Prepared for the American Hospital Association and American College of Healthcare Executives by Hogan & Hartson, L.L.P.

EXCESS BENEFIT AND REASONABLE COMPENSATION:An Analysis of the Intermediate Sanctions Rules

Excess Benefit TransactionAn excess benefit transaction is defined in theFinal Regulations as any transaction in whichan economic benefit is provided by an applica-ble tax-exempt organization, directly or indi-rectly, to a disqualified person that exceeds thevalue of the consideration (including the per-formance of services) received by the organiza-tion. Furthermore, an excess benefit may beprovided indirectly by an exempt organizationto a disqualified person through:

l a controlled entity; or l an intermediary (as discussed below).

The Final Regulations also retain the “initialcontract” exception (sometimes referred to bycommentators as a “one free bite” rule), where-by the intermediate sanctions rules are notapplied to any fixed payment made pursuant toa binding written contract between the applica-ble exempt organization and a party who wasnot a disqualified person immediately prior toentering into the contract (as discussed below).

Applicable Tax-exempt Organization As noted above, the intermediate sanctionsapply to transactions with applicable tax-exempt organizations, which include any501(c)(3) public charity (private foundations

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IntroductionIn 1996, Congress enacted the Taxpayer Bill ofRights 2. (See §§ 4958 63 of the InternalRevenue Code of 1986, as amended.) Underthese statutory provisions, the InternalRevenue Service (IRS) for the first time wasauthorized to impose “intermediate sanctions”on various individuals who use the assets of aSection 501(c)(3) or 501(c)(4) tax-exemptorganization for improper personal gain.Accordingly, the intermediate sanctions rulesexpose to personal liability certain insiders,called disqualified persons, and exempt organ-ization managers. Prior to enactment of theintermediate sanctions law, the only option forthe IRS to sanction improper transactionsbetween the organization and its insiders wasrevocation of the organization’s tax-exempt sta-tus – a drastic step that the IRS often was hesi-tant to take as disproportionate to the offense.

On January 22, 2002, the IRS released finalregulations (the Final Regulations) that areeffectively the same as the temporary regula-tions issued on January 10, 2001 (theTemporary Regulations), with some additionalclarifications.1 While the Final Regulations areimportant for all 501(c)(3) and 501(c)(4)organizations, they should be of particular

interest to such organizations that are involvedin financial transactions with executives orBoard members or that pay substantial com-pensation to executives.

Under the express terms of Section 4958, if a501(c)(3) public charity or a 501(c)(4) socialwelfare organization and one or more disquali-fied persons engage in an excess benefit trans-action, both the disqualified persons and theorganization managers who approved thetransaction may be subject to significant sanc-tions in the form of penalty excise taxes. Morespecifically, disqualified persons initially aresubject to a tax of 25 percent of the amount ofexcess benefit derived from a transaction withan applicable exempt organization, and are fur-ther subject to an additional tax of 200 percentof the amount of excess benefit if not “correct-ed” within a designated time period. In addi-tion, exempt organization managers are subjectto a tax of 10 percent of the excess benefit ifthey knowingly participate in an excess benefittransaction, unless the participation was notwillful and was due to reasonable cause.

This brief outlines the IRS’ Final Regulationson intermediate sanctions.

are excluded) or 501(c)(4) social welfare organ-ization, and any organizations that have beenso exempt at any time during a five-year periodending on the date of an excess benefit transac-tion (the “lookback period”).2 In addition, anorganization that has applied for exemption orfiled an information return as a 501(c)(4)organization, or has otherwise held itself out asbeing described in 501(c)(4), is an applicabletax-exempt organization for purposes of theintermediate sanctions.3 The intermediatesanctions rules, however, are not applicable togovernmental entities such as state universitiesthat are exempt from or not subject to taxationwithout regard to Section 501(a) or are relievedfrom filing an annual return pursuant to regu-lations under Section 6033 – even if such insti-tutions also have obtained tax-exempt statusunder Section 501(c)(3).

Disqualified Person As defined in Section 4958 and the FinalRegulations, a disqualified person is any per-son who was in a position to exercise substan-tial influence over the affairs of the organiza-tion at any time during the five-year periodending on the date of the transaction. Asdescribed below, the Final Regulations specifycertain individuals who are deemed to havesubstantial influence and others who aredeemed not to have substantial influence.Disqualified persons also include:

l a member of the family of a person whowas in a position to exercise such influ-ence;4 and

l an entity controlled 35 percent or more bydisqualified persons.5

In all other cases, a determination of whether aperson has substantial influence is based on afacts and circumstances inquiry.

