement and before being raised by the IRS, the organization takes steps to correct its prior practices and implement policies and procedures reasonably designed to prevent a reoccurrence of the problem. Those steps include:

    • removing insider leaders (directors, officers and senior management employees) who allowed the private inurement to occur
    • appointing new, disinterested insiders who will be attentive in to performing due diligence and avoiding conflicts of interest
    • acting to recover any excess benefits from insiders
    • taking reasonable steps to implement policies and procedures designed to prevent problems in the future.

    Negligible amounts of private inurement will not result in loss of tax-exempt status if the inurement was inadvertent and the organization acted reasonably before and after the problem was discovered, according to the proposed regulations.

    Given the emphasis on discovery and correction of transgressions by organizations, exempt organizations should assess and augment current procedures and practices where needed. Organizations may want to:

    • review and document compensation decisions and any transactions with insiders to ensure reasonableness
    • update or adopt a Conflict of Interest Policy -- the instructions to the recently revised Form 1023 (Application for Recognition of Exemption from Federal Income Taxation - available on the IRS Web site) contain a model policy
    • ensure that officers and directors respond annually to a conflict of interest questionnaire so that the organization is aware of potential conflicts.

    If an organization becomes aware of an excess benefit transaction, correcting or taking reasonable steps to correct it may help avoid the loss of tax-exempt status.