NEW TAX ON "EXCESS BENEFIT" TRANSACTIONS

By Roy Whitehead, Jr., Pam Spikes, and Bill Humphrey

The Taxpayer Bill of Rights 2 introduces a dramatic change to the way the IRS exercises enforcement authority over tax-exempt organizations. A new IRC section 4958, "Taxes on Excess Benefit Transactions," presents significant new tax planning and management challenges for the "organization managers," accountants, auditors, and lawyers of tax-exempt entities and "insiders" who deal with tax-exempt organizations. The new section grants authority for the IRS to redirect its enforcement activity concerning "excess benefit" (private inurement) transactions from the seldom used, and often ineffective, sanctions solely against the affected tax-exempt entity to personal tax sanctions against individuals deemed insiders and organizational managers.

Prior to the enactment of the Taxpayer Bill of Rights 2, the only available enforcement sanction to insure that the tax-exempt status of entities such as health-care facilities benefitted the community and not private individuals was the harsh penalty of revocation of the tax- exempt status of the entity. Because insiders and organization managers will be faced with personal rather than corporate liability for excess benefit transactions, wise insiders, including physicians and hospital administrators, must be very careful how they structure and approve compensation and benefit packages, and the purchase of physician practices.

The Targets

The new act shifts responsibility for, and sanctions against, excess benefit transactions from the tax-exempt organization to two categories of targeted persons who receive or approve an excess benefit. Excess benefits or private inurements occur when a benefit is received for inadequate consideration by an individual who has the ability to exercise substantial control or influence over an exempt organization. The two categories are the disqualified person(s) and organizational manager.

Disqualified persons are defined as individuals who are in the position to exercise substantial influence over the governance of the tax-exempt organization. A significant change in the definition of disqualified persons apparently was intended by the House Ways and Means Committee because the committee's report highlights a rejection of the previously held IRS position that physicians are automatically regarded as disqualified persons when they participate in the governance of a tax-exempt organization from which they receive a financial benefit. Historically, the IRS mechanically presumed members of the hospital's medical staff are "insiders" for the purpose of considering inurement questions.

The House Report clearly indicates that physicians are not to be automatically considered disqualified persons for purposes of the new act. The effect of the report, if followed by the IRS, will be to allow more physician participation in the governance of heath-care organizations. Now, if the report standard is applied, they are considered disqualified persons only if they are perceived to exercise a substantial influence over the health-care organization's affairs.

Any individual designated as an officer, director, or trustee does not automatically warrant status as a disqualified person. As with physicians, other officers and directors of a tax-exempt entity, must also be found in a position to exercise substantial influence to be considered a disqualified person.

The organizational manager is defined to include any officer, director, or trustee of a tax-exempt organization, or any individual having powers or responsibility similar to officers, directors, or trustees of an organization. This portion of the act is apparently intended to encourage individuals such as health-care administrators, who have authority to make decisions with respect to authorizing benefits, to be aware of and concerned about their personal responsibility and liability.

The Intermediate Sanctions

The act imposes a penalty excise tax as an "intermediate sanction" when an IRC section 501(c)(3) or (c)(4) organization such as an exempt HMO engages in an excess benefit transaction with a disqualified person. When such a transaction occurs, intermediate tax sanctions may be imposed on the disqualified person (insider) who improperly benefits from the transaction, and on organizational managers who knowingly participate in or approve the improper transaction.

Excess benefit transactions normally arise in two ways:

* A non-fair market value transaction: transactions in which the disqualified person engages in a non-fair market value transaction, including unreasonable compensation, with an exempt organization;

* A revenue-sharing transaction: transactions in which a disqualified person receives payment based on an exempt organization's revenue, and the transaction would violate the present law of private law inurement prohibition.

The Tax

The act imposes a two-tiered level of taxation, focusing first on the initial occurrence of the excess benefit transaction and, secondly, on whether there has been a voluntary correction of the excess benefit transaction. The first tier excise tax is determined as follows:

* The disqualified person who has benefitted from the excess benefit transaction will be assessed in the amount of 25% of the amount of the excess benefit. That is, the amount by which the transaction differs from the fair market value, the amount of compensation exceeding reasonable compensation, or the amount of a prohibited transaction based upon the organization's gross or net income, and,

* The organizational manager or managers who participate in the excess benefit transaction, with knowledge, are subject to a tax in the amount of 10% of the excess benefit unless such participation is not willful and due to reasonable cause. The penalty tax on the organizational managers is to be personally paid by the organizational manager(s) rather than the tax-exempt organization.

The second tier excise tax is designed to encourage speedy correction of the excess benefit transaction. It provides that if the transaction has not been corrected within the specified time period, the disqualified person will be subject to an additional penalty tax of 200% of the amount of the excess benefit. The specified time period begins with the date on which the transaction occurs and ends on the earlier of the mailing of a deficiency notice with respect to the first tier tax or the date on which such tax is assessed. Correction, under the act, means undoing the excess benefit to the extent possible and taking any additional measures necessary to place the exempt organization in a financial position not worse than it would have been if the disqualified person were dealing under the highest fiduciary standards.

Reasonableness

Unfortunately the act does not provide clear guidance with respect to the determination of fair market value and reasonableness. The committee report says that a transaction participant is entitled to a rebuttable presumption of reasonableness under the act with respect to the compensation arrangement with a disqualified person when the arrangement was approved by a board of directors or trustees that--

* is composed entirely of individuals unrelated to and not subject to control of the disqualified person;

* obtained and relied upon appropriate data as to the comparability of compensation levels paid by similarly situated organizations for functioning comparable positions in the organizations location; and

* adequately documented the basis of the determination to include the minutes of the board or committee meetings including a review of the qualifications of the individual whose compensation is being established and the basis for determining that the individual's compensation was reasonable in light of the review and data presented.

With these three criteria satisfied, penalty excise taxes can be imposed only when the IRS develops sufficient contrary evidence to rebut the evidence submitted by the parties.

Managing Personal Liability

The act will require entities such as health-care organizations to rapidly refocus the process by which they manage transactions with physicians and other insiders under the act. Wise tax-exempt organization managers should consider the following steps:

* An immediate review and adoption of internal procedures that will allow for the satisfaction of the three qualifying criteria for the presumption of reasonableness. Important among these actions is the adoption and careful good faith enforcement of a strong conflicts-of-interest policy that complies with the new act standards.

* Immediately advise and warn physicians, health-care officers, directors, trustees, and others who have responsibilities under the act, of their potential personal tax liability under the act and of the knowing and willful standard.

* Commence an organizational education process about the act and ensure that individuals understand that they, and not the organization, must individually bear the burden of the penalty excise tax. Ensure that insiders and individuals understand the impact of the act and the definition of disqualified persons and organizational managers.

* Review the post-September 14, 1995 organizational transactions with a view toward taking advantage of the rebuttal presumption protection by attempting to satisfy the three criteria of reasonableness. The act is retroactive to September 14, 1995.

Additionally, administrators of tax-exempt organizations should be aware that they will be required to include on Form 990 information on disqualified persons, excess benefit taxes paid, and excess benefit transactions discovered. Finally, for the purposes of notice to the beneficiary general public, copies of the Form 990 Information Return must be available for inspection by the general public during normal working hours. *

Roy Whitehead, Jr., JD, LLM, is an associate professor of business law, Pam Spikes, PhD, CPA, an associate professor of accounting, and Bill Humphrey, PhD, CPA, a professor of accounting, at the University of Central Arkansas.

Editor:
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editor:
Richard M. Barth, CPA

JUNE 1997 / THE CPA JOURNAL