Persons Having Substantial InfluenceThe Final Regulations provide that a person is

in a position to exercise substantial influenceover an organization if that person has thepowers or responsibilities, or holds the type ofinterests, described in one of the following cat-egories (such individuals will be “per se” dis-qualified persons because of their actual pow-ers and responsibilities and not by virtue oftheir titles or positions). They include:

l Individuals serving on the governing bodywho are entitled to vote.

l Presidents, chief executive officers or chiefoperating officers: An individual mayserve in one of these capacities, regardlessof title, if that person has or shares ulti-mate responsibility for implementing thedecisions of the governing body or super-vising the management, administration oroperation of the applicable organization.

l Treasurers and chief financial officers: Anindividual may serve in one of thesecapacities, regardless of title, if that indi-vidual has or shares ultimate responsibilityfor managing the organization’s financialassets.

l Persons with a material financial interestin a provider-sponsored organization if ahospital that participates in the provider-sponsored organization is an applicabletax-exempt organization.

Persons Deemed Not To HaveSubstantial InfluenceThe Final Regulations also provide specific cat-egories of persons deemed not to be in a posi-tion of substantial influence over the organiza-tion. These persons include:

l any other applicable tax-exempt organiza-tion described in Code Section 501(c)(3);

l with respect to a 501(c)(4) organizationsubject to the intermediate sanctions rules,any other “applicable tax-exempt organi-zation” described in Code Section501(c)(4);6 and

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l employees of the applicable tax-exemptorganization who, within the taxable yearin which benefits are provided: (a) receiveeconomic benefits (directly or indirectly)less than the amount of compensation ref-erenced for a highly compensatedemployee;7 (b) do not fall within the statu-tory categories of disqualified persons;and (c) are not a substantial contributor tothe organization.8

Facts and Circumstances TestIf a person does not fall within the categoriesdescribed above, the determination of whetherhe or she is a disqualified person depends on allof the facts and circumstances. The FinalRegulations outline non-exclusive lists of factsand circumstances tending to show whether aperson does or does not have substantial influ-ence over an organization.

Facts and circumstances tending to show sub-stantial influence include:

l the person founded the organization;l the person is a substantial contributor to

the organization;9

l the person’s compensation is primarilybased on revenues derived from activities ofthe organization that the person controls;

l the person has or shares authority to controlor determine a substantial portion of theorganization’s capital expenditures, operat-ing budget or compensation for employees;

l the person has managerial control over adiscrete segment of the applicable exemptorganization and that segment representsa substantial portion of an applicableexempt organization’s activities, assets,income or expenses (e.g., the head of thecardiology department at a hospital is adisqualified person where that particulardepartment is a principal source ofpatients and revenue for the hospital);

l the person owns a controlling interest(measured by vote or value) in a corpora-tion, partnership or a trust that is a dis-qualified person; or

l the person is a non-stock organizationcontrolled, directly or indirectly, by one ormore disqualified persons.

Facts and circumstances tending to show nosubstantial influence include:

l the person has taken a bona fide vow ofpoverty as an employee, agent or on behalfof a religious organization;

l the person is an independent contractor,such as an attorney, accountant or invest-ment manager or advisor, whose sole rela-tionship to the organization is providingprofessional advice, unless the person isacting in that capacity with respect to atransaction from which the person mighteconomically benefit either directly or indi-rectly (aside from customary fees receivedfor the professional services rendered);

l the person’s direct supervisor is an indi-vidual who is not a disqualified person;

l the person does not participate in manage-ment decisions affecting the applicableexempt organization in its entirety or adiscrete but substantial segment or activityof the organization that represents a sub-stantial portion of the activities, assets,income or expenses of the organization;

l the person has no prior involvement withthe exempt organization with respect to aninitial contract (as discussed more fullybelow); or

l any preferential treatment a personreceives based on the size of that person’sdonation if also offered to any other donormaking a comparable contribution as partof a solicitation intended to attract a sub-stantial number of contributions.

