Intermediate sanctions

Intermediate sanctions is a term used in regulations enacted by the United States Internal Revenue Service that is applied to certain types of non-profit organizations who engage in transactions that inure to the benefit of a "disqualified person" within the organization. These regulations allow the IRS to penalize the organization and the disqualified person receiving the benefit. Intermediate sanctions may be imposed either in addition to or instead of revocation of the exempt status of the organization.
Summary.
The "Taxpayer Bill of Rights 2" which came into force on July 30, 1996, added section 4958 to the Internal Revenue Code. Section 4958 adds intermediate sanctions as an alternative to revocation of the exempt status of an organization when private persons benefit from transactions with a 501(c)(3) public charity or 501(c)(4) non-profit organization. NOTE: 501(c)(3) private foundations are subject to similar regulations found in Section 4941 of the Internal Revenue Code.
Intermediate Sanctions may be imposed on any "disqualified person" who receives an "excess benefit" from a covered non-profit organization and on each "organization manager" who approves an excess benefit. If you are a disqualified person you are subject to having participated in an excess benefit transaction, if the transaction is so defined.
Being a disqualified person does not automatically result in a finding that a transaction involves an excess benefit. If you are not a disqualified person, then you cannot be subject to an excess benefit (your transaction with the non-profit organization is considered to be at arm's length).
If there is a finding that there has been an excess benefit, the disqualified person must reimburse the organization to place the organization back in the position it was in before the excess benefit transaction was completed. As well, there are stiff interest penalties and excise penalties in excess of 200%. The organizational managers who participated in the transaction may also be fined an aggregate of $10,000 per violation and are jointly and severally liable for payment of such penalty. These penalties are cumulative, thus an individual may be liable as a disqualified person and as an organization manager.
History.
The "Taxpayer Bill of Rights 2" (effective July 30, 1996) added section 4958 to the Internal Revenue Code. On August 4, 1998, the IRS proposed regulations to implement IRC 4958. On March 16 and 17, 1999, the IRS held public hearings on these proposed regulations. It was not until January 10, 2001 that the IRS issued Temporary Regulations, which were to be effective for up to 3 years. Then, on January 23, 2002 the Final Regulations were issued, superseding the Temporary Regulations.
On September 9, 2005, the IRS announced proposed rulemaking to clarify the relationship between penalties imposed under section 4958 and revocation of exempt status.
Who is a Disqualified Person?
You are a disqualified person if you are a person who, during five years beginning after September 13, 1995, and ending on the date of the transaction in question, were in a position to exercise substantial influence over the affairs of the exempt organization. Note: You can be an individual, another organization, a partnership or unincorporated association, trust or estate.
In affiliated organizations, your substantial influence must be determined separately for each organization but "benefits" provided by a controlled entity will be treated as being provided by the exempt organization. A person may be a disqualified person for more than one organization.
The intermediate sanction statute identifies certain persons as having substantial influence as a matter of law — such persons are conclusively presumed to be disqualified persons. The temporary regulations identify additional categories of those who have a substantial influence. The IRS considers these individuals to be presumptively disqualified.
Under the statute, the following are disqualified:
Other persons defined by the regulations as having substantial interest include:
Not a Disqualified Person.
Under the temporary regulations certain persons are deemed not to have substantial influence including:
Facts and Circumstances Test
Whether an individual or organization is a disqualified person in any cases not under the above categories is determined by a "facts and circumstances test". The regulations include two lists of facts and circumstances (1) including facts and circumstances that tend to show an individual "has substantial influence" and (2) including facts and circumstances that tend to show a person "'does not" have substantial influence.
(1). Facts and circumstances which tend to show a person has substantial influence include:
(2). Facts and circumstances which tend to show a person has no substantial influence include:
Who is an Organization Manager?
An organization manager is any officer, director, trustee, or person having similar powers or responsibilities, regardless of his or her title. A person is an officer if specifically so designated under the articles or bylaws of the organization, or if he or she regularly exercises general authority to make administrative or policy decisions for the organization. If a person only makes recommendations, but cannot implement decisions without approval of a superior, that person is not an officer. The regulations make it clear that a "contractor who acts solely in a capacity as an attorney, accountant, or investment manager or advisor is not an officer."
An organization manager includes anyone on a committee of the board (whether a member of the board), if the organization is claiming that the rebuttable presumption of reasonableness (see below) is based on the committee's (or the designee's) actions. If the committee is responsible for determining the reasonableness of a transaction, and this determination is relied upon by the organization, every member of the committee will be considered an organization manager.
When Does an Organization Manager Participate in a Transaction?
Silence or inaction can be participation by the organization manager if the manager is under a duty to speak or act, as well as any affirmative action. Abstention is considered consent to a transaction. If a manager has opposed the transaction in a manner consistent with his/her responsibilities to the organization, the manager will not be considered to have participated in the action.
Knowing Participation — "Knowing" means that the manager:
Although knowing does not mean having reason to know, under the regulations, evidence that a manager has reason to know is relevant to determine whether the manager has actual knowledge. It is up to the IRS to prove that the manager knowingly participated.
If an organization manager relies on a reasoned written opinion of an appropriate professional, his or her participation will ordinarily not be considered knowing. In addition, an organization manager's participation is ordinarily not considered knowing if the requirements of the rebuttable presumption of reasonableness are satisfied.
Willful Participation — an organization manager participation is willful if it is voluntary, conscious and intentional. It is not willful if the manager does not know that the transaction is an excess benefit transaction.
Due to Reasonable Cause — if the manager exercised responsibility on behalf of the organization with ordinary business care and prudence participation is due to reasonable cause.
Safe Harbor Provision of the Law.
Congress, in the legislative history, intended to create a rebuttable presumption of reasonableness, or "safe harbor." Under this safe harbor, compensation is presumed to be reasonable and a property transfer is presumed to be at fair market value if: (1) the compensation arrangement or terms of transfer are approved, in advance, by an authorized body of the exempt organization, composed entirely of individuals without a conflict of interest, (2) the board or committee obtained and relied upon appropriate data as to comparability in making its determination; and (3) the board or committee adequately documented the basis for its determination, concurrently with making the decision.
The disqualified person or organization manager has the initial burden of proving that the compensation was reasonable. If the three criteria above are met, the burden of proof shifts to the IRS and the IRS must prove that the compensation was unreasonable. The IRS can rebut the presumption with sufficient contrary evidence showing the compensation was not reasonable or showing a transfer not to be at fair market value.
Penalties.
The intermediate sanction provision goes on to create a penalty which is essentially a claw back of any benefits received plus a penalty as well as excise penalties that may be in excess of 200% of the benefit received. The organization must be returned to the state it was in, to the extent possible, before the person received the excess benefit. While the contract may be modified to prevent any excess benefit once any penalties are paid, organization managers may be liable for penalties up to $10,000 and held jointly and severally liable.
In order to prevent the IRS's invocation of intermediate sanctions, any individual serving on the governing body of the organization may not have a conflict of interest regarding the transaction, and if they are on the governing body and have a conflict, they may answer questions posed by other members, but they must recuse themselves in the decision-making process, including debate.
External links.
By Steven T. Miller, Director, Exempt Organizations I.R.S., expressing his "personal views" regarding the Temporary Regulations interpreting the benefit limitation provisions of Section 4958 of the Internal Revenue Code.
Steven T. Miller's 2nd article explaining (in his personal view) how to determine which officials are covered and suggesting a relatively simple process for ensuring full compliance.
Lisa Runquist, Esq. explains how to determine compliance. Intermediate Sanctions
Text of the Final Regulations effective January 23, 2002 as published in the Federal Register.