Intermediate Sanctions (Portfolio 476)

Part of Tax

Tax Management Portfolio, Intermediate Sanctions, No. 476, discusses in detail the applicable sanctions that, under §4958, may be imposed on so-called “excess benefit transactions” involving §501(c)(3) public charities, §501(c)(4) organizations, and their insiders. 

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Tax Management Portfolio, Intermediate Sanctions, No. 476, discusses in detail the applicable sanctions that, under §4958, may be imposed on so-called “excess benefit transactions” involving §501(c)(3) public charities, §501(c)(4) organizations, and their insiders. Enacted in 1996 by the Taxpayer Bill of Rights 2, §4958 was added to the Internal Revenue Code to provide the IRS with a tool to penalize insiders of §501(c)(3) public charities and §501(c)(4) organizations who receive excess compensation or engage in unfair business transactions with the organizations, as well as managers who knowingly approve such arrangements. Section 4958 imposes an excise tax on a “disqualified person” — a person with substantial control over the organization — who receives excessive economic benefit from the organization, as well as on the organization manager(s) who approves the benefit knowing it to be excessive. The IRS may choose to invoke these penalties on the disqualified person as an alternative to revoking the organization's tax exemption, hence the term “intermediate sanctions” to describe this new penalty regime. Amendments made by the Pension Protection Act of 2006 extended the intermediate sanctions penalty system to certain transactions involving donor advised funds and supporting organizations and their substantial contributors, even when there is no “excess” benefit.
The Portfolio begins by reviewing the background leading to the adoption of §4958. It then identifies the exempt organizations to which §4958 applies and the key definitions of “disqualified person” and “organization manager.” The Portfolio provides a thorough consideration of how an “excess benefit transaction” may be effected via transactions involving compensation, revenue sharing, and property transfers. The Portfolio discusses the “initial contract” exception and the procedures for qualifying for a “rebuttable presumption of reasonableness” and describes how the excise taxes are imposed as well as the “correction” and abatement of §4958 sanctions. The Portfolio reviews the application of §4958 to donor advised funds and supporting organizations added in 2006 by the Pension Protection Act. Finally, the Portfolio addresses the interplay of §4958 with good governance practices and the reporting requirements of the revised Form 990.
Other portfolios that discuss intermediate sanctions include T.M., Tax Issues of Educational Organizations; 484 T.M, Tax Issues of Religious Organizations; and T.M., Tax-Exempt Organizations: Organizational and Operational Requirements.
This Portfolio may be cited as Roady, T.M., Intermediate Sanctions.


Celia Roady, Esq.

Celia Roady is a partner in the Tax Practice of Morgan, Lewis & Bockius, LLP, Washington, D.C. office. She focuses her practice on tax and governance issues affecting tax-exempt organizations, including charities, foundations, colleges and universities, museums, and other nonprofit organizations. Ms. Roady was appointed by the Internal Revenue Service to be a member of its Advisory Committee on Tax-Exempt and Government Entities for 2010–2012. She has also been named by Legal Times as one of Washington, D.C.’s “leading lawyers” in the tax field and is listed in Chambers USA: America's Leading Lawyers for Business (2005–2010) and The Best Lawyers in America (2007–2010).
Ms. Roady chairs the annual conference on “Representing and Managing Tax-Exempt Organizations,” sponsored by the Georgetown University Law Center. She also is a frequent speaker for the American Bar Association (ABA), American Law Institute, and other nonprofit conferences and symposia. In 2004–2005, Ms. Roady served on the Governance Work Group of the Panel on the Nonprofit Sector, which was convened by Independent Sector to provide comments to the Senate Finance Committee.
Ms. Roady is a fellow with the American College of Tax Counsel and has served as vice chair of communications for the ABA Section on Taxation. She is a former ABA Tax Section council member and former chair of the Exempt Organizations Committee, as well as a former chair of the Exempt Organizations Committee of the D.C. Bar Tax Section.
Following graduation from Duke University in 1973, Ms. Roady received her law degree in 1976 from Duke University and her LL.M. from Georgetown University in 1979.

