CRS REPORTS ON PAST INTERMEDIATE SANCTIONS INITIATIVES.

THE TAX TREATMENT OF EXEMPT ORGANIZATIONS: INTERMEDIATE SANCTIONS

Harry G. Gourevitch Senior Specialist in Taxation and Fiscal Policy Office of Senior Specialists

November 15, 1994

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THE TAX TREATMENT OF EXEMPT ORGANIZATIONS: INTERMEDIATE SANCTIONS

SUMMARY

A charitable or other organization exempt from tax under section 501(c)(3) of the Internal Revenue Code is not allowed to have any part of its net earnings inure to the benefit of a private individual or shareholder. In addition, the exempt organization must serve exclusively a public rather than a private interest, allowing it to be formed and operated for not more than incidental private benefits.

Under current law, violation of either of these private inurement and private benefit prohibitions subjects an organization to revocation of its tax exemption. In most cases, however, the Internal Revenue Service is reluctant to revoke an organization's tax exemption as it may hurt innocent parties -- the organization's intended beneficiaries -- while at the same time leaving untouched the persons who benefited from the violations. The health care bills reported in 1994 by the House Ways and Means and Senate Finance Committees included provisions that would impose intermediate sanctions in the form of penalty excise taxes on tax-exempt health care organizations that violate the private inurement prohibition. Intermediate sanctions could be imposed instead of or in addition to revocation of tax-exemption. The provisions do not apply to private benefit transactions that do not also constitute private inurement.

The Senate Finance Committee bill would impose penalty excise taxes on two kinds of transactions: First, any transaction not allowed under current law in which an economic benefit is provided by an exempt organization to an insider, the value of which exceeds the consideration received in return (e.g., unreasonably high compensation to the insider); and second, any transaction not allowed under current law in which the amount of an economic benefit to an insider is determined by the gross or net revenues of the organization or one of its units (e.g., compensation of the head of an exempt hospital's surgery department based on the department's gross or net profits). The House Ways and Means Committee bill, in addition to including these two provisions, also included a prohibition on any lending by an exempt organization to one of its executives, directors, or other managers. Both bills would apply intermediate sanctions only to health care organizations that qualify under Code sections 501(c)(3) and 501(c)(4) (social welfare organizations and certain tax-exempt HMOs). The bills were not enacted.

The report examines the intermediate sanctions provisions in the two bills and discusses certain issues they raise. It points out that the arm's length standard on which some of the provisions are based had proved to be generally ineffective when it was applied to self- dealing transactions between private foundations and their donors. If Congress again takes up intermediate sanctions legislation to be applicable to public charities, it may want to consider extending any such legislation to violations of the private benefit prohibition.

                              CONTENTS

BACKGROUND

Section 501(c)(3) of the Internal Revenue Code (Code) exempts from Federal income tax religious, charitable, educational, and certain other organizations that meet certain statutory and regulatory requirements: their net earnings may not inure to the benefit of any private shareholder or individual, not more than an insubstantial part of their activities may consist in lobbying, they may not participate in campaigns for political office, and they may not be organized or operated for the benefit of private rather than public interests. ¹

Organizations exempt under sec. 501(c)(3) qualify either as public charities or private foundations. Private foundations are organizations that are primarily supported by a small number of contributors and do not receive substantial support from the public. All other sec. 501(c)(3) organizations are public charities. Generally, private foundations enjoy the same favorable tax treatment as public charities: exemption from Federal income tax and the right to receive donations deductible by the donors for income, gift, and estate tax purposes.

