The International Journal
of Not-for-Profit Law

Volume 1, Issue 2, December 1998

A quarterly publication of the International Center for Not-for-Profit Law

Table of Contents

Letter from the Editor


Registration of Associations in Central and Eastern Europe and the Newly Indpendent States: A Survey
Rachel L. Holmes

The Case for Intermediate Sanctions
Milton Cerny

Voluntary Organizations in Europe: The European Convention on Human Rights
Erik Denters and Wino J.M. van Veen

Improving Civil Society in Hungary
Daniel Csanády

El Proyecto de Ley N. 4690/98 (Developing State - NGO Relations in Brazil)
Anna Cynthia Oliveira

NGO Legislation in Georgia
Vasha Salamadze


The Non-Profit Handbook (1997-1998 National Edition)
Reviewed by Karla Simon

Handbuch Stiftungen
Edited by Bertelsmann Stiftung

Case Notes

Trustees of Sahebzadi Oalia Kulsum Trust v Controller of Estate Duty [1998] 233 ITR 434

Revenue Commissioners v Sisters of Charity of the Incarnate Word

Gaudiya Mission v. Kamalaksha DAS Brahmachary

Country Reports

Asia Pacific:
Regional | Australia | China | India | Japan | Mongolia | Nepal | New Zealand | the Philippines | Thailand | Vietnam

Central and Eastern Europe:
Regional | Albania | Bosnia-Herzogovina | Bulgaria | Croatia | Czech Republic | Hungary | Latvia | Lithuania | Macedonia | Poland | Slovakia | Slovenia | Yugoslavia

Latin America and the Caribbean:
Argentina | Brazil | Ecuador | Puerto Rico | Venezuela

Middle East and North Africa:
Regional | Egypt | Jordan | Morocco

Newly Independent States:
Regional | Armenia | Azerbaijan | Belarus | Georgia | Kazakhstan | Kyrgyzstan | Moldova | Russia | Tajikistan | Turkmenistan | Ukraine | Uzbekistan

North America:
Canada | Mexico | the United States

Sub-Saharan Africa:
Regional | Ethiopia | Mauritius | South Africa

Western Europe:
Regional | England and United Kingdom | Finland | France | Germany | Republic of Ireland | Netherlands | Northern Ireland | Sweden | Turkey

International Developments:
UNESCO | Loccum Conference | Birmingham Conference

Self-Regulation Initiatives

United States - Overview of the Bishop Estate Controversy

United States - Maryland Association of Nonprofits Adopts "The Standards of Excellence"

International Grantmaking

Options for Increasing U.S. Support for Chinese Nonprofit Organizations
Robert A. Boisture

Grantmaking by Private Foundations in the International Arena
Thomas Chomicz

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Editorial Board

Subscription Information

Previous Issues

ICNL Homepage

The Case For Intermediate Sanctions

Milton Cerny
Caplin & Drysdale, Chartered
Washington, D.C.

On July 30, 1998 the Department of Treasury issued its eagerly awaited rulemaking notice for public comment on the proposed regulations to implement the intermediate sanctions provisions under section 4958 for public charities.1 These regulations present the most sweeping governance and administrative rules that nonprofit organizations have faced since the 1959 regulations defined the parameters for charitable activities.


The need for intermediate sanctions arose from concern expressed by the United States Congress because of perceived improprieties by a few tax exempt organizations and the Internal Revenue Service’s inability to deal with these potentially abusive transactions short of revocation of tax exemption.

The Clinton Administration’s concern that existing tax law was not adequate to curtail abusive transactions was expressed by Commissioner Margaret Richardson testifying at a hearing of the House Ways and Means Oversight Committee. Richardson stressed that the absence of any sanctions short of revocation for public charity violations of the private inurement and private benefit rules creates serious enforcement problems for the Service. The Commissioner noted that revocation is often highly disproportionate to the violation, and often punishes the wrong parties by threatening the continued existence of the public charity and its ability to perform needed services for its community while allowing the abusers to retain the benefits of their misconduct.2

While the IRS has made increasing use of closing agreements, requiring public charities to take various corrective acts as a condition for the Service refraining from proposing revocation of exemption, the Commissioner stressed the limitations of this strategy. In particular, she noted that because closing agreements are negotiated on a case-by-case basis, it is difficult to ensure consistent results, and further, because closing agreements are negotiated after the violation and are not publicized, they provide limited guidance, or deterrence, for other organizations.