The Final Regulations include 13 examplesanalyzing facts and circumstances to deter-

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mine whether a person is a disqualified per-son. The examples include a non-highly com-pensated employee of a community organiza-tion, a highly compensated employee of acommunity organization, a limited-votingmember of a 501(c)(3) organization withbroad-public membership, the headmaster ofa school, a gaming management company, amajority stockholder of a tax-exempt gamingmanagement company, a for-profit hospitalmanagement company managing a wholehospital joint venture, the dean of a lawschool that is part of a large university, thechairman of a small academic departmentthat is part of a large university, a hospital-employed radiologist, a cardiologist who ishead of a hospital’s cardiology department, anoutside accountant, and a substantial contrib-utor to a theater. Each example illustrates theanalysis for determining whether a person isin a position to exercise substantial influenceover an organization. Among other things,the Final Regulations revised one example toclarify that an exempt organization’s manage-ment company is a per se disqualified personwhere the management company is ultimate-ly responsible for management of the hospital(consistent with the functions of a president,CEO or COO), whereas under the TemporaryRegulations, a management company’s statusas a disqualified person would have beendetermined based on the facts and circum-stances.

Excess Benefit Transaction DefinedIn order for intermediate sanctions to beimposed, there must be an “excess benefittransaction” between the applicable tax-exemptorganization and a disqualified person. Anexcess benefit transaction is any transaction inwhich an economic benefit is provided by anapplicable tax-exempt organization, directly orindirectly, to or for the use of a disqualifiedperson that exceeds the fair market value(FMV) of the consideration (including the per-formance of services) received by the exemptorganization.10 This definition encompasses the

payment of excess compensation to a disquali-fied person and any other property transfer ortransaction between a disqualified person andan applicable tax-exempt organization.

Initial Contract ExceptionThe Final Regulations retain the "initial con-tract" exception (sometimes referred to bycommentators as the "one free bite" rule),whereby the intermediate sanctions rules arenot applied to any fixed payment made pur-suant to a binding written contract between theapplicable exempt organization and a partywho was not a disqualified person immediatelyprior to entering into the contract (e.g., anewly-hired executive director of an organiza-tion). Payments falling under the initial con-tract exception are not considered excess bene-fit transactions. The following concepts formthe basis for the initial contract exception:

l A “fixed payment” means an amount ofcash or other property that is specified inthe contract, or determined by a fixed for-mula specified in the contract, and whichis paid or transferred in exchange for theprovision of specific services or property.

l A “fixed formula” may incorporate anamount that depends on future specifiedevents or contingencies (e.g., revenuesgenerated by activities of the organization)provided that no person exercises discre-tion when calculating the amount of a pay-ment or deciding whether to make a pay-ment (e.g., tying compensation to increas-es in the Consumer Price Index). If a for-mula allows for any discretion by any per-son, the contract will fall outside of thescope of the initial contract exception.11

l If an initial contract has both fixed andnon-fixed payment components, the non-fixed payment component will not fallunder the initial contract exception andshould be analyzed under the general rulesgoverning excess benefit transactions.

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l The initial contract exception will notapply where the contract is materiallychanged or if a person fails to substantial-ly perform his or her obligations under thecontract. A material change generallyincludes extensions or renewals and a“more than incidental” change in theamount payable under the contract.

l The Final Regulations provide 11 exam-ples applying the initial contract exceptionto employment, management and servicecontracts between applicable exemptorganizations and their employees, third-party management companies and scien-tific research organizations.

Indirect Economic BenefitAn excess benefit may be provided indirectly byan exempt organization to a disqualified personthrough a controlled entity12 or through anintermediary. All consideration and benefits ex-changed between a disqualified person and anapplicable exempt organization, and all entitiesthe exempt organization controls, are taken intoaccount in the aggregate to determine whetherthere has been an excess benefit transaction. Itshould be noted that an authorized body of anentity controlled by the exempt organization,even if it is not an applicable exempt organiza-tion, can establish the rebuttable presumption ofreasonableness (discussed below) for transfers ofeconomic benefits to a disqualified person.

An economic benefit is provided through athird-party intermediary where an applicableexempt organization provides a benefit to athird-party intermediary; the intermediaryprovides economic benefits to a disqualifiedperson of the exempt organization; and eitherthere is evidence of an oral or written agree-ment or understanding that the intermediarywill transfer property to a disqualified person,or the intermediary has no significant businessor exempt purpose of its own to make thetransfer to the disqualified person.

