Bench & Bar

JAN 2018

The Bench & Bar magazine is published to provide members of the KBA with information that will increase their knowledge of the law, improve the practice of law, and assist in improving the quality of legal services for the citizenry.

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15 BENCH & BAR | F or most of us, the word "charitable" evokes warm feelings. It can refer to a state of mind, a course of conduct or a type of organization. e latter, charitable organizations, are organi- zations whose missions are to do good, and while that doesn't always exempt them from criticism, it does exempt them from taxation. Unknown to many is that, due to their favored tax status, these types of organizations have sharp teeth that can bite the hand that purports to feed them, and that's not just limited to dental-related charities. 1 For if an "applicable tax-exempt organization" 2 unjustly enriches certain individuals (and certain entities), Section 4958 of the Internal Revenue Code 3 (the "Code") imposes upon them a payback obligation plus penalties. In olden days, if a charity violated its tax-exemption rules, the potential penalties were limited and somewhat crude. If the orga- nization's misdeeds received adverse press coverage, public support (often in the form of charitable contributions) could decline and even dry up. 4 If violation of exemption standards was discovered in the midst of an IRS audit, the organization could negotiate a "closing agreement" whereby it would pay a fine (and possibly enter into something akin to a corporate integrity agreement). 5 e last and worst of penalties the IRS had in its arsenal was revocation of tax-exempt status, essentially the IRS "death penalty." Except in the most egregious of cases, the IRS was rightly hesitant to unleash this weapon, for it would penalize the charity, as well as its charitable beneficiaries, rather than punishing the individuals who engaged in (and often benefitted from) the conduct that put the organization in the crosshairs. While these options are still available, they now are supplemented by what are called the "intermediate sanctions" penalties of Section 4958. Unlike revocation, Section 4958, which was enacted in 1996, targets persons who are deemed to exercise significant influence over the charitable organization, if they receive an economic benefit from the charity that does not satisfy fair market value standards. 6 Excessive compensation is but one example. e statutory penalties come in the form of excise taxes, and for that reason the statute was situated in the middle of the Code's excise tax regime (for the most part applicable to private foundations). Because Section 4958 rep- resents a statutory penalty short of revocation, someone back in the mists of time chose to christen it the "intermediate sanctions" law. A transaction that confers a benefit on an influential person that does not meet applicable fair market value standards is referred to as an "excess benefit transaction" and the benefit conferred is called an "excess benefit." In defiance of more descriptive terminology, Section 4958 nomenclature also includes awkward phrases such as "disqualified person" 7 and "organization manager" (discussed below). So what are these sanctions? First of all, as we've indicated, none of them are imposed on the exempt entity. 8 e recipient of an excess benefit must pay an excise tax to the IRS equal to twenty-five per- cent (25%) of the excess benefit. Well enough, but doesn't that mean that he or she got away with three-fourth's of the excess benefit? No, for if the person fails to "correct" the excise benefit transaction within a prescribed time period, Section 4958 imposes a second level tax equal to two hundred percent (200%) of the excess benefit, bringing the total tally up to two hundred and twenty-five percent (225%) of the excess benefit. Generally, a "correction" requires the insider to restore the charity to where it would have been had it not provided the excess benefit, which at the very least requires the beneficiary to pay back to the charity any excess benefit (plus interest) in order to avoid the two hundred percent (200%) excise tax. 9 So the law presents the disqualified person with the Hobson's choice of paying the excess benefit back to the charity or paying twice that to the federal government. Who is subject to these sanctions? Broadly, and disregarding for the moment a secondary excise tax on organization managers, it is any individual who wields substantial influence over the exempt organization (which influential standing bestows upon them "dis- qualified person" status). 10 Some positions, such as those of a voting board member, chief executive officer and chief financial officer, automatically qualify for membership in this select club, 11 while others are subject to a "facts and circumstances" determination. 12 e net is broader than that, however, for once a person becomes a disqualified person, he or she retains that status for five years after the underlying connection ends. 13 In addition, certain family members 14 and certain entities owned by disqualified persons 15 are also subject to the Section 4958 excise taxes. Most Section 501(c)(3) organizations are required to file a Form 990 each year. Technically, these are not really tax returns (true to their moniker, exempt organizations generally pay no tax), but are referred to as "information returns." Sounds harmless enough. In the last decade, however, the IRS has transformed this return from a document that mostly disclosed innocuous financial data into a cross-examinatory instrument (some would say of torture) that, in the avowed interest of transparency and compliance, requires the organization to lay out a wealth of information for all to see, 16 much of which highlights IRS hot spots. 17 Among other areas, this still-evolving form has significantly expanded required disclo- sure relating to officer compensation (and compensation of other highly-paid individuals) and to conflict of interest policies and transactions (defined as transactions with "interested persons" 18 ). e IRS has used the form to expose (and in many cases put a stop to) certain practices, including the bifurcation of compensation amongst several related organizations—with the effect of avoiding full disclosure of aggregate compensation—and to require organi- zations to identify certain pay practices, such as reimbursement of spousal travel, reimbursement of first class airfare and payment of "tax gross-ups", that have fallen into disfavor in recent years, thereby putting a further chill on their continued use. 19 e Form 990 queries whether the organization has engaged in an excess benefit transaction during the year, and if it has, whether it has been corrected. It also asks whether the organization discovered, during the year, a previously unreported excess benefit transaction from a prior year, with the same follow-up question. 20 If, in response to either question, the "yes" box is checked, the return preparer is directed to complete Part I of Schedule L of Form 990, entitled "Excess Benefit Transactions." At the end of that part of the sched- ule, there is a pithy one-word question: "Corrected?", followed by

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