|Arthur D. Cassill, CPA, PhD, is
associate professor of accounting at the University of North
Carolina at Greensboro. |
Susan E. Anderson, CPA, PhD, is assistant professor of accounting at the University of North Carolina at Greensboro.
With the enactment of the Taxpayer Bill of Rights 2, tax-exempt organizations face significant new reporting requirements and penalty taxes. Although President Clinton signed the bill into law on July 30, 1996, many provisions are retroactive to September 14, 1995. This article discusses the law and describes the steps tax-exempts can take to reduce their exposure to the new penalties.
CPAs who serve tax-exempts as employees or consultants will have to
explain the implications of this legislation to an ever-growing body
of tax-exempt organizations. A recent Government Accounting Office
report says there are now more than 1.1 million tax-exempts in the
United States, with the number growing at the rate of over 40,000
annually. These organizations raise over $700 billion of revenue
annually and control an estimated 11% of the gross domestic product.
By passing the Taxpayer Bill of Rights 2, Congress is seeking to hold
tax-exempts more accountable to improve compliance and to provide the
public with more information about these organizations through
additional disclosure requirements.
KEEPING THE "STATUS" QUO
To maintain tax-exempt status, an organization must not allow any of its earnings to "inure" to the benefit of a private shareholder or individual. Inurement is the improper diversion of an organizations net earnings by persons with substantial influence over the organization for their private benefit or that of related parties (such as family members). Examples include excessive salaries, interest-free loans and paying a predetermined percentage of offerings to those in control of religious organizations.
Two types of organizations are tax-exempt under Internal Revenue Code section 501(c)(3): public charities and private foundations. Public charities include churches, educational institutions and hospitals. Private foundations are defined by a complex set of rules in IRC section 509(a).
Under prior law, if a public charity engaged in activities resulting in private inurement, the only sanction specifically authorized was revocation of the organizations tax-exempt status.
In contrast, private foundations have been subject to penalty excise taxes since 1970. IRC section 4945 levies a penalty on any private foundation expenditure that does not serve a charitable purpose. Individuals who have close relationships with private foundations and foundation managers also are subject to penalty excise taxes under IRC section 4941 if they participate in "self-dealing" transactions with the foundation.
Because revocation of exempt status was such a severe penalty, for several years Treasury Department officials argued in favor of penalty excise taxes (called intermediate sanctions) to improve enforcement of inurement violations. These arguments culminated in the enactment of the Taxpayer Bill of Rights 2, which provides rules similar to those already in existence for private foundations and allows the Internal Revenue Service to levy penalties on individuals who benefit from inurement. The new penalty taxes apply to public charities and also to social welfare organizations.
|An Internal Revenue Service report says that for the year ending September 30, 1995, the agency had approved over 46,000 new applications from entities seeking tax-exempt status, up 21% since 1991.|
Under newly enacted IRC section 4958, intermediate sanctions are imposed on "excess benefit transactions" between a "disqualified person" and a tax-exempt organization. An excess benefit transaction is one in which the economic benefit an organization provides is greater than the value of the consideration (including performance of services) it receives. A disqualified person is anyone who is in a position to exercise substantial influence over the organizations affairs. (The statute does not define substantial influence, but the Treasury regulations may provide guidance when they are issued.)
Excess benefit transactions also include those in which a tax-exempt makes payments wholly or partially based on its revenues, as defined by regulations to be written by the Treasury. The penalty taxes will be levied on any disqualified persons who benefit from the transactions and on organization managers who participate in the transactions knowing they are improper.
Who are disqualified persons? Individuals who are officers, directors
or trustees typically are disqualified persons unless they are not
able to exercise substantial influence over the organization. The
legislative history says an individual may be disqualified even if he
or she is not employed by the organization in question as long as that
person is able to exercise substantial influence. Family members of
disqualified persons also are considered disqualified, as are entities
in which a disqualified person has a 35% ownership interest. An
individuals classification as disqualified continues for five years
after he or she severs ties with the tax-exempt organization.
THE RULES AT WORK
Here are some examples of how the rules operate.
