A powerful new tool for the IRS.

On July 30, 1996, President Clinton signed into law a bill providing for intermediate sanctions on certain transactions involving some nonprofit organizations. The new law applies only to 501(c)(3) and 501(c)(4) organizations. Other nonprofit entities, such as 501(c)(6) associations and 501(c)(5) trade unions, are not subject to these taxes.

The Treasury Department had long maintained that an intermediate sanctions provision was necessary for dealing with perceived abuses in the nonprofit sector. Prior to the new law, if the Internal Revenue Service uncovered private inurement or other financial abuses, it had only two choices: Revoke the organization's exemption or do nothing. Since the IRS was unwilling to revoke exemptions, except in the most flagrant cases of abuse, it usually did nothing. It is interesting to note that Congress intended that the intermediate sanctions penalty excise tax be imposed by the IRS in lieu of revocation of the organization's tax-exempt status, but the act makes no statutory change to the IRS's ability to impose revocation. The Congressional Report makes clear that intermediate sanction taxes may be imposed with or without revocation of tax-exempt status.

The new taxes are not imposed directly on the nonprofit organization; rather, they are imposed on a "disqualified person" who received an "excessive economic benefit" and on any "organization manager" who knowingly and willfully participated in the "excess benefit transaction."

Definitions

The term disqualified person is broadly defined as "any person who was, at any time during the five-year period ending on the date of the excess benefit transaction, in a position to exercise substantial influence over the affairs of the organization." The term also extends to include family members of the disqualified person and certain entities in which at least 35 percent of the control or beneficial interest are owned by the disqualified person.

An organization manager is an "officer, director, or trustee of the organization" or any other person "having powers or responsibilities similar to those of the officers, directors, or trustees of the organization."

An excess benefit transaction occurs whenever the nonprofit organization provides economic benefits to a disqualified person that exceed the value of the goods or services provided by the disqualified person to the organization. The excess benefit is the excess of the amount received by the individual over the value provided to the organization. For example, if a nonprofit organization pays $50,000 to a disqualified person for property with a fair market value of $35,000, there would be a $15,000 excess benefit to the disqualified person.

Amount of the tax

The initial tax imposed on an excess benefit transaction is 25 percent of the excess benefit. In the justcited example, the disqualified person would have to pay an excise tax of $3,750 (25 percent of $15,000). In addition, the disqualified person is required to return the excess benefit. This must be done either by undoing the transaction or by restoring the organization to a financial position that is at least as good as it would have had if the transaction had not taken place.

According to a source at the IRS, the regulations for making the organization whole will very likely require that an additional sum will be owed for income earned on the excess benefit (see Internal Revenue Code Sections 4958 and 4941). In the example, the disqualified person could either take back the property and return the $50,000 to the organization, or he or she could give the organization an additional $15,000 (plus income thereon) to make it whole. If the disqualified person does not correct the transaction, within a specified time period, he or she is liable for an additional tax of 200 percent of the excess benefit. In the above example, if the disqualified person did not correct the transaction, he or she would have to pay an additional $30,000 (200 percent of the $15,000 excess benefit), in addition to the original tax.

The tax on organization managers is equal to 10 percent of the excess benefit and is limited to $10,000 per transaction. In order for a manager to be penalized, he or she must have participated in the excess benefit transaction knowing that the disqualified person was receiving an excess benefit. There is also an exception for cases when the manager's actions were not "willful" and were due to "reasonable cause."

In the example, a manager, such as a board member, who approved the transaction and knew that the amount paid was greater than the property's value would be subject to a $1,500 tax (10 percent of the $15,000 excess benefit). The law also provides for joint and several liability, which means that if more than one manager approved the transaction knowing it was excessive, each would be liable for the tax. Thus, the IRS could collect the $1,500 from one or more of the directors, or any one director could be liable for the entire $1,500 tax. According to the IRS, the total tax collected from the directors should not exceed the $1,500.

Reporting taxable benefits as

compensation

One of the primary areas where the intermediate sanctions are likely to come into play is in excessive compensation. If a disqualified person receives compensation that is greater than the fair market value of the services performed (i.e., what the market would pay for a person with similar qualifications in a similar position), the excess would be subject to the 25 percent tax and would have to be returned to the organization to avoid a 200 percent tax. Under the law, compensation can include a tax-exempt organization's payment of personal expenses and benefits and other non-fair-market-value transactions that benefit disqualified individuals, but only if it is clear that the organization intended and made the payment as compensation for services.

According to a source at the IRS, there is a danger that if an exempt organization does not report as compensation taxable benefits received by a disqualified person, then those unreported amounts could be treated as an excess benefit subject to the excise tax and required to be repaid under the terms outlined earlier even if the unreported benefit plus reported compensation was less than the fair market value of the services provided. Similarly, any reimbursement of the intermediate sanctions liability of a disqualified person or organization manager will be treated as an excess benefit unless treated as compensation to the recipient.