IRS and Treasury presented a package of proposals intended to provide the government with effective targeted sanctions. The general approach was to adopt a series of graduated levels of penalty taxes on "disqualified persons" and "organization managers" that engage in excess benefit transactions for their own private benefit with "applicable organizations."3

The concept of intermediate sanctions was introduced into the Internal Revenue Code with the 1969 enactment of the private foundation rules. These rules establish a two-tier penalty tax system for self-dealing transactions, expenditures for noncharitable purposes and certain other broad categories of acts. Extending the intermediate sanctions concept to public charities is neither a new nor totally untested idea. As early as 1977, the Treasury Department, endorsing the findings of the Filer Commission, recommended to Congress that a slightly modified version of the private foundation rules be applied to public charities. In 1976, Congress incorporated a form of intermediate sanctions in the section 501(h) rules governing lobbying by public charities, and, in 1987, adopted a two-level, foundation-type penalty tax scheme in section 4955 for public charity violations of the prohibition on intervention in political campaigns.

Arguments for penalizing individuals receiving excessive compensation and other excessive remuneration for transactions involving public charities is unassailable. Revocation is often a disproportionate and misdirected sanction, inappropriately punishing an organization, its employees, and, most importantly, those it serves, while allowing the insiders who benefited from the abusive transaction to retain the benefit of their misconduct.

In order to cure the serious weakness in the tax law, Congress with broad support for the charitable sector "narrowly tailored" intermediate sanctions to excess benefit transactions and unreasonable compensation agreements engaged in with disqualified persons.

Congress in enacting these provisions included an abatement of the penalty tax if it can be established that the violation was due to reasonable cause, not due to willful neglect and the transaction was corrected within 90 days after IRS mails a notice of deficiency. While not made a part of the legislation, the House Report expressed the intent that parties to a transaction are entitled to rely on a "rebuttable presumption" of reasonableness for compensation and the valuation of property if 1) appropriate documentation can be shown through comparable compensation agreements, 2) determinations are made by unrelated individuals and 3) there is a clear showing of the basis for the Boards action. Once the presumption is properly made the burden is on the IRS to show contrary evidence to rebut the probative value of the organization’s evidence.

The important portions of the Code and the proposed regulations are outlined below.

Applicable Tax Exempt Organization

Generally, with certain exceptions, an applicable tax exempt organization includes 501(c)(3) and 501(c)(4) organizations exempt from Federal income tax under section 501(a). This definition includes organizations that either have applied for tax exemption or claim such status by filing a nontaxable return with the IRS.

Disqualified Persons

The statute defines a disqualified person as an individual who, at any time during the five years prior to the transaction in question,4 was "in a position to exercise substantial influence over the affairs of the organization." The statute also provides that any member of a disqualified person’s family, as well as any entity in which a disqualified person or family member owns more than a 35% of the control or beneficial interest, also is a disqualified person.5

The proposed regulations provide that certain categories of individuals and entities are automatically disqualified persons, certain categories are automatically not disqualified persons, and set up a facts and circumstances test for all others. The proposed regulations also provide a number of helpful examples.6

Automatic Disqualified Persons

The proposed regulations list categories of persons including organizations or entities as well as an individual who are deemed to have "substantial influence" over the affairs of an organization, regardless of the surrounding facts and circumstances. This list includes people who are in a position to exercise substantial have the power or influence to affect major decisions of an organization — whether or not they choose to exercise that power.

In this category are members of the organization’s governing body who are entitled to vote. Presidents, chief executive officers, and chief operating officers — including persons with different titles who perform these functions — also are automatic disqualified persons. The regulations specify that a person performs the functions of a president, chief executive officer, or chief operating officer if that person "has or shares ultimate responsibility for implementing the decisions of the governing body or supervising the management, administration, or operation" of the organization. If more than one person has these responsibilities, i.e., there is more than one CEO, all individuals with the responsibilities of a CEO are automatic disqualified persons.

