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Exempt Organizations Bulletin (February 2001)

Treasury Regulations Implement
"Intermediate Sanctions"




By Carol S. Boulanger, a tax partner and Michael Burnstein and Wayne Batchis, former associates in our New York office. If you have or can obtain the Acrobat Reader, or have an Acrobat-enabled web browser, you may wish to download or view our February 2001 Exempt Organizations Bulletin (a 96K pdf file), containing a printed version of this article.

This article concerning the "intermediate sanctions" excise tax applicable to certain exempt organizations is part of the Pillsbury Winthrop Shaw Pittman LLP Tax Page, a World Wide Web demonstration project, no portion of which is intended and cannot be construed as legal or tax advice. Comments are welcome on the design or content of this material.


The Treasury Department has issued long-awaited guidance, in the form of temporary regulations, under section 4958 of the Internal Revenue Code of 1986, as amended (the "Code"). Known as the "intermediate sanctions" provision, section 4958 was enacted by section 1311 of the Taxpayer Bill of Rights 2, P.L. 104-168, and is generally effective for transactions occurring on or after September 14, 1995.

Section 4958 imposes penalty taxes on transactions between certain tax-exempt organizations and related persons. Covered organizations include universities, hospitals, museums, and any other "public charities" described in section 501(c)(3) of the Code, as well as certain organizations described in section 501(c)(4) of the Code. The temporary regulations are effective from January 10, 2001, though January 9, 2004.

Managers and "Disqualified Persons" May Be Personally Liable

A transaction is subject to scrutiny under section 4958 if it is between (1) an organization that is, or was at any time during the previous five years, exempt from federal income tax under section 501(c)(3) (other than a private foundation) or section 501(c)(4) of the Code, and (2) a so-called "disqualified person," including current and former insiders and related persons. In general, penalty taxes are imposed if the disqualified person receives an "excess benefit" as a result of the transaction.

Two separate penalty taxes may apply. The first is imposed on the disqualified person at the rate of 25 percent of any excess benefit received. To the extent the transaction is not corrected within applicable time limits, an additional tax is imposed at the rate of 200 percent of the uncorrected excess benefit. The second tax, imposed on managers of the organization who knowingly participate in the transaction, is 10 percent of any excess benefit, limited to $10,000 per transaction. A manager will not be liable if his or her participation was not willful and there was reasonable cause.

The Internal Revenue Service may impose these taxes in addition to, or in lieu of, revoking the organization's tax-exempt status.

The Regulations Help Identify "Disqualified Persons"

The temporary regulations broadly define "disqualified person." Any person in a position to exert "substantial influence" over an organization's affairs at any time during the five-year period ending on the date of the relevant transaction is considered a disqualified person. In addition, certain family members of a disqualified person, and certain entities controlled by a disqualified person, are themselves considered disqualified persons.

The temporary regulations consider the following persons to be in a position to exert substantial influence:

    voting members of the organization's governing body,

    officers who are responsible for implementing the decisions of the governing body with broad supervisory authority,

    officers for managing the organization's finances and

    in the case of a hospital that participates in a provider-sponsored organization, persons with a material financial interest in the organization.

The temporary regulations also provide that certain persons are considered not to have substantial influence. In the case of a related person who is on neither list, it is necessary to consider all relevant facts and circumstances in determining whether or not the person has substantial influence. In this regard, the temporary regulations consider, among other things, whether the person founded or contributes to the organization or exercises control over an important segment of the organization.

Virtually any Transaction May Result in an Excess Benefit

Under the temporary regulations, a transaction gives rise to an excess benefit to the extent that the value of the benefit conferred upon the disqualified person, directly or indirectly, exceeds the value of any consideration provided in return. All forms of economic benefit must be scrutinized, including any benefit conferred as compensation or in the context of a sale and purchase of property.

Compensation results in an excess benefit if it is unreasonable. The temporary regulations consider the following items in determining whether a disqualified person's total compensation is reasonable:

    all cash and noncash compensation, including salary, fees, bonuses, severance payments, and deferred and noncash compensation under a qualified pension, profit-sharing, or stock bonus plan,

    the payment of certain liability insurance premiums and

    any other benefits, including medical, dental, life insurance and disability benefits, certain expense allowances or reimbursements and foregone interest.

In general, a payment purporting to be compensation for services rendered will not be respected as such—and will therefore risk treatment as an excess benefit—unless the organization clearly indicates its intent to treat the payment as compensation at the time it is paid.

The temporary regulations provide an exception for certain contracts that a person may enter into before becoming a disqualified person, but that provide for fixed payments thereafter. Certain economic benefits are disregarded altogether.

Safe Harbors May Limit Exposure

There are two safe harbors under which a covered organization may minimize exposure to the penalty taxes. The first provides that if the organization's governing body complies with certain procedures, it will enjoy a rebuttable presumption that the transaction is fair, and therefore not an excess benefit transaction. To invoke this safe harbor, the organization must take certain steps to ensure the fairness of the transaction and contemporaneously document compliance with the requirements of the safe harbor. The second safe harbor allows an organization's managers to avoid the 10 percent penalty tax by showing reliance on a reasoned, written opinion of an appropriate professional after full disclosure of the relevant facts. Each safe harbor provides detailed procedural requirements.

Managers Should Implement Safeguards to Avoid Penalties

To minimize the risk of section 4958 taxes, covered organizations should identify potential disqualified persons and, to the extent possible, make sure that their transactions satisfy the requirements of the safe harbors. They should also ensure that all compensation arrangements comply with the contemporaneous-documentation requirements.

Available Materials

The following Treasury Decisions contain the text of and corrections to the temporary regulations, as well as background and explanatory material:


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