Examples of how intermediate sanctions might be triggered abound. One example provided by the IRS is a case it had seen previously, where an exempt organization paid for the wedding of a child of an executive director and did not report the cost of the wedding as income on that person's Form W-2. Under the new law, that income would be subject to the penalty tax, as well as to regular income tax. In addition, any managers who knew of and approved the transaction would be subject to the additional 10 percent tax.

Other more typical types of compensation that association executives should be sure to report as income include spousal travel expenses, nonqualified benefit plan contributions, and personal usage of employer-provided transportation. For example, an executive using an association-provided vehicle to commute should be certain that the value of that and other personal usage is included on his or her Form W-2. The IRS indicated that for the transition period, the filing of a Form 1099 and an amended personal return would likely suffice to prevent an excise tax from being imposed on a disqualified person. Care should be taken, however, to file Form 1099 before any IRS audit or inquiry takes place. After the IRS becomes involved, it would treat such a filing as irrelevant.

Determining what is a reasonable level of compensation has always been a difficult and uncertain task; however, existing law provides some standards that apply in this case. A nonprofit organization and disqualified individuals are "entitled to rely on a rebuttable presumption of reasonableness" if an excess benefit transaction meets three requirements:

* The transaction was approved by a board composed of individuals entirely unrelated and not subject to the control of the disqualified person.

* The board obtained and relied on appropriate data as to comparability.

* The board adequately documented the basis for its determination.

It is not clear exactly what constitutes "appropriate data as to comparability" for these purposes, but the Congressional Reports give as examples salaries for other similar positions, salary surveys, and actual offers from other organizations attempting to hire the same individual. The IRS has been instructed to issue regulations to provide additional guidance.

Effective dates

The intermediate sanctions taxes apply to transactions occurring on or after September 14, 1995. The taxes do not apply to transactions occurring between September 14, 1995, and December 31, 1996, provided that a binding contract existed between the organization and the individual prior to September 14, 1995.

In terms of excessive compensation, there is also a special transition rule. For arrangements entered into between September 13, 1995, and December 31, 1996, organizations are granted a reasonable time (90 days is given as an example of "reasonable") after the agreement is entered into to meet the three requirements on page 51. For compensation arrangements entered into beginning in 1997 and later, the requirements must be met before the individual receives any compensation.

Disclosure on Form 990

Even though nonprofit organizations are not directly fined under these provisions, there are possible repercussions from potential donors. The new law requires nonprofit organizations to disclose, on their Form 990 (for years beginning after the enactment date, July 30,1996), the amounts of taxes paid in any excess benefit transaction to which the organization was a party. Thus, if intermediate sanctions are imposed on any of an organization's insiders, the excise taxes become a matter of public record, and a potential public relations disaster would be in the making.

It would be wise to promptly share information on this new law with your board of directors. The board may well be liable for decisions that it makes regarding compensation issues in the future. In addition, in order to be able to fulfill their fiduciary responsibilities, the board will want to be sure that all compensation agreements with disqualified individuals entered into since mid-September 1995 have met the three requirements described earlier.

Andrew S. Lang is president and chief executive officer of Lang & Associates, P.A., Bethesda, Maryland, a consulting firm specializing in nonprofit organizations. George E. Cowperthwaite is a partner in the firm who heads the tax department. E-mail: [e-mail].

This article represents the authors' interpretation of the views and policies of the IRS. Although the IRS provided assistance in the preparation of this article, it does not represent official IRS positions or policies, nor does it constitute a legal opinion. For additional information, consult your tax adviser.

Other Provisions of the Law

While intermediate sanctions apply only to 501(c)(3) and 501(c)(4) organizations, all tax-exempt groups must guard against one or more additional penalties under the tax bill signed by the president. They include the following.

* Bigger late-filing and completeness penalties. Now every tax-exempt organization will pay a penalty of at least $20 per day when a return is filed late, up to the lesser of $10,000 or 5 percent of gross receipts. The penalty is hiked to $100 per day, or a maximum of $50,000, when gross receipts go over $1 million. Prior law set a daily penalty of $10, up to $5,000.

When a return is filed on time but is incomplete, the penalty still applies. As always, burden of proof is on the association to show "reasonable cause."

* Public disclosure of tax returns. Until now, almost all tax-exempt groups were penalized if they failed to respond on time to requests to inspect returns or other tax documents (such as their application for tax exemption). Now they must also provide copies, charging only "reasonable" fee for reproduction and mailing. Copies must be provided for up to the three most recent taxable years for the Form 990 to anyone who requests them. They must be provided immediately if requested in person or in 30 days if requested in writing. Penalties are now $20 per day, up to $10,000 -- and an additional $5,000 when the IRS finds "willful" failure to comply.

* More return information required. Any group filing an IRS Form 990 now must include information on the private inurement transactions discussed in the adjoining article. In addition, all must disclose added information regarding any excise taxes incurred on lobbying and political activities. Failure to provide required information will trigger the now larger penalties on incomplete returns.

* Effective dates. Higher penalties for late filing and incomplete returns start with returns for years ending on or after the bill's enactment date (July 30, 1996). The additional return information will be required on returns filed for fiscal years starting, after the enactment date.