In addition, treasurers and chief financial officers — or any person who performs the functions of a treasurer or chief financial officer — are deemed to be disqualified persons. The proposed regulations define treasurer or chief financial officer as any person, regardless of title, who "has or shares ultimate responsibility for managing the organization’s financial assets and has or shares authority to sign drafts or direct the signing of drafts, or authorizes electronic transfers of funds, from organization bank accounts." As with CEOs, there may be more than one treasurer or CFO; if so, each will be an automatic disqualified person.

Finally, persons with a material financial interest in a provider-sponsored organization in which a tax exempt hospital participates are deemed to be disqualified persons. These would include physicians who have a material financial interest in a physician-hospital organization or a preferred provider network that includes an exempt hospital.

Persons Who Are Deemed Not Disqualified Persons

The proposed regulations are helpful in that they include two categories of persons who are deemed not to be disqualified persons — regardless of the surrounding facts and circumstances.7 The first category is other applicable public charities and social welfare tax-exempt organizations — that is, all other organizations to which intermediate sanctions apply.

The second category that is significant for smaller organizations excludes employees (1) who receive total economic benefits from the organization of less than the amount of compensation that causes someone to be a "highly compensated employee" under the Code, i.e., approximately $80,000 per year for 1998; (2) who are neither automatic disqualified persons (such as a member of the board, CEO, or CFO) nor family members (or 35% controlled entity) of an automatic disqualified person; and (3) who are not "substantial contributors" to the organization. "Substantial contributor" is defined as someone whose contributions exceed both $5,000 and 2% of the organization’s total contributions to date.

The examples clarify that the $80,000 threshold applies to the total value of compensation plus any other economic benefits received form the organization. Thus, for example, a person who receives a salary of less than $80,000 per year for services rendered to the charity, but also sells business services to the charity exceeding $20,000, does not qualify for the automatic non-disqualified person treatment, because the total economic benefit provided by the organization exceeds $80,000.8

Facts and Circumstances Test

In all cases other than those where a person is deemed automatically either to be or not to be a disqualified person, the proposed regulations apply a "facts and circumstances" test to determine a person’s status.9 The regulations provide a non-exclusive list of facts and circumstances tending to show whether a person has substantial influence over an organization. They include: (1) the person is a founder of the organization; (2) the person is a substantial contributor to the organization; (3) the person receives compensation based on revenues of activities that the person controls; (4) the person has authority to control a "significant portion" of the capital expenditures, operating budget, or compensation of employees of the organization; (5) the person has managerial authority or is a "key advisor" to a person with managerial authority; and (6) the person owns a controlling interest in an entity that is a disqualified person. Again, this test is not all inclusive.

The regulations also cite certain facts and circumstances tending to show lack of substantial influence and they include: (1) the person has taken a vow of poverty as an employee or agent of a religious organization; (2) the person is an independent contractor, such as an attorney or accountant, acting in that capacity; and (3) if a contributor, the person receives only such preferential treatment as is available to any other donor making a comparable contribution as part of a solicitation designed to attract a substantial number of contributions.10

No Initial Transaction Exception

The proposed regulations clearly omit an "initial transaction exception," commonly referred to as the "first bite rule," to the effect that a person negotiating an initial agreement cannot be a disqualified person. Comments submitted prior to the release of the proposed regulations argued in favor of such a rule on the ground that a person generally does not have "substantial influence" over an organization prior to execution of this first agreement.

The proposed regulations have directly rejected that position in providing that an excess benefit transaction occurs on the date that a disqualified person receives the excess benefit from the organization for federal income tax purposes, not on the date a binding contract is signed. Thus, negotiations for any CEO compensation arrangement will be given close scrutiny, notwithstanding that this first agreement would in the normal course have been negotiated at arm’s-length with a disinterested governing body.

Excess Benefit Transactions

Under section 53.4958-4 of the proposed regulations, an excess benefit transaction includes "any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit." The regulations provide that an excess benefit may be provided directly or indirectly through an entity "controlled by or affiliated with" the applicable tax-exempt organization, such as a taxable subsidiary.

Disregarded Benefits

The proposed regulations disregard certain categories of benefits for purposes of determining whether an excess benefit has been provided. First, reimbursements of members of the organization’s governing body’s reasonable expenses of attending meetings of the governing body are disregarded. "Reasonable expenses" for this purpose do not include "luxury travel"11 or "spousal travel."12 The proposed regulations neither define nor illustrate the phrase "luxury travel." Consequently, organizations will want to exercise some caution in this area until the IRS offers further guidance on what it will accept as reasonable travel expenses.