Example 1. Anderson provides services as director of
charity X. She is considered a disqualified person. To persuade her to
accept this position, charity X offered Anderson a lucrative
compensation package far greater than that received by directors of
charities of comparable size. Unless Anderson and charity X can
demonstrate that the compensation package equals the fair market value
of her services, Anderson will be subject to a penalty tax. In
addition, if any of charity Xs managers agreed to the package knowing
it constituted inurement, they also will be subject to penalty taxes.
Example 2. Benson provides services to charity Y as a fundraising manager and is considered a disqualified person. As part of his employment contract, Benson is compensated based on a percentage of the funds he raises. Under regulations to be developed by the Treasury, Benson will likely be subject to a penalty tax. Any of charity Ys managers who agreed to the compensation scheme knowing it was improper also will be subject to a penalty.
Example 3. Channing left her position as manager of charity Z in 19x1. Since an individual remains a disqualified person for five years after leaving a tax-exempt organization, Channing is considered disqualified until 19x6. In 19x5, she sold land to charity Z for a price significantly above the propertys fair market value. Channing is considered a disqualified person and is subject to a penalty tax. Any manager of charity Z participating in the transaction also is subject to a penalty if he or she knew the transaction was improper.
As these examples illustrate, whether a transaction results in private inurement depends on a measure of reasonable compensation or fair market value. Existing standards, such as those under IRC section 162, may be used to evaluate the reasonableness of such payments. The Joint Committee on Taxation (JCT) report describes a rebuttable presumption of reasonableness that was not included in the statute. The Treasury may adopt this description when it issues regulations. According to the JCT report, a compensation arrangement is presumed to be reasonable if it meets three requirements:
- The arrangement was approved by an independent board (or an
independent committee authorized by the board). The board must be
composed entirely of individuals unrelated to and not subject to the
control of the disqualified person(s) involved in the arrangement.
- The independent board obtained and relied on data analyzing the
comparability of the compensation arrangement with those offered by
similar taxable and tax-exempt organizations.
- The independent board adequately documented the basis for its determination.
The JCT report also provides for a similar rebuttable presumption on
property transfers if the transfer is approved by an independent board
that used appropriate comparability data.
CALCULATING THE PENALTY TAX
A disqualified person who benefits from an excess benefit transaction is subject to a first-tier penalty tax of 25% of the excess benefit. In addition, organization managers who participate knowing the transaction is improper are subject to a first-tier penalty tax of 10% of the excess benefitto a maximum of $10,000 per transactionregardless of the number of managers involved. A second-tier tax on disqualified persons is assessed if the transaction is not corrected within the taxable period, which the law defines as beginning on the date of the excess benefit transaction and ending the earlier of the date the first-tier tax is assessed or the date the statutory notice of deficiency is mailed. The second-tier tax is 200% of the excess benefit.
This provision seems to imply that to avoid the second-tier tax,
tax-exempts must monitor themselves and correct excess benefit
transactions before the IRS imposes the first-tier tax upon audit.
Correction occurs by removing the excess benefit to the extent
possible and taking any additional measures necessary to put the
organization in a financial position not worse than it would have been
in had the disqualified person been dealing under the highest
fiduciary standards. If a tax-exempt organization takes timely
corrective action, the IRS may abate the second-tier tax, particularly
if the excess benefit transaction occurred during the period prior to
enactment (between September 14, 1995, and July 30, 1996). Example.
Andersons annual compensation as director of charity X is $500,000.
The IRS determines that the fair market value of her services is
$200,000. Anderson is subject to a first-tier tax of $75,000
($300,000325%). Charity Xs managers who allowed the excess
benefitknowing that it was improperare subject to a $10,000 penalty
tax (the lesser of $10,000 or $300,000310%). If Andersons compensation
is not modified to remove the excess benefit by the date the
first-tier tax is assessed, she will be subject to a second-tier tax
of $600,000 (200% of $300,000).
