Reasonable compensation rules.
News Notes, "Intermediate Sanctions" T-FA, October 1998, p. 656).
A disqualified person is any person, who, at any time during the five-year period ending on the date of the transaction, was in a position to exercise substantial influence over the organization's affairs. Any disqualified person who engages in an excess benefit transaction is liable for a 25% tax on the excess benefit. In addition, if an excess benefit is not corrected within the taxable period, a disqualified person is liable for a 200% tax on the excess benefit. Moreover, any organization manager (officer, director, trustee, etc.) who knowingly participates in an excess benefit transaction is liable for a tax equal to the lesser of $10,000 or 10% of the excess benefit.
Excess Benefit Transaction
An excess benefit transaction is a transaction in which a designated organization provides a direct or indirect economic benefit to (or for the use of) a disqualified person (or certain related parties), if the value of the economic benefit provided exceeds the value of the consideration the organization receives for providing that benefit. For example, if the compensation paid to a disqualified person exceeds the value of the services performed for such compensation, an excess benefit transaction results. Accordingly, to avoid imposition of these onerous taxes, compensation to a disqualified person must be reasonable.
Under Prop. Regs. Sec. 53.4958-4(b)(3), compensation paid for services is reasonable if it represents an amount that a similar enterprise under similar circumstances would pay for similar services. Generally, the circumstances to be taken into account are those existing when the contract for services was made. However, if reasonableness of compensation cannot be determined based on those circumstances, this determination is made based on all the facts and circumstances up to and including the payment date. The IRS cannot consider circumstances that exist when the issue is raised on examination.
The fact that a state, local legislative body, agency or court authorized or approved a particular compensation package paid to a disqualified person is not determinative of the reasonableness of compensation for Sec. 4958 purposes.
Compensation for these purposes includes all items that a designated organization provides in exchange for services. These items of compensation include (but are not limited to):
* All forms of cash and noncash compensation paid, including salaries, fees, bonuses and severance payments;
* All forms of deferred compensation earned and vested, whether or not funded and paid under a Sec. 401(a) qualified deferred compensation plan. However, if deferred compensation for services performed in multiple prior years vests in a later year, that compensation is attributed to the years in which the services were performed;
* Premiums paid for liability (or any other) coverage, as well as any payment or reimbursement by the organization of charges, expenses, fees or taxes not ultimately covered by such insurance;
* All other benefits (whether or not included in income for tax purposes), including payments to welfare benefit plans on behalf of the persons being compensated (e.g., plans providing medical, dental, life insurance, severance pay and disability benefits), and both taxable and nontaxable fringe benefits (other than working condition fringe benefits described in Sec. 132(d) and de minimis fringe benefits described in Sec. 132(e)), including expense allowances or reimbursements or forgone interest on loans that the recipient must report as income on his income tax return; and
* Any economic benefit provided by a designated organization, whether directly or through another entity owned, controlled by or affiliated with this organization (whether such other entity is taxable or tax-exempt).
The proposed regulations provide examples illustrating whether the reasonableness of compensation can be determined based on circumstances existing when a service contract was made. These circumstances generally exist if the compensation is based on fixed and determinable criteria. For instance, employment contracts that provide for salary payments, specific amounts of health and retirement benefits and annual salary increases based on changes in the Consumer Price Index, would meet these criteria. On the other hand, compensation under an employment contract for a disqualified person providing for a specified salary and bonus payment within the governing body's discretion, with no specified limitations or guidelines, would fail this test, because there are no guidelines in the contract for a bonus.
Intent to Compensate
Under Prop. Regs. Sec. 53.4958-4(c), an economic benefit is not consideration for services unless the organization providing the benefit clearly indicates its intent to treat the benefit as compensation when paid. If a designated organization or a disqualified person properly reports an economic benefit as required, the organization will have provided clear and convincing evidence that it intended to provide an economic benefit as compensation for services when paid. If the designated organization's failure to report an economic benefit as required under the Code is due to reasonable cause, the organization will be treated as having provided clear and convincing evidence of the requisite intent.
This proper reporting requirement is satisfied if the organization reports the economic benefit as compensation on original or amended Federal tax information returns for the payment (e.g., Form W-2 or 1099) or the organization (e.g., Form 990, Return of Organization Exempt From Income Tax Under section 501(c) of the Internal Revenue Code (except black lung benefit trust or private foundation) or section 4947(a)(1) nonexempt charitable trust). However, these forms must be filed before the commencement of an IRS examination in which the reporting of the benefit is questioned.