Perhaps the most important step organizations can take in this regard is to develop an explicit travel reimbursement policy. Throughout the proposed regulations the drafters have emphasized the importance of adhering to sound procedures and documentation.13 The intermediate sanctions rules do not prohibit organizations from providing luxury or spousal travel to disqualified persons; instead, they mean that such benefits should be treated as compensation and, when combined with all other elements of compensation provided to the disqualified person, must not exceed the fair market value of the services provided in return.

Second, the proposed regulations exclude economic benefits provided to a disqualified person solely as a member of or volunteer for a covered organization are disregarded, provided the same benefit is provided to members of the public for a membership fee of $75 or less per year. Examples are advance ticket purchases and gift shop discounts. However, benefits provided only to donors who contribute at least a specified amount which is more than $75 are not disregarded, and therefore could qualify as "excess benefits" under the general test described above if provided to a disqualified person.

Finally, benefits provided to a disqualified person solely as a member of a charitable class served by the organization in furtherance of its exempt purpose are disregarded for section 4958 purposes.

Reasonable Compensation

The regulations provide that compensation is reasonable only if the amount paid "would ordinarily be paid for like services by like enterprises under like circumstances." In determining the reasonableness of compensation, all items of compensation must be considered, including deferred compensation earned and vested, premiums for liability or other insurance coverage, severance payments, and all fringe benefits (except section 132(d) "working condition fringe benefits" and section 132(e) "de minimis fringe benefits"), in addition to salary and bonuses. The proposed regulations indicate that where reasonableness of compensation cannot be determined based on circumstances existing at the date the contract for services was made, that determination will be made based on all facts and circumstances up to and including circumstances as of the date of payment. The facts and circumstances present when the contract is questioned, however, are not relevant — i.e., the IRS may not challenge — and the organization cannot defend — the reasonableness of compensation or other benefits based on developments after the benefits were conferred. Certain factors must be present in order to establish that the compensation was reasonable.14

Intent to Treat Item as Compensation

An item of economic benefit will be considered compensation only if the organization provides "clear and convincing evidence that it intended to so treat the economic benefit when the benefit was paid." In the absence of such clear and convincing evidence, the item will not be treated as provided in consideration for services — with the usual result that it will be an excess benefit transaction if paid to a disqualified person.

The regulations provide that reporting a benefit as compensation on a Form W-2, 1099, or 990, prior to the commencement of an audit, constitutes clear and convincing evidence of intent to treat it as compensation. In addition, reporting the benefit as income by the recipient on his or her Form 1040 also constitutes clear and convincing evidence of intent to treat it as compensation. An organization also may establish clear and convincing evidence of intent to treat an item as compensation by showing that the failure to report the item as such was due to "reasonable cause" under the IRS’s stringent rules. Reasonable cause can be shown by establishing that there were significant mitigating factors with respect to the failure to report, or that the failure resulted from events beyond the organization’s control and the organization acted in a reasonable manner to correct the problem upon its discovery.

The regulations also provide that in certain cases an organization may be able to provide clear and convincing evidence that a payment was clearly intended as compensation even if the organization did not report the payment to the IRS. Thus, for example, if a covered organization contracts with a corporation to perform services, the service contract provides clear and convincing evidence that the payments under the contract are intended as compensation for services. Because payments to corporations need not be reported to the IRS, no negative inference arises from the absence of such reporting.15

Rebuttable Presumption that Transaction is Not an Excess Benefit Transaction

Consistent with the legislative history of section 4958, the regulations provide a rebuttable presumption that compensation will be treated as reasonable, and consideration paid for property transfers will be presumed to be a fair market value amount, if the decision-making process with respect to the compensation arrangement or property transfer follows prescribed procedures.16 This is an important safeguard for organizations. Even if the presumption were not specifically provided in the regulations, the prescribed procedures represent "best practices" that should be followed when entering into any compensation arrangement or property transfer involving a disqualified person. The presumption applies if three procedural requirements are met: (1) the arrangement is approved by members of the organization’s governing body or a committee thereof, none of whom have a conflict of interest with respect to the transaction; (2) the governing body or committee obtained and relied upon appropriate data as to comparability or fair market value; and (3) the governing body or committee adequately and contemporaneously documented the basis for its determination.

