An organization which qualifies for tax-exempt status under Section 501(c)(3) of the Internal Revenue Code ("Code") may not allow any of its earnings to inure to the benefit of a private individual. The Taxpayer Bill of Rights 2 (the "Act") which was passed in 1996 introduced a penalty for "private inurement" which is designed to address situations in which the inurement does not rise to a level requiring the revocation of the organization's exempt status. At the time the Act was passed, the IRS was given the authority to promulgate regulations to provide further guidance on these "intermediate sanctions." On August 4, 1998, the IRS published Proposed Regulations in the Federal Register concerning the intermediate sanctions (the "Proposed Regulations"). Among other things, the Proposed Regulations provide increased guidance on the definition of a "disqualified person" as well as further insight into the safe harbor available to organizations entering into transactions with disqualified persons.

The intermediate sanctions of the Act impose a penalty excise tax on any organization "manager" who knowingly participates in an "excess benefit" transaction and upon any "disqualified person" who benefits from any such transaction. The tax is not imposed upon the exempt organization. The tax, however, is in addition to the sanction of revocation of tax-exempt status, which now is reserved for particularly egregious cases which indicate the organization is no longer operating within its charitable purpose.

I. Disqualified Person:

Generally, an "excess benefit" transaction is any transaction between an exempt organization and a "disqualified person" where the "disqualified person" receives an economic benefit that exceeds the value of the consideration provided for that benefit. The Proposed Regulations clarify that the intermediate sanctions also may apply to revenue sharing arrangements which result in prohibitive private inurement. A revenue sharing arrangement is one in which the economic benefit provided to the disqualified person is determined in whole or in part by revenues of one or more activities of the organization.

A disqualified person is someone who has substantial influence over the affairs of the exempt organization. The following are deemed to be disqualified persons:

1. individuals serving on the governing body who are entitled to vote;
2. presidents, chief executive officers, and chief operating officers;
3. treasurers and chief financial officers; and
4. persons with a material interest in a provider-sponsored organization.

The following persons are deemed not to be disqualified persons:

1. any employee who receives total compensation from the organization of less than $80,000.00 annually and is not a substantial contributor to the organization; and
2. other tax-exempt organizations described in Section 501(c)(3) of the Code.

All other cases will be analyzed based on the relevant facts and circumstances. Examples given in the Proposed Regulations indicate that physicians who are members of the medical staff of a tax-exempt hospital will not be deemed disqualified persons solely on that basis. Instead, relevant facts and circumstances, such as the level of managerial authority, will be analyzed.

II. Rebuttable Presumption of Reasonableness:

The Proposed Regulations provide further detail on how an organization can fall within the safe harbor provided by the rebuttable presumption of reasonableness. The presumption would apply in situations in which the board of directors addresses a transaction involving a disqualified person.

A rebuttable presumption of reasonableness applies to any transaction approved by an organization's board of directors if that board: (1) was composed entirely of individuals who do not have a conflict of interest with respect to the transaction; (2) obtained and relied upon appropriate data as to comparability prior to making its determination; and (3) adequately documented the basis for its determination concurrently with making that determination. When these three criteria are satisfied, the intermediate sanctions can be imposed only if the IRS develops sufficient evidence to rebut the presumption by showing that the compensation was not reasonable or that the transfer was not at fair market value. The Proposed Regulations provide additional clarification for these requirements:

1. A member of a board of directors will not have a conflict of interest with respect to a compensation arrangement or transaction if that member: (a) is not a disqualified person and is not related to a disqualified person; (b) is not in an employment relationship subject to the direction or control of a disqualified person; (c) is not receiving compensation subject to approval by a disqualified person; (d) has no material financial interest affected by the compensation arrangement or transaction at issue; and (e) does not approve a transaction providing economic benefit to a disqualified person participating in the transaction who in turn approves a transaction providing economic benefits to the member.
2. A board has reviewed appropriate data as to comparability if it has received information sufficient to determine whether the compensation arrangement at issue will result in payment of reasonable compensation or the transaction will be for fair market value. Whether the information is sufficient should be evaluated by taking into account not only the information available, but also the knowledge and expertise of the members of the board. Relevant information should include the compensation paid by similarly situated organizations for comparable positions, the availability of similar services in a geographic area, independent compensation surveys, actual written offers from similar institutions competing for the services of the disqualified person, and, if applicable, independent appraisals of the value of the property. An organization with annual gross receipts of less than $1,000,000.00 will be considered to have appropriate data if it has data on compensation paid by five comparable organizations in the same or similar communities for similar services.
3. In order for a decision to be documented adequately, the records of the board of directors must contain: (a) the terms of the transaction approved and the date on which it was approved; (b) the members of the board of directors who were present during the debate on the transaction and those who voted on it; (c) the comparability data obtained and relied upon by the board and how the data was obtained; and (d) the actions taken with respect to consideration of the transaction by anyone who was otherwise a member of the board of directors but who had a conflict of interest with respect to the transaction.

If the board of directors determines that reasonable compensation for the specific arrangement at issue or fair market value for the transaction at issue is higher or lower than the comparability data obtained, the board of directors must record the basis for its determination. All records must be prepared by the next meeting of the board of directors occurring after final action has been taken. The board of directors should review and approve the minutes for the prior meeting within a reasonable time period thereafter.

In the event that a disqualified person has a conflict of interest with respect to a transaction, that person should withdraw and excuse himself or herself from the meeting not only for the vote, but also for the discussion of the matter.

The rebuttable presumption of reasonableness places a significant burden on exempt organizations; however, given the significant benefit of the rebuttable presumption, tax-exempt organizations should take all steps necessary to meet these criteria with regard to each transaction entered into with a "disqualified person."

While the Proposed Regulations are not final at this point, the preamble states that the Proposed Regulations may be relied upon by exempt organizations until they are finalized. Thus, the rebuttable presumption can be utilized as a modified safe harbor for exempt organizations.

For more information on IRS regulations, contact Adam M. Beaudoin, Stuart B. Dorsett, Merrill G. Jones, II, William R. Lathan, Jr, W. Daniel Martin, III, James W. Norment, Hugh R. Overholt, Samuel H. Poole, Stanley M. Sams, J. Troy Smith, Jr., H. L. Stephenson, III, David L. Ward, Jr., Leigh A. Wilkinson, or A. Rexford Willis, III.