The proposed regulations contain several examples illustrating how to establish an organization's intent to treat an economic benefit as consideration for services. In one example, the failure to report a bonus to a disqualified person arose as a result of a computer malfunction. As soon as the employer became aware of this malfunction, the employer amended the employee's W-2. In this situation, the failure to report the bonus on an information return issued to the disqualified person arose from events beyond the employer's control and the employer acted in a responsible manner both before and after the failure occurred. Because reasonable cause existed for failing to report the bonus, the employer is treated as having clear and convincing evidence of its intent to provide the bonus as compensation for services when paid.
Prop. Regs. Sec. 53.4958-5 applies a facts-and-circumstances test to assess whether a revenue-sharing transaction results in inurement and therefore constitutes an excess benefit transaction. A revenue-sharing transaction arises when the amount of the economic benefit provided by a designated organization to (or for the use of) a disqualified person is determined (in whole or in part) by the revenues of one or more of the organization's activities. A revenue-sharing transaction may constitute an excess benefit transaction regardless of whether the economic benefit provided to the disqualified person exceeds the fair market value of the consideration provided in return, if, at any point, it permits him to receive additional compensation without providing proportional benefits that contribute to the organization's accomplishment of its exempt purpose.
If the economic benefit is provided as compensation for services, relevant facts and circumstances include (but are not limited to) the relationship between the size of the benefit provided and the quality and quantity of the services provided, as well as the ability of the party receiving the compensation to control the activities generating the revenues on which it is based.
Prop. Regs. Sec. 53.4958-5(d) contains three examples illustrating the principles used in determining whether a revenue-sharing transaction constitutes an excess benefit transaction, two of which follow:
Example 1: A is the manager of the investment portfolio of M, an applicable tax-exempt organization for purposes of Sec. 4958. A and several other professional investment managers work exclusively for M in an office in M's building. A's compensation consists of a flat base annual salary, health insurance, eligibility to participate in a retirement plan and a bonus that is equal to a percentage of any increase in the value of M's portfolio over the year (net of expenses for investment management other than the in-house managers' compensation). The revenue-based portion of A's compensation gives A an incentive to provide the highest quality service in order to maximize benefits and minimize expenses to M. A has a measure of control over the activities generating the revenues on which his bonus is based, but A can increase his own compensation only if M also receives a proportional benefit. Under these facts and circumstances, the payment to A of the bonus described above does not constitute an excess benefit transaction.
Example 2: L, an applicable tax-exempt organization for purposes of Sec. 4958, enters into a contract with H, a company that manages charitable gaming activities for public charities. As a result of the contractual relationship, H becomes a disqualified person with respect to any transaction involving L that provides economic benefits to H directly or indirectly. Under the contract, H agrees to provide all of the staff and equipment necessary to carry out charitable gaming operations on behalf of L, and to pay L a percentage of the net profits, which are calculated as the gross revenue less rental for the equipment, wages for the staff, prizes for the winners and other specified operating expenses. H retains the balance of the proceeds after expenses and after paying L its percentage of the net profits. As manager, H controls the activities generating the revenue on which its compensation is based. In addition, because H owns the equipment and employs the staff needed to operate the charitable gaming activities, H controls what L is charged, including the profit H makes above the cost of these items. Therefore, H can also control the net revenues relative to the gross revenues from the gaming activity. The structure of the compensation H receives for its services does not provide H with an appropriate incentive to maximize benefits and minimize costs to L. H benefits whether expenses are high and net revenues are low or expenses are low and net revenues are high. By contrast, L suffers if expenses for the charitable gaming operation are high and net revenues are low. All of the gross revenues generated by the charitable gaming operation belong to L. The arrangement between H and L allows a portion of those revenues to inure to H. Therefore, this arrangement results in the inurement of L's net earnings to the benefit of H, and the entire amount paid to H under this arrangement constitutes an excess benefit.
These proposed regulations provide practitioners and designated organizations with guidance in determining the reasonableness of compensation to avoid excess benefit transactions. Unfortunately, the IRS is now more likely to assess the penalty excise tax against designated organization managers and disqualified persons based on the proposed criteria. Before Sec. 4958 was effective, loss of tax-exempt status was the only sanction available when a designated organization engaged in a transaction that resulted in private inurement. (See Tax Clinic, "No `Insider' Inurement Finding Reinstates Charitable Exemption," p. 298, this issue.) In situations in which the Service was reluctant to attempt to terminate an organization's exempt status as a result of engaging in such a transaction, it may now impose this tax without feeling constrained by the impact of its actions.
FROM RANDY A. SCHWARTZMAN, CPA, MST, NEWYORK, NY
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|Title Annotation:||tax exempt organizations|
|Author:||Schwartzman, Randy A.|
|Publication:||The Tax Adviser|
|Date:||May 1, 1999|
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