Approval By an Independent Board or Committee

In order to satisfy this requirement, the board or committee approving the arrangement must consist solely of individuals who lack a conflict of interest with respect to the arrangement in question. The regulations clarify that regular members of the board or committee who do have conflicts may recuse themselves from deliberation and voting. Any conflicted directors may meet with other members of the group to answer questions about the transaction, but then must leave the room prior to debate and voting on the proposal.

The proposed regulations also provide guidance as to when a member of a board or committee has a conflict of interest.17 Obviously, a member of the board who is the disqualified person involved in the transaction in question has a conflict of interest. Beyond that, persons who are related to the disqualified person and those who economically benefit from or have a material financial interest affected by the transaction have conflicts. Further, individuals in employment relationships subject to the direction or control of the disqualified person, or who receive compensation or other payments subject to the approval of the disqualified person, are considered to have conflicts. Finally, anyone who participates in a reciprocal arrangement — where the disqualified person approves a transaction to his or her benefit in exchange for approval of a transaction to the disqualified person’s benefit — has a conflict of interest.

A board-appointed committee may approve a transaction if doing so is authorized by state law. If state law permits it, members of the committee may be persons who are not members of the full board. Members of the committee whose action is relied upon in claiming application of the rebuttable presumption are deemed to be organization managers for purposes of the organization manager tax — regardless of whether they otherwise serve as members of the board or officers of the organization.

If a committee’s actions must be ratified by the full governing body in order to be effective, the committee’s action cannot be relied upon for application of the presumption. In that situation, to earn the presumption, members of the full board approving the committee’s action cannot include anyone with a conflict of interest.

Appropriate Data

The proposed regulations provide that the board or committee approving the transaction has appropriate data as to comparability. Relevant information includes: (1) compensation paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions; (2) the availability of similar services in the area; (3) "independent compensation surveys compiled by independent firms;" (4) actual written offers from similar organization competing for the disqualified person; and (5) if the transaction involves the transfer of property, independent appraisals of that property. The proposed regulations include a special rule intended to make compliance with this element of the presumption easier for small organizations.18 When approving compensation arrangements, organizations with annual gross receipts of less than $1 million may rely on data as to compensation paid by five comparable organizations "in the same or similar communities" for similar services. For this purpose, an organization’s annual gross receipts are determined on a rolling average of the three prior taxable years. Organizations related by common control or by their governing documents must be aggregated to determine whether this special rule is available.

Contemporaneous Documentation

In order to earn the rebuttable presumption, the organization must maintain adequate contemporaneous documentation. The proposed regulations make it clear that the documentation must be contemporaneous with the approval of the transaction — after-the-fact documentation will not be sufficient to claim the presumption.19 In order to satisfy the documentation requirement for the presumption, the written or electronic records of the board or committee approving the transaction must note: (1) the terms of the transaction and the date it was approved; (2) the members of the board or committee who were present during debate and those who voted on it; (3) the comparability data obtained and relied upon and how the data was obtained; and (4) any actions taken by a regular member of the board or committee who had a conflict of interest. The board or committee must record the basis for any determination it then makes that reasonable compensation or fair market value is more or less than the range of comparable data. The proposed regulations specify that for such as decision to be documented concurrently, records must be prepared by the next meeting of the board or committee and must be reviewed and approved "within a reasonable time period thereafter."

Timing Is Critical

One difficulty with the rebuttable presumption as described in the proposed regulations is determining when the transaction is ripe for approval. The proposed regulations specify that the presumption cannot apply until all circumstances necessary to determine the reasonableness of compensation exist.20 Thus if a disqualified person is to receive a discretionary bonus of unknown amount, the reasonableness of his or her compensation cannot be determined — and the three procedural requirements of the presumption cannot be met — until the amount of the bonus is known. The exact application of this timing rule may be clarified in the final regulations.