Since at least 1950 Congress had been concerned with problems of self-dealing between private foundations and insiders. Self-dealing transactions are transactions between a private foundation and individuals or companies in an insider's relationship to the foundation, such as substantial donors, or officers, directors or other managers of the foundation, or entities controlled by one of the aforementioned individuals. Such transactions may violate the section 501(c)(3) private inurement and private benefit prohibitions. Private inurement occurs when a private foundation or public charity makes a dividend-like distribution of its income or assets to insiders. With some exceptions discussed later, arm's length transactions do not constitute private inurement. A private benefit transaction is a transaction between a private foundation or public charity and private parties which benefits primarily the private parties (who may but need not be insiders). ²

The Revenue Act of 1950 set forth certain self-dealing transactions between a private foundation and its donors that were prohibited if they violate an arm's-length standard. ³ Arm's length standards were imposed with regard to loans, payments of compensation, preferential availability of services, substantial purchases or sales, and certain other transactions. The House bill on the 1950 act would have gone further. Generally, it would have prohibited outright a private foundation from entering into financial transactions with 1) its donors, 2) its officers, directors, and trustees, and 3) certain persons related to its contributors, officers, directors, and trustees. However, the Senate Finance Committee believed that private foundation abuses could be prevented without prohibiting transactions that were at arm's length, and its version prevailed in conference.

In 1965, a Treasury Department report on private foundations concluded that the self-dealing prohibitions enacted in 1950 did not work well. ⁴ According to the report the main difficulty arose in administering the new provisions because of the vagueness of the statutory standards. Financial transactions between private foundations and donors were prohibited only if they violated arm's length standards. This meant that the Internal Revenue Service (IRS) was required to determine the adequacy of security for a loan, the reasonableness of interest, the reasonableness of salaries, the preferential basis for making services available, and the adequacy of consideration. Such determinations required difficult and often subjective judgments. Another problem with the 1950 provisions, the Treasury report stated, was that the penalty for violations -- loss of exemption for at least one year and denial of deduction for contributions under certain circumstances -- was so severe that it was imposed only rarely. Loss of exemption also would often have punished the wrong parties -- the charitable organization and its beneficiaries -- rather than the insiders who had used the organization for personal benefit.

The Treasury report further expressed the belief that the public did not receive an overall benefit from allowing a donor or other insider to deal with his or her private foundation. It recommended that a general prohibition on self-dealing be adopted as it would eliminate the undue burden of administering the arm's length standard. ⁵ The report noted that such a general prohibition would be consistent with the long-established principle of nontax law that bans all self-dealing between a trustee and the trust of which he or she is a fiduciary. ⁶

In the Tax Reform Act of 1969, Congress enacted prohibitions on certain specified acts of self-dealing between a private foundation and a "disqualified person", that is, a substantial donor, a foundation manager, or an individual or entity related to either. ⁷ The prohibited acts of self-dealing between a private foundation and a disqualified person include: a sale or leasing of property; the lending of money except interest-free loans by a disqualified person to a private foundation; with certain exceptions, the furnishing of goods, services or facilities; the payment by a private foundation to a disqualified person of excessive compensation; and the transfer by a private foundation of its assets or income to a disqualified person. ⁸ Any violation of these self-dealing prohibitions became subject to two-tier penalty excise taxes, a moderate first-tier excise tax initially, to be followed by additional more severe second-tier taxes if the self-dealing transaction had not been corrected within a certain time period. ⁹ Correcting the self- dealing transaction means undoing the transaction to the extent possible. ¹⁰

The prohibitions on self-dealing by private foundations were reviewed in 1983 by the House Ways and Means Subcommittee on Oversight. The Assistant Secretary of the Treasury for Tax Policy at the time testified that the rules adopted in 1969 were, in general, achieving their purposes. ¹¹ He said that the objective standards provided by the current rules establish clear guidelines for compliance by private foundations and make administration by the IRS much easier than under the 1950 subjective arm's length rules. He also found that imposing penalty taxes on the persons responsible for improper activities was a great improvement over denial of tax exemption. The 1969 prohibitions on self-dealing by private foundations which were designed to prevent private inurement and private benefit transactions are still in force today substantially unchanged. Up to now no intermediate sanctions have been enacted to deal with violations of the private inurement and private benefit prohibitions by public charities. ¹²