Certain Economic Benefits May BeExcluded from Excess BenefitDeterminationCertain categories or types of economic bene-fits may be excluded from a determination ofwhether a transaction is an excess benefittransaction, even if such benefits have beenprovided to disqualified persons. Theyinclude:

l Non-taxable fringe benefits excludedunder Section 132, except for certain lia-bility insurance premium, payments orreimbursements that must be taken in toaccount (as discussed below).13

l Expense reimbursements paid to employ-ees under an “accountable plan,” asdefined under Treasury Regulations §1.622(c)(2).

l Economic benefits provided to a volun-teer (who is a disqualified person) if thebenefit is provided to the general public inexchange for a membership fee or contri-bution of $75 or less per year.

l Economic benefits provided to a disquali-fied person as a member of, or a donor to,an applicable exempt organization, pro-vided that certain requirements are met.

l Economic benefits provided to a personsolely because the person is a member of acharitable class that the applicable tax-exempt organization intends to benefit aspart of the accomplishment of the organi-zation’s exempt purpose.

l Any transfer of an economic benefit to orfor the use of a governmental unit, if thetransfer is for exclusively public purposes.

l Any payment made pursuant to, and inaccordance with, a final individual pro-hibited transaction exemption issued bythe Department of Labor under theEmployee Retirement Income SecurityAct with respect to a transaction involvinga plan that is an applicable tax-exemptorganization.

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Definition of ReasonableCompensationCompensation paid to a disqualified person willnot be regarded as an excess benefit transaction ifthe total compensation paid (taking into accountall benefits other than those specifically excludedabove) is reasonable. Reasonable compensationis defined as “an amount that would ordinarily bepaid for like services by like enterprises (whethertaxable or tax-exempt) under like circum-stances.” This determination is generally madebased on the circumstances existing at the datewhen the contract for services was made. Wheresuch a determination cannot be made, the deter-mination is based on all the facts and circum-stances up to and including circumstances exist-ing on date of payment. Furthermore, if the con-tract is materially modified, or if the contract isterminable and subject to cancellation as of aparticular date by the organization without thedisqualified person’s consent, then the contract istreated as a new contract entered into as of thedate of modification or termination.

For purposes of determining whether there isan excess benefit transaction, compensationincludes, but is not limited to:

l all forms of cash and non-cash compensa-tion, including salary, fees, bonuses andseverance payments paid;

l all forms of deferred and non-cash com-pensation that is earned and vested,whether or not funded, and whether or notpaid under a deferred compensation planthat is qualified under Code Section 401(a);

l the amount of premiums paid for liabilityor any other insurance coverage or thepayment or reimbursement of any penalty,tax or correction owed under the interme-diate sanctions rules or certain expensesincurred by an organization resulting froma disqualified person’s willful conduct,unless such payments are excludable fromincome as a de minimis fringe benefitunder Section 132;

l all other benefits such as medical, dentaland life insurance, disability and fringebenefits (other than fringe benefitsdescribed in Section 132); and

l any economic benefit provided by anapplicable tax-exempt organization itselfor indirectly through another entityowned, controlled by or affiliated with thetax-exempt organization.

Note, however, that inclusion of an item in adisqualified person’s compensation for purpos-es of the intermediate sanctions rules does notgovern whether the item must be included inthe disqualified person’s gross income forincome tax purposes.

An economic benefit will be treated as com-pensation for services only if the applicable tax-exempt organization can provide contempora-neous written substantiation of its intent totreat the benefit as compensation when thebenefit was paid. Such written substantiation isestablished by the organization or the disquali-fied person reporting such economic benefitson applicable federal tax forms (i.e., Forms W-2, 1099, 990, 1040) prior to an IRS examinationin which the reporting of the benefit is ques-tioned. If an organization’s failure to report apayment was due to reasonable cause, then theorganization will be treated as providing clearand convincing evidence of its intent to treatthe payment as compensation. Reasonablecause will exist where the organization canestablish that there were significant mitigatingfactors, or that the failure to report arose fromevents beyond the organization’s control andthat the organization acted in a responsiblemanner before and after the failure occurred.

Contemporaneous written substantiation alsoincludes an approved written employment con-tract or documentation that the governingbody or authorized officer approved the pay-ment as compensation for services. The FinalRegulations clarify that written evidence upon

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which the applicable tax-exempt organizationbased a reasonable belief that a benefit wasnon-taxable can serve as written contempora-neous evidence demonstrating that a transferwas approved as compensation, even if theorganization’s belief later proves to be erro-neous. Such written evidence must have beenin existence on or before the due date of theapplicable federal tax information return(including extensions but not amendments). Ifthe organization fails to establish its intent totreat a benefit as compensation for services, anyservices provided will not be treated as provid-ed in consideration for the economic benefit.