Revenue-Sharing Transactions

Congress authorized the IRS to write regulations treating certain "revenue-sharing" transactions resulting in inurement as excess benefit transactions, in addition to transactions in which a disqualified person receives an economic benefit in excess of the value of the benefit he or she provides in return. In response to this authority, the proposed regulations provide a facts and circumstances test for determining whether inurement results from a transaction in which the economic benefit provided to a disqualified person is based on the revenues of one or more of the organization’s activities. For these purposes, the proposed regulations do not distinguish between gross and net revenues.21

"Proportionality" requirement. The regulations state that a revenue-sharing transaction may constitute an excess benefit transaction resulting in penalties if "at any point, it permits a disqualified person to receive additional compensation without providing proportional benefits that contribute to the organization’s accomplishment of its exempt purpose." The regulations provide two facts and circumstances that are relevant to the determination of whether the required proportionality has been achieved.22

First, the regulations specify that the relationship between the size of the benefit provided, on the one hand, and the quality and quantity of the services provided in exchange, on the other hand, is relevant. Second, the regulations state that the ability of the disqualified person to control the activities generating the revenues on which his or her compensation is based is relevant to the determination of whether inurement has occurred.

The regulations provide examples of revenue-sharing transactions with disqualified persons. In one example, an organization’s investment manager receives a bonus based on any increase to the value of the organization’s investment portfolio. Because the bonus gives the manager an incentive to provide high-quality services, and because the organization will receive benefits proportional to any benefit the manager receives, the contract providing for the bonus is not an excess benefit transaction.23 A contrasting example involves the manager of an organization’s gambling operation. The example concludes that the arrangement is an excess benefit transaction because it provides for benefits to the organization of a percentage of the net profits after operating expenses — with the remainder going to the disqualified person. Because the manager has control over and benefits from the operating expenses, the arrangement does not provide an incentive for the disqualified person to maximize the quality of his services, and does not provide benefits to the organization proportional to those received by the disqualified person.24

Although these tests and examples are helpful, commentators likely will request that the IRS provide further guidance as to the application of this section of the proposed regulations. In addition, the IRS has specifically requested comments on the revenue-sharing provisions of the proposed regulations.

Fair Market Value Not Relevant. The regulations specifically provide that, for purposes of determining whether a revenue-sharing transaction results in inurement, it is not relevant whether the disqualified person ultimately receives only fair market value for the benefits he or she provides the organization in return. The revenue-sharing provisions of the proposed regulations thus concern the structure of arrangements, not their results. If the basic revenue-sharing structure permits the disqualified person to receive benefits disproportionate to the benefits he or she provides in return, the arrangement is per se an excess benefit transaction.25

The logical result of this focus on structure rather than fair market value is that the "excess benefit" in an improper revenue-sharing transaction is the entire benefit provided to the disqualified person under the transaction — not just the portion of the benefit which exceeds the fair market value of the benefit provided in return. Commentators have noted that under this "all or nothing" approach, it is unclear how an organization ever could "correct" an improper revenue-sharing transaction, particularly when the disqualified person has provided valuable services under a contract enforceable under state law.

Prospective v. Retroactive Application. The proposed regulations provide that this portion of the regulations will apply only to revenue-sharing transactions which occur on or after the date of publication of final regulations. However, the date the transaction occurs — as defined by the proposed regulations — may well occur significantly after the arrangement is entered into. For example, if an organization enters into a revenue-sharing arrangement before the issuance of final regulations that provides disproportionate benefits to a disqualified person which the disqualified person will not receive until after the publication of final regulations, the arrangement will be subject to the revenue-sharing restrictions, even though the contract was signed prior to the publication of final regulations.26

Application of the Section 4958 Excise Taxes on Excess Benefit Transactions

Section 4958 of the Code imposes three separate taxes on excess benefit transactions: a first-tier tax on the disqualified person, a first-tier tax on foundation managers, and a second-tier tax on the disqualified person in the case of failure to correct.

The First-Tier Taxes

Tax on the disqualified person. The first-tier tax on the disqualified person is 25% of the excess benefit received. Except in the case of improper revenue-sharing arrangements, the excess benefit is the amount by which the value of the compensation or other benefits received by the disqualified person exceeds the fair market value of the services or property provided by the disqualified person in return. If more than one disqualified person receives an excess benefit from a particular transaction, each such disqualified person is jointly and severally liable for the tax.

Tax on organization managers. The statute also imposes a tax, equal to 10% of the excess benefit, on any organization manager who knowingly participated in the excess benefit transaction, unless the participation was not willful and was due to reasonable cause. The tax on any organization manager for a single transaction is limited to $10,000.