ADDITIONAL FILING AND PUBLIC DISCLOSURE RULES
The new provisions also permit the Treasury secretary to impose increased disclosure requirements. Tax-exempts are now required to disclose information on their Forms 990, Return of Organization Exempt from Income Tax, about disqualified persons, details of excess benefit transactions and penalty taxes paid under sections 4911, 4912 and 4955. These code sections impose penalties on lobbying and political expenditures. In addition, the bill increases the penalty for failure to file a complete and timely form 990 from $10 to $20 a day for each day the failure continues. The penalty is 5% of gross receipts up to a maximum of $10,000. Organizations with annual gross receipts over $1 million are subject to a $100 a day failure to file penalty, to a maximum of $50,000.
Tax-exempt organizations (other than private foundations) must
provide copies of their applications for tax-exempt status and their
three most recent tax returns to anyone requesting these documents.
Tax-exempts may charge a reasonable fee to cover reproduction and
mailing costs. If a tax-exempt does not provide these copies within 30
days of a written request, it is subject to a $20 per day penalty, to
a maximum of $10,000. Organizations that willfully fail to make these
documents available are subject to a $5,000 penalty for each return
and application requested. An organization will be relieved of these
requirements if it makes these documents widely available in
accordance with standards to be established by the Treasury.
RETROACTIVE EFFECTIVE DATE
Intermediate sanctions may be imposed on excess benefit transactions occurring on or after September 14, 1995. The provision does not apply to benefits paid under a written contract binding on September 13, 1995, that has not materially changed. According to the JCT report, if a contract was formed after September 13, 1995, but before January 1, 1997, the contracting parties may rely on the rebuttable presumption of reasonableness described earlier by meeting the three criteria within a reasonable period (such as 90 days) after entering into the compensation package. Assuming the regulations follow the JCTs rebuttable presumption criteria, the presumption will be allowed only if the three criteria are satisfied before payment of the compensation for contracts written in 1997 and later.
The requirements to report tax penalties and excess benefit transactions are effective for taxable years beginning on or after July 30, 1996. The requirement that organizations provide copies of their tax returns is effective for requests made no earlier than 60 days after regulations describing procedures for making returns widely available are issued.
|Tips to Avoid Intermediate Sanctions|
CPAs can advise tax-exempts of steps they can take to reduce or eliminate the impact of the penalty taxes. These steps are listed in the sidebar at left. Since the law is retroactive to September 14, 1995, existing contracts must be examined to determine whether corrective action is needed to avoid penalties. New contracts should be entered into only after the guidelines of the JCT reports rebuttable presumption of reasonableness have been met. Managers may escape penalties if there was reasonable cause for their actions. This provision also applies to private foundations, so past rulings in this area should provide guidance on the definition of reasonable cause. Unfortunately, written advice in the form of private letter rulings is unlikely because the IRS will not issue rulings on reasonable compensation cases and valuation issues.
The new provisions have a significant overall impact on tax-exempts.
- It is now more difficult for tax-exempts to hire highly compensated executives simply because they can receive lucrative compensation packages in the for-profit arena without exposing the organization to sanctions.
- Tax-exempts that want to attract high-profile individuals to help raise funds cannot do so if compensation is based solely on revenues raised.
- Tax-exempts must appoint trustees who are knowledgeable about compensation issues and willing to implement the laws compensation oversight requirements.
- If the Treasury Department adopts regulations for public charities similar to those already in existence for private foundations, the definition of disqualified persons will extend to trustees, directors and others with substantial influence over the organization. Joint and several liability could be imposed on unsuspecting managers and others because they simply do not have singular decision-making authority for compensation or excess benefits transactions decisions.
- Smaller tax-exempt organizations may find it difficult to meet their goals due to costly information reporting not previously required.
- Tax-exempts must take heed of these new provisions. The JCT estimates revenues from intermediate sanctions of $33 million over the next five years (1996 to 2002). The fact that revenues are expected to be collected indicates the IRS is intent on imposing the sanctions aggressively. Because regulations will not be forthcoming soon, tax-exempts must be more attentive to their actions until clarifying guidance is available.
An Internal Revenue Service report says that for the year ending September 30, 1995, the agency had approved over 46,000 new applications from entities seeking tax-exempt status, up 21% since 1991.