Timing Rules for Determining Reaso-nableness of Compensation Paid toDisqualified PersonsFor purposes of determining whether a pay-ment to a disqualified person is reasonablecompensation, reasonableness is determinedwith respect to any fixed payment (includingpayments based on a fixed formula, as suchterm is defined under the initial contractexception discussed above) at the time the par-ties enter into the contract. For non-fixed pay-ments, reasonableness of compensation isbased on all the facts and circumstances, up toand including circumstances as of the date ofthe payment at issue (because determining theamount of such payment or whether to makesuch payment requires the exercise of discre-tion after the contract is executed). The FinalRegulations clarify that these general timingrules apply to property subject to a substantialrisk of forfeiture. Therefore, if the property issubject to a substantial risk of forfeiture andsatisfies the definition of fixed payment, rea-sonableness is determined at the time the par-ties enter into the contract providing for thetransfer of the property. However, if the prop-erty is not a fixed payment, then reasonable-ness is determined based on all the facts andcircumstances, up to and including circum-stances as of the date of payment. An examplewas added to the Final Regulations to illustratehow the regular timing rules for determining

reasonableness apply to property that is subjectto a substantial risk of forfeiture.

Revenue-sharing ArrangementsThe Final Regulations, like the TemporaryRegulations, do not provide any guidance onthe controversial topic of “revenue-sharing”transactions or arrangements in which com-pensation is calculated by reference to theexempt organization’s revenues. Such arrange-ments are often entered into between physi-cians and hospitals, and between educationalinstitutions and technology providers involvedin distance learning transactions. The IRS inthe Final Regulations continues to leave therevenue-sharing arena reserved for possiblefuture consideration in additional regulations.In the meantime, revenue-sharing arrange-ments will continue to be subject to the generalrules governing excess benefit transactions. Asan important gloss on these general rules,Treasury Department officials have previouslyindicated in public comments that at presentthere are no “per se” structurally impermissiblerevenue-sharing arrangements.

Penalty Taxes on ExcessBenefit TransactionsUnder Code Section 4958, a disqualified per-son who engages in an excess benefit transac-tion will be subject to a first-tier penalty excisetax equal to 25 percent of the amount of excessbenefit. If the transaction is corrected withinthe taxable period14 and the IRS finds that thetransaction was due to reasonable cause andnot willful neglect, then the 25 percent tax willbe abated. If the transaction is not correctedwithin the taxable period, then the disqualifiedperson will be liable for a second-tier penaltytax of 200 percent of the excess benefit.Furthermore, an organization manager whoparticipates in the excess benefit transaction,knowing that it was such a transaction, is liablefor payment of an excise tax equal to 10 percentof the excess benefit (capped at $20,000 perexcess benefit transaction), unless the partici-

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pation was not willful and was due to reason-able cause. If more than one disqualified personor organization manager is liable for any penal-ty excise taxes, all such persons are jointly andseverally liable.

The excise taxes apply to excess benefit trans-actions occurring on or after September 14,1995. These taxes do not apply to a transactionpursuant to a written contract that was bind-ing on September 13, 1995 and all times there-after. A written binding contract that is mate-rially modified or terminable without the dis-qualified person’s consent is treated as a newcontract as of the date of such modification ortermination.

Correction of the Excess BenefitCorrection of the transaction entails undoingthe excess benefit to the extent possible andtaking any additional measures necessary toplace the organization in a financial positionnot worse than that in which it would be if thedisqualified person had been dealing with thehighest fiduciary standards. Correction occursif the disqualified person repays an amount ofmoney equal to the excess benefit, plus anyadditional amount needed to compensate theorganization for loss of the use of the money.Correction may also occur, at the discretion ofthe applicable tax-exempt organization, if thedisqualified person returns property thatresulted in an excess benefit and takes anyadditional steps necessary to make the organi-zation whole.

The Final Regulations require that where aSection 501(c)(3) organization involved in anexcess benefit transaction ceases to exist or isno-longer tax-exempt, the correction amountmust be paid to a publicly-supported charitythat has been in existence as such for a contin-uous period of at least 60 calendar months end-ing on the correction date. The disqualifiedperson also must not be a disqualified personwith respect to the substituted public charityand must not be allowed to make or recom-

mend any grants or distributions by the substi-tuted public charity. The 60-month existencerequirement, according to the IRS, prevents thedisqualified person from creating a new organ-ization to receive the correction amount. Theserequirements (other than the public supportedcharity requirement) also apply to a substituteSection 501(c)(4) organization receiving thecorrection amount.

Amount of Excess BenefitIn the case of an unreasonable compensationarrangement, the excess benefit will be theamount by which the compensation exceedsreasonable compensation. In the case of anon-FMV transaction, the excess benefit willbe the amount by which the transaction differsfrom FMV.