Organization Managers. The statute provides that organization managers are officers, directors, and trustees of an organization, as well as any individuals having similar powers or responsibilities. The proposed regulations define an officer as including a person specifically designated as an officer under the organization’s articles of incorporation or bylaws and any person who "regularly exercises general authority to make administrative or policy decisions on behalf of the organization."27 The proposed regulations specify that independent contractors acting as attorneys, accountants, and investment managers are not officers.28 Further narrowing the concept of organization managers, the proposed regulations state that anyone whose authority is limited to recommending particular administrative or policy decisions and who cannot implement those recommendations without approval of a superior, is not an officer or employee or religious organization who have taken a vow of poverty.29

In addition, if an organization invokes the rebuttable presumption of reasonableness described above based on the actions of a committee, all members of the committee are deemed to be organization managers, regardless of whether they are also officers, directors, or trustees.

Knowing Participation. The tax is imposed on an organization manager only if the manager (1) had actual knowledge of sufficient facts to determine that the transaction would be an excess benefit transaction; (2) was aware that the act might violate the federal tax law governing excess benefit transactions; and (3) either negligently failed to make reasonable attempts to ascertain whether the transaction was an excess benefit transaction or knew that the transaction was an excess benefit transaction.

"Willful," for this purpose, means "voluntary, conscious, and intentional." Participation by an organization manager is not willful if the manager does not know that the transaction is an excess benefit transaction.

A manager has "reasonable cause" for participation in a transaction if he or she has exercised his or her responsibility "with ordinary business care and prudence." If a manager relies on the advice of legal counsel expressed in a reasoned written opinion that a transaction is not an excess benefit transaction, the manager’s participation ordinarily is not knowing or willful and is due to reasonable cause. The manager must fully disclose the factual situation to legal counsel in order for this rule to apply. This advice of counsel rule applies to in-house counsel as well as to an outside law firm.

The Second-Tier Tax

If a first-tier tax is imposed on a disqualified person and the transaction is not corrected within the "taxable period," the disqualified person must pay an additional tax of 200% of the excess benefit. The taxable period begins on the date the transaction occurs and ends when a notice of deficiency with respect to the first-tier tax is mailed or when the first-tier tax is assessed, whichever is earlier.

Correction. The proposed regulations state that correction means "undoing" the excess benefit to the extent possible, and "taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person had been dealing under the highest fiduciary standards." Repayment of the excess benefit, with interest, constitutes correction. If a disqualified person receiving excessive compensation is under contract, the contract may need to be modified in order to prevent future excess benefit transactions.

Applicable Tax-Exempt Organizations

The statute defines "applicable tax-exempt organization," i.e., an organization to which the new intermediate sanctions rules apply, as any organization which is either described in section 501(c)(3) or section 501(c)(4) of the Code, or was described in section 501(c)(3) or section 501(c)(4) during the five years preceding the questioned transaction.30

There are two classes of organizations specifically excepted from the intermediate sanctions rules. First, because private foundations are already subject to strict penalties similar to the section 4958 excise taxes, Congress explicitly exempted them from the intermediate sanctions regime. Second, foreign organizations that receive substantially all of their support from sources outside the United States are not subject to intermediate sanctions, even if they have applied for and received recognition of section 501(c)(3) or 501(c)(4) status from the IRS. Public universities that have not applied for and received recognition of section 501(c)(3) status (because they are already exempt under section 115) are not section 501(c)(3) organizations and therefore are not subject to intermediate sanctions.

An organization is a section 501(c)(4) organization — and is covered by intermediate sanctions — if it asserts that status by filing a Form 990 (Annual Information Return for Tax-exempt Organization) as a section 501(c)(4) organization rather than a Form 1120 (Corporate Tax Return), or by otherwise holding itself out as a section 501(c)(4) organization.

Relationship Between Intermediate Sanctions and Revocation of Exempt Status

The preamble to the proposed regulations invites comments from the public on future guidance concerning the appropriate relationship between intermediate sanctions and revocation of exempt status. The proposed regulations themselves provide only that imposition of intermediate sanctions will not preclude revocation of exemption. The legislative history indicates that revocation will be appropriate only when the excess benefit transaction rises to the level where "it calls into question whether, on the whole, the organization functions as a charitable or other tax-exempt organization."