Table of Contents

Detailed Analysis

I. Introduction

Introductory Material

A. Problems with Pre-Act Penalties for Inurement

1. Section 501(c)(3) Organizations

2. Section 501(c)(4) Organizations

3. Definition of Insider for Purposes of Inurement

B. Section 4941: A Template for § 4958

C. Previous Proposals for Intermediate Sanctions Legislation

II. Overview of § 4958

III. Definition of Applicable Tax-Exempt Organization

Introductory Material

A. Section 501(c)(3) Organizations

1. Application of § 508 Rules

2. Private Foundation Exclusion; Terminating Private Foundations

3. Foreign Charities

4. Governmental Entities and Instrumentalities

5. Collectively Bargained Apprenticeship Funds

B. Section 501(c)(4) Organizations

C. Impact of Nonrecognition of Exemption or Revocation of Exemption

IV. Definition of a Disqualified Person

Introductory Material

A. Disqualified Persons by Reason of Position

B. Disqualified Persons by Reason of Facts and Circumstances

C. Other Categories of Disqualified Persons

D. Persons Not Disqualified by Reason of Position

E. Persons Not Disqualified by Reason of Facts and Circumstances

F. Treatment of Donor-Advisors as Disqualified Persons

V. Definition of Organization Manager

VI. Excess Benefit Transactions

Introductory Material

A. Reasonableness Standard in General

1. Compensation

2. Sources of Compensation

3. Indirect Economic Benefits

a. Controlled Entity

b. Intermediary Entity

c. Examples

4. Embezzlement of Funds by Disqualified Person: "Provided by" Requirement

5. Initial Contract Exception

6. Timing of Reasonableness Determination

7. Intent to Treat Economic Benefit as Consideration for Services

8. Treatment of Insurance or Indemnification for Excise Taxes

B. Revenue-Sharing Transactions; Incentive Compensation

1. Pre-§ 4958 IRS Position Regarding Incentive Compensation Plans

a. The Incentive Plan Should Build Upon a System of Reasonable Compensation

b. The Plan Should Reflect the Realistic Needs of the Organization for Services

c. The Plan Should Be Formulated and Adopted Through a Process Independent of the Employees

d. The Structure of the Plan Should Minimize the Potential for Employee Control

e. The Incentive Formula Should Promote Exempt Objectives

f. The Plan Should Not Encourage Conduct Contrary to Exempt Purposes

g. The Plan Should Ensure that Aggregate Compensation Payments Are Reasonable

2. IRS Information Letter Dated January 9, 2002

C. Loans As Excess Benefit Transactions

D. Transfer or Use of Property

E. Early Cases and Technical Advice under § 4958

1. Sta-Home Health Agencies v. Comr.

2. Peters v. Comr.

3. Technical Advice Memorandum 200243057

4. Technical Advice Memorandum 200244028

F. Special Rules for Donor Advised Funds and Supporting Organizations

VII. Rebuttable Presumption of Reasonableness

Introductory Material

A. Independent Approval

B. Comparable Data

C. Adequate Documentation

D. Effect of Establishing Rebuttable Presumption

VIII. Imposition of Excise Tax

Introductory Material

A. Initial Tax on Disqualified Person

B. Second-Tier Tax on Disqualified Person

C. Definition of Correction

D. Excise Tax on Organization Manager

1. Definition of Participation

2. Definition of Knowing

a. Reliance on Professional Advice

b. Qualification for Rebuttable Presumption of Reasonableness

3. Definition of Willful

4. Reasonable Cause

IX. Abatement of § 4958 Excise Taxes

X. Reporting Excess Benefit Transactions

XI. Church Tax Inquiries and Examinations

XII. IRS Discretion to Impose Revocation and/or Excise Taxes

Working Papers

Working Papers

Table of Worksheets

Other Sources

Worksheet 1 Easier Compliance is Goal of New Intermediate Sanction Regulations

Worksheet 2 Rebuttable Presumption Procedure is Key to Easy Intermediate Sanctions Compliance

Worksheet 3 IRS Information Letter 2002-0021 by Marvin Friedlander, Manager, Exempt Organizations Technical Group I, Internal Revenue Service, dated January 9, 2002

Worksheet 4 Intermediate Sanctions (IRS 4958) Update, from FY 2003 CPE Text for Tax Exempt Organizations

Worksheet 5 Kamehameha Schools Bishop Estate Closing Agreement




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