Excise Tax on Organization ManagersAs noted above, organizational managers whoknowingly participate in an excess benefittransaction will be liable for a 10 percent excisetax on the excess benefit up to a maximum of$20,000 per transaction, unless such participa-tion was not willful and was due to reasonablecause. The regulations define organizationmanager as any officer, director or trustee of anapplicable tax-exempt organization or anyindividual having powers or responsibilitiessimilar to those in such positions, regardless oftitle. In addition, those persons serving on acommittee of the governing body of the organ-ization that is invoking the rebuttable pre-sumption of reasonableness (discussed below)based on the committee’s actions is an organi-zational manager. A person will be consideredan officer if so designated in the organizationaldocuments or if that person regularly exercisesgeneral authority to make administrative orpolicy decisions on behalf of the organization(but not including persons who merely havethe authority to recommend a particularadministrative or policy decision). Indepen-dent contractors acting in the capacity of attor-neys, accountants or investment managers andadvisors are not officers.

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Knowing Participation byOrganizational ManagersFor purposes of the 10 percent excise tax, par-ticipation by organization managers includesaffirmative action and silence or inactionwhere the manager is under a duty to speak oract. Where a manager has opposed an excessbenefit transaction in a manner consistent withhis responsibilities to the organization, themanager will not be considered as having par-ticipated in the transaction. Knowing partici-pation in an excess benefit transaction existsonly if the manager:

l has actual knowledge of sufficient facts sothat, based solely on these facts, the trans-action would be an excess benefit transac-tion;

l is aware that such a transaction may vio-late federal tax law governing excess bene-fit transactions; and

l negligently fails to make reasonableattempts to ascertain whether the transac-tion is an excess benefit transaction, or themanager is in fact aware that it is such atransaction.

The Temporary Regulations provided a safeharbor in which an organization manager’sparticipation in a transaction would ordinarilynot be considered knowing if the managerrelies on the fact that the requirements givingrise to the rebuttable presumption of reason-ableness, as discussed below, are satisfied withrespect to the transaction. The FinalRegulations provide that an organizationalmanager’s participation in a transaction is ordi-narily not considered knowing if the appropri-ate authorized body has met the requirementsof the rebuttable presumption with respect tothe transaction. Failure to satisfy the require-ments of this safe harbor, however, does notnecessarily mean that the organization manag-er acted knowingly.

Willful Participation, Reliance onProfessional AdviceA manager who knowingly participates in anexcess benefit transaction will be fined unlesssuch participation was not willful and was dueto reasonable cause. Participation is willful if itis voluntary, conscious and intentional (regard-less of whether a tax law avoidance motiveexists), but is not willful if the manager doesnot know that the transaction in which he isparticipating is an excess benefit transaction. Amanager’s participation will be due to reason-able cause if the manager exercised his respon-sibility on behalf of the organization with ordi-nary business care and prudence. If a managerrelies on professional advice (including legalcounsel, certified public accountants or inde-pendent valuation experts who meet therequirements for qualified appraisers)expressed in a “reasoned written opinion”(addressing the facts and applicable standards),the manager’s participation in such transactionordinarily will not be considered “knowing” or“willful” and ordinarily will be considered “dueto reasonable cause.”

Rebuttable Presumptionthat Transaction is Not anExcess Benefit TransactionIn general, payments under a compensationarrangement, a property transfer or any otherbenefit or privilege between an applicable tax-exempt organization and a disqualified personshall be presumed to be reasonable or at FMVif the following three requirements are met:

l The compensation arrangement or termsof the property transfer are approved bythe organization’s governing body, com-mittee of the governing body or partyauthorized by the governing body com-posed entirely of individuals who do nothave a conflict of interest with respect tothe arrangement or transaction.

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l The governing body, committee thereof orparty authorized by the governing bodyobtained and relied upon appropriate dataas to comparability prior to making itsdetermination.

l The governing body, committee thereof orparty authorized by the governing bodyadequately documented the basis for itsdetermination concurrently with makingthat determination.

Once the presumption is established, the IRSmay rebut the presumption with additionalinformation showing that the compensationwas not reasonable or that the transfer was notat FMV. Note, however, that failure to establishthe rebuttable presumption does not create aninference that the transaction is an excess ben-efit transaction.