In determining whether revocation is appropriate, the preamble states that relevant factors include the size and scope of the excess benefit transaction in question, the extent to which the organization has engaged in other excess benefit transactions, whether other federal and state laws have been violated, and whether the organization has engaged in correction and compliance activities since the excess benefit transaction.


The proposed regulations have gone a long way to implement the rules envisioned by Congress to penalize abusive transactions. However, the regulations will need further clarification and amplification as need in the areas described above. Covered organizations would be well-advised to take several steps to minimize their exposure to intermediate sanctions. As a preliminary step to complying with the new intermediate sanctions rules, organizations should attempt to identify all their disqualified persons.

Organizations will need to consult with counsel to develop procedures for ensuring that transactions with disqualified persons receive appropriate review within the context of their operations. Small organizations with only a few disqualified persons and infrequent transactions with them probably should subject each of these transactions to board review and documentation. Larger organizations, such as hospitals or universities, probably will need to develop a process for distinguishing significant transactions from more routine matters.

All affected organizations will need to review and regularize their record-keeping practices. The proposed regulations place a premium on maintenance of careful records documenting board consideration of transactions between the organization and its disqualified persons. In some cases, contemporaneous records evidencing board consideration and a deliberate decision concerning a transaction may make the difference between a transaction the IRS chooses to respect and one it challenges.

Further, organizations must on a continuous basis identify and review appropriate comparability data for compensation arrangements with disqualified persons. The required thoroughness and sophistication of the data will vary. A large hospital or university likely will need a professional comparability study and an extensive review process when setting the compensation of its CEO. In contrast, a smaller organization paying a modest salary to its executive director may be able to rely on published information to establish comparability.


About the author: Milton Cerny [] is a partner in the Washington, DC law firm Caplin & Drysdale.  He is former Chief of the National Office Exempt Organizations Rulings Branch of the Internal Revenue Service.  He wishes to express his appreciation for the assistance from the Exempt Organizations Practice Group at Caplin & Drysdale, in particular Julie Davis and Elizabeth Sellers.

1 26 C.F.R. § 53.4958-1 - 53.4958-7.

2 Hearings held June 15 and August 2, 1993.

3 Treasury Department Proposal to Impose Intermediate Sanctions on Certain Tax Exempt Organization, August 8, 1995, BNA Daily Tax Report.

4 Notable exceptions are foreign organizations that receive substantially all of their support from sources outside the U.S., private foundations and state universities that have not applied for exemption under section 501(c)(3).

5 Section 4958(f)(1)(A).

6 53.4958-3.

7 53-4958-3(d).

8 53.4958-3(d)(2)(A).

9 53.4958-3(e)(2).

10 It should be noted, however, that the independent contractor factor does not apply if the person is advising the organization with respect to a transaction that might economically benefit him or her, either directly or indirectly, aside from fees received for professional services rendered.

11 Section 274 of the Code provides a fairly comprehensive set of regulations for taxable travel if it is "lavish or extravagant" which appear to provide more definitive administrable rules.

12 Conditions permitting, spousal travel as a business expense can be found in Section 162 of the Code.

13 Defining an explicit travel reimbursement policy not only will help organizations make justifiable decisions about particular reimbursement requests, and documentation will bolster their ability to defend their practice in the event of IRS review.

14 This is a very difficult area that will require proper reporting and determination of timing issues. Thus, services performed in multiple prior years that vests in a later year are considered under the regulations as compensation attributable to the years in which the services are performed. 53.4958-4(b)(3)(ii)(B).

15 53.4958-5(c)(2)(iii).

16 53.4958-6.

17 53.4958-6(d)(iii).

18 53.4958-6(iv)(2)(ii).

19 53.4958-6(d)(3)(1).

20 53.4958-6(e).

21 53.4958-5(a).

22 53.4958-5(c).

23 53.4958-5(d) example 1.

2453.4958-5(d) example 2.

25 53.4958-5(a).

26 53.4958-5(c).

27 53.4958-3(c)(2).

28 53.4958-3(e)(2). Exempted unless acting in that capacity regarding that transaction could benefit economically.

29 53.4958-3.

30 The proposed regulations specify that the intermediate sanctions regime applies to organizations based on their status without regard to any excess benefit transactions — that is, even if an organization ultimately loses its exemption due to one or more excess benefit transactions, the section 4958 excise taxes


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