WAYS AND MEANS OVERSIGHT HEARINGS ON ABUSES BY PUBLIC CHARITIES

In 1993 and 1994, the House Ways and Means Subcommittee on Oversight held public hearings (hereinafter Oversight hearings) that focused on compliance by public charities with the private inurement and private benefit prohibitions and on their IRS enforcement. ¹³ As noted earlier, the private inurement prohibition is designed to prevent dividend-like distributions of charitable assets or income to individuals who are in an insider's relationship to the exempt organization. It prohibits, for example, payments of excessive compensation to insiders, but it does not, of course, prohibit payments of reasonable compensation. A bargain sale of an exempt organization's assets to insiders would also constitute prohibited private inurement. Prohibited private benefit arises when an exempt organization is organized or operated primarily for the benefit of private interests, such as a small identifiable group of individuals (who may but need not be insiders), rather than the public as a whole.

At the Oversight hearings, IRS representatives presented eight cases (without disclosing the identity of the organizations involved) that were the subject of IRS examinations. ¹⁴

First, an exempt section 501(c)(3) health-care organization operated a clinic and whose chief executive received total compensation in excess of $1 million. In addition, the organization made substantial payments for his personal expenses. The organization had sold its charitable assets and was purchasing physicians' private medical practices, often at more than fair market value. The issues raised included private inurement, private benefit and exempt status.

Second, a large exempt health-care institution paid its chief executive "extraordinary compensation" that included a base salary, substantial bonuses, and generous perquisites and fringe benefits (actual amounts were not disclosed). The staff physicians received a base salary and a substantial percentage of fees collected with respect to their department without any cap on the amount an individual physician could receive. The compensation arrangements raised issues of private inurement, private benefits and exempt status.

Third, an exempt university gave its president a significant compensation package, including salary, deferred compensation, expense accounts and loans (one of which was noninterest bearing). He also received the use of an expensive residence whose maintenance costs, including maid service, were paid by the university. The compensation and benefits raised issues of private inurement, private benefit and exempt status.

Fourth, a public charity provided assistance to the poor. A principal officer of the organization, along with relatives, used its funds to pay for personal expenses such as leasing of vehicles, educational expenses, vacations, home improvements, and rental of resort property. The officer's use of the organization's funds raised issues of private inurement, unreported income, and exempt status.

Fifth, an exempt organization headed by a television evangelist paid his personal expenses, including an "extravagant reception," resort vacations, and a large down-payment on his home. The issues raised included private inurement, unreported income and exempt status.

Sixth, another exempt organization headed by a television evangelist paid his personal expenses, including a home mortgage, household expenses, and country club dues. The organization purchased additional homes for the minister, designated them as parsonages and paid substantial associated expenses. In addition, the organization spent substantial sums on expenses for a house owned by a member of the minister's family. The issues raised included private inurement, private benefit and exempt status.

Seventh, another organization headed by a television evangelist raised large sums of money through fraudulent or misleading fundraising. Only a small part of the funds raised was used for charitable purposes. The organization paid the personal expenses of the officers and controlling individuals. The issues raised included private inurement, private benefit and exempt status.

Eighth, a number of exempt organization contracted with a fundraising organization which absorbed as its fees virtually all money collected, with very little money being available for the exempt organizations' charitable programs. The issues raised included private benefit and exempt status.

With certain exceptions, exempt organizations are required each year to file with the IRS Form 990, which is an information return listing items of gross income, receipts, disbursements, and certain other information that is available for public inspection upon written request. ¹⁵ However, most of the transactions described in these cases were not reported on Form 990 or, if reported, were scattered among other items or transactions making it very difficult to separately identify them.

These cases, as well as other testimony presented at the hearings, convinced the Oversight Subcommittee that while a majority of public charities comply with the tax rules governing their exemption, some of them appear to be operated in violation of the private inurement and private benefit prohibitions. The Subcommittee also found that these prohibitions are not sufficiently enforced by the IRS, partly because the sole sanction available is revocation of the tax exemption. ¹⁶ No lesser penalties are allowed, though in recent years the IRS has begun using closing agreements, which can have the practical effect of an intermediate penalty. ¹⁷ As noted earlier, revoking an organization's tax exemption is a severe penalty, which in many cases penalizes the wrong parties -- the intended beneficiaries of its charitable work and the local community -- while leaving untouched the insiders or other private parties who benefited from the diversion of the organization's assets and/or income. For example, the third case described at the hearings involved a university whose president appeared to receive excessive compensation in violation of the private inurement prohibition. Under current law, the IRS could have revoked the university's exemption, but this would have penalized the students and the university's employees, while the president would have been able to keep his possibly excessive compensation.

TREASURY'S AND CONGRESSMAN STARK'S PROPOSALS

In November 1993 Congressman Stark introduced an intermediate sanctions bill, H.R. 3697, that was patterned after the Code's self- dealing prohibitions imposed on private foundations. The bill would have imposed penalty excise taxes on health care organizations exempt under Code sections 501(c)(3) or 504(c)(4) (public welfare organizations and certain exempt HMOs) that engage in either of two kinds of self-dealing first, a transfer or lease of property between- the organization and a disqualified person (transfers or leases in the ordinary course would be excepted if made on a basis comparable to the basis on which similar transactions are made to third persons); and second, the lending of money between the organization and a disqualified person (interest-free loans by a disqualified person to the organization would be excepted if the proceeds were used for its exempt purposes). In addition, the bill would have imposed penalty excise taxes on the payment of excessive compensation to a disqualified person, or on other acts of private inurement by an exempt organization. No congressional action was taken on H.R. 3687.

Although the Executive branch had not included any provisions on intermediate sanctions in its health reform bill, H.R. 3600,) it unveiled an intermediate sanctions legislative proposal at the May 16, 1994 Oversight hearings. While the Stark bill adopted self- dealing prohibitions similar to those applicable to private foundations, the Treasury proposed a narrower approach of imposing penalty excise taxes only on payments of compensation to insiders that are unreasonable, and on transfers of property by an insider to an exempt organization for excessive consideration. The Treasury also would have required exempt organizations to provide additional information on Form 990, and it would have adopted measures to make the form more readily accessible to the public.

In presenting the Treasury's proposal, the Assistant Secretary for Tax Policy explained that it did not follow the outright prohibitions on self-dealing applicable to private foundations since public charities are subject to greater public scrutiny that reduces the risks of their misconduct. ¹⁸ In effect, the Treasury proposed an arm's length standard. For example, under the Stark bill a loan by an exempt organization to a disqualified person would automatically be subject to penalty excise taxes. Under the Treasury proposal, there would first have to be a factual determination of whether the loan was part of the disqualified person's compensation. If it was, there would have to be a further factual determination of whether the total compensation including the loan was reasonable. If the loan was not part of the insider's compensation, a determination would have to be made if the loan carried a reasonable rate of interest and other terms that were reasonable. Each of these factual determinations requires the making of difficult arm's length judgments. In 1950 Congress had adopted arm's length standards to police the activities of private foundations but later found that they were unworkable and rejected them in favor of prohibitions on acts of self-dealing in the Tax Reform Act of 1969. It should be noted, however, that even under the self-dealing prohibitions enacted in 1969 determinations of reasonable compensation continued to be made under an arm's length standard.

INTERMEDIATE SANCTIONS IN THE HEALTH CARE BILLS

The health care bills reported in 1994 by the House Ways and Means and Senate Finance Committees both incorporated provisions on intermediate sanctions. The Ways and Means Committee bill combined some of the features of the Stark bill with the Treasury proposals, while the Senate Finance Committee bill more closely resembles the Treasury proposals.

The Ways and Means bill imposed penalty excise taxes on three categories of "excess benefit transaction[s]" engaged in by an exempt health care organization: One, any transaction in which an economic benefit is provided by an organization to a disqualified person if the value of the economic benefit exceeds the value of the consideration received by the organization; two, the lending of money by an organization to one of its officers, directors or other managers; and three, any transaction not allowed under current law in which the amount of any economic benefit provided to a disqualified person is determined in whole or in part by the gross or net income of one or more activities of the organization. ¹⁹ The penalty excise taxes have a two-tier structure. If, following the imposition of the first-level tax, the excess benefit is not corrected within a specified time period, an insider would be subject to a more severe second-level tax. They would be imposed on a disqualified person other than a manager, and could also be imposed on an organization's officers, directors or other managers who participated in the transaction knowing that it is improper. Generally, no excise tax would be imposed on the public charity itself, except that it would be subject to tax if it tried to avoid the penalty excise taxes by terminating its tax-exempt status.

The House bill would also impose certain penalty excise taxes directly on an exempt health care organization that fails to satisfy certain new statutory requirements. These new requirements, which are unrelated to the private inurement and private benefit prohibitions, included obligations to perform certain community outreach services, to prepare annually a community needs assessment and plan, to be governed by an independent board, not to discriminate against indigent patients needing emergency services, and certain others.

The health care bill, S. 2351, reported by the Senate Finance Committee followed the Ways and Means bill in imposing penalty excise taxes if an exempt health care organization granted to a disqualified person ²⁰ an economic benefit not allowed under current law that exceeded the consideration received by the organization, or if it granted to a disqualified person an economic benefit not allowed under current law that was determined in whole or in part by the gross or net income of one or more activities of the organization. ²¹ The Senate Finance bill, however, did not include the outright prohibition in the Ways and Means bill on loans by an organization to an officer, director or other manager. The Senate Finance Committee report directs the Secretary of the Treasury to issue guidance on the kinds of transactions and arrangements that would be subject to penalty excise taxes under the bill. ²²

In determining whether compensation paid to a disqualified person was reasonable, the report states it is the Committee's intent that an organization will be entitled to rely on a rebuttable presumption of reasonableness with respect to a compensation arrangement if it can demonstrate to the Secretary of the Treasury's satisfaction that the arrangement was approved by an independent board (or an independent committee authorized by the board) that relied on appropriate comparability data (e.g., compensation levels paid by similar organizations, both taxable and tax-exempt) for functionally comparable positions, and if it had adequately documented the basis of its determination. ²³ A similar rebuttable presumption is to arise in determining whether a transfer of property between an organization and a disqualified person was at market value. ²⁴ Neither the Senate Finance Committee bill nor the Committee's report define or otherwise explain the term "rebuttable presumption of reasonableness". Evidently it is derived from the ABA report which recommends that such a presumption be established if certain procedures for reviewing compensation and transactions with insiders are followed. The procedures referred to in the ABA report are for the most part the ones listed in the Committee's report. The effect of such a presumption, according to the ABA report, would be that ". . . the [IRS] would have the burden of proving the unreasonableness by clear and convincing evidence." ²⁵

The two-tier structure of penalty excise taxes in the Senate Finance Committee bill is substantially similar to that in the Ways and Means Committee bill, except that a manager who participated with guilty knowledge in a taxable transaction would be subject to a first-tier tax of 2.5 percent and a second-tier tax of 50 percent, instead of the one-time 10 percent tax on a manager in the Ways and Means bill. Also like the Ways and Means Committee bills, the public charities themselves would be subject to penalty excise taxes only if they terminated their tax-exemption to avoid penalty excise taxes on taxable transactions.

ISSUES

The Ways and Means Committee and Senate Finance Committee health care bills were not enacted during the 103d Congress. Intermediate sanction proposals raise a number of policy issues that Congress may consider should the proposals come again as part of health care legislation or separately.

ARE INTERMEDIATE SANCTIONS NEEDED?

Certainly a basic question is whether there is any need to enact intermediate sanctions legislation applicable to public charities. The 1993 and 1994 Oversight hearings appear to have established to the Subcommittee's satisfaction a need for sanctions that fall short of revocation of exempt status for violations of the private inurement and private benefit prohibitions. Anecdotal evidence presented at the hearings of abuses of these prohibitions by a number of public charities, while it may not be representative of the charitable community as a whole, does suggest that there is a notable problem that cannot be effectively dealt with under current law. Testimony suggested that violations of the private inurement and private benefit prohibitions often go unpunished because of the absence of sanctions that are short of revocation of tax-exemption. In addition, intermediate sanctions in the private foundation area