Requirement One: Approval ProcessThe governing body is the Board of Directors,trustees or equivalent controlling body of thetax-exempt organization. The Board mayauthorize a committee of the Board membersto act on behalf of the Board to the extent per-mitted by state law. If the organization’s con-trolling documents or state law requires fullapproval of an arrangement or transaction,then committee approval will not be sufficient.The Board also may authorize other parties toact on its behalf in approving compensationarrangements or property transfers provided itspecifies procedures and such delegation isallowed under state law. The preamble to theFinal Regulations clarifies that a single individ-ual may constitute a committee of the govern-ing body or a party authorized to act on itsbehalf if permitted under state law.

As required, each member of the Board, com-mittee of the Board or authorized person estab-lishing the rebuttable presumption may nothave a conflict of interest. A person will nothave a conflict if the person:

l is not the disqualified person and is notrelated to any disqualified person partici-pating in or economically benefiting fromthe compensation arrangement or transac-tion by a family relationship described inSection 4958 or the proposed regulations;

l is not in an employment relationship sub-ject to the direction or control of any dis-qualified person participating in or eco-nomically benefiting from the compensa-tion arrangement or transaction;

l is not receiving compensation or otherpayments subject to approval by any dis-qualified person participating in or eco-nomically benefiting from the compensa-tion arrangement or transaction;

l has no material financial interest affectedby the compensation arrangement ortransaction; and

l does not approve a transaction providingeconomic benefits to any disqualifiedperson participating in the compensationarrangement or transaction, who in turnhas approved or will approve a transac-tion providing economic benefits to theperson.

Requirement Two: Comparability DataIn making a determination as to reasonable-ness of compensation or FMV, the Board, com-mittee thereof or authorized person must haveobtained and relied upon appropriate data as tocomparability. Appropriate data includes (butis not limited to) compensation levels paid bysimilarly situated organizations, both taxableand tax-exempt, for functionally comparablepositions; the availability of similar services inthe geographic area of the applicable tax-exempt organization; current compensationsurveys compiled by independent firms; actualwritten offers from similar institutions compet-ing for the services of the disqualified person;and independent appraisals of the value ofproperty that the applicable organizationintends to purchase from, or sell or provide to,the disqualified person.

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The examples illustrating appropriate data forcomparability indicate that generic nationalcompensation surveys that lack specificity willbe insufficient data where the Board lacksexpertise on compensation matters. In contrast,customized surveys prepared by a firm withexpertise, which sort data by different variablesand are accompanied by a written report, willoften suffice as appropriate data.

In addition, there is a special rule for smallorganizations with annual gross receipts of lessthan $1 million.15 These organizations will haveappropriate data for comparability if they havedata on compensation paid by three comparableorganizations in the same or similar communi-ties for similar services. Such information maybe compiled through an informal telephonesurvey and a brief written report to the Board.

Requirement Three: DocumentationFor a decision to be documented adequately,the written or electronic records of the Board orcommittee thereof must specify:

l the terms of the transaction that wasapproved and the date it was approved;

l the members of the governing body orcommittee who were present during debateon the transaction or arrangement that wasapproved and those who voted on it;

l the comparability data obtained and reliedupon by the governing body or committeeand how the data was obtained; and

l the actions taken with respect to consider-ation of the transaction by anyone who isotherwise a member of the governing bodyor committee, but who had a conflict ofinterest with respect to the transaction orarrangement.

The requirement of concurrent documentationmeans that records must be prepared by thelater of the next meeting of the Board or com-mittee or 60 days after the final Board or com-

mittee approval of a particular arrangement orproperty transfer. Such records must bereviewed and approved by the Board or com-mittee as reasonable, accurate and completewithin a reasonable time period thereafter.

When Can the RebuttablePresumption be Established?Consistent with the rules discussed aboveregarding the timing of the reasonablenessdetermination with respect to a particulartransaction, the Final Regulations state that anapplicable exempt organization can establish arebuttable presumption of reasonableness withrespect to fixed payments (or those calculatedpursuant to a fixed formula) at the time theparties enter into the contract. Likewise, undera special rule, the rebuttable presumption ofreasonableness can be established for paymentsmade pursuant to a deferred compensationarrangement such as a qualified pension, prof-it-sharing or stock bonus plan when the partiesenter into the contract for services.

In contrast, for non-fixed payments the rebut-table presumption can only be established afterdiscretion is exercised, the exact amount of thepayment is determined (or a fixed formula forcalculating the payment is specified), and theabove-described three requirements for therebuttable presumption are satisfied. The FinalRegulations do, however, include a limited excep-tion for non-fixed payments subject to a cap.Under this exception, the rebuttable presumptioncan be established for non-fixed payments if:

l prior to approving the contract, the govern-ing body obtains comparability data show-ing that a fixed payment up to a certainamount would be reasonable compensation;

l the maximum amount payable under thecontract including fixed and non-fixedpayments does not exceed the reasonablecompensation amount; and

l the other requirements for establishing therebuttable presumption are satisfied.

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Note: To assure compliance with IRS standards of professional practice, Hogan & Hartson, L.L.P., disclos-es to you that any federal tax advice in this communication was not intended or written to be used,and cannot be used, for the purpose of avoiding federal tax penalties; and, if used to promote, mar-ket, or recommend any transaction, investment or matter, the advice was written to support thepromotion or marketing of the transaction or matters addressed. Taxpayers should seek advice,based on their particular circumstances, from an independent tax advisor.

Footnotes1 Prior to the Temporary Regulations, the IRS issued proposed regulations implementing the intermediate sanctions rules in August 1998 (the

“Proposed Regulations”). The Temporary Regulations generally clarified and expanded upon the Proposed Regulations, while nonetheless keep-ing intact the general framework of the intermediate sanctions rules as outlined in the Proposed Regulations.

2 For transactions prior to September 14, 2000, the lookback period begins on September 14, 1995 and ends on the date of the transaction. 3 A foreign organization that receives substantially all of its support from sources outside the United States is not an applicable tax-exempt organi-

zation for Section 4958 purposes.4 A person’s family includes his or her spouse; brothers or sisters (by whole or half blood); children; grandchildren; great grandchildren; ancestors;

and the spouses of brothers or sisters, children, grandchildren, and great grandchildren.

5 A 35-percent controlled entity is: (a) a corporation in which disqualified persons, as determined otherwise under the regulations, own more than35 percent of the combined voting power; (b) a partnership in which disqualified persons own more than 35 percent of the profits interest; or (c)a trust or estate in which disqualified persons own more than 35 percent of the beneficial interest. In making these determinations, the construc-tive ownership rules of Code Section 267(c) apply.

6 Under both the Temporary Regulations and the Final Regulations, a Section 501(c)(3) organization cannot be a disqualified person vis-à-visanother Section 501(c)(3) organization and a Section 501(c)(4) organization cannot be a disqualified person vis-à-vis another Section 501(c)(4)organization. However, a Section 501(c)(4) organization may be treated as a disqualified person with respect to a Section 501(c)(3) organization.

7 As referenced in Code Section 414(q)(1)(B)(i). For 2007, this amount is $100,000.8 Code Section 507(d)(2) defines substantial contributor as any person who contributes or bequeaths an aggregate amount of more than $5,000 to

the organization, if such amount is more than 2 percent of the total contributions and bequests received by the organization taxable year of theorganization taking into account the current taxable year and the four preceding taxable years. (See other subsections of 507(d)(2) for special rulesand exceptions.)

9 See footnote 8 above.10 The Final Regulations define fair market value as the price at which property or the right to use property would change hands between a willing

buyer and a willing seller, neither being under any compulsion to buy, sell, or transfer the property or right to use the property, and both havingreasonable knowledge of relevant facts.

11 Amounts payable pursuant to a qualified pension, profit-sharing, or stock bonus plan under Section 401(a), or pursuant to an employee benefitprogram that is subject to and satisfies coverage and non discrimination rules (e.g., Sections 127 and 137) are treated as fixed payments regard-less of the exempt organization’s discretion with respect to the plan or program.

12 Control by an applicable exempt organization means (i) ownership (by vote or value) of more than 50 percent of the stock of a corporation; (ii)ownership of more than 50 percent of the profits or capital interest in a partnership; (iii) in the case of a nonstock corporation, 50 percent or moreof the directors or trustees of the controlled entity are representatives of, or controlled by, the applicable exempt organization; and (iv) ownershipof more than 50 percent of the beneficial interest in any other entity.

13 The preamble to the Final Regulations indicates that the IRS refused to treat lodging furnished for the convenience of the employer as a disregard-ed economic benefit.

14 The taxable period begins with the day on which the excess benefit transaction occurs and ending on the earlier of (a) the date of mailing a noticeof deficiency under Section 6212 with respect to the Section 4958(a)(1) tax (the 25 percent excise tax); or (b) the date on which the tax imposedby Section 4958(a)(1) is assessed.

15 For purposes of determining eligibility for the special rule for small organizations, if a tax-exempt organization is affiliated with another entity bycommon control or governing documents, the annual gross receipts of all such related organizations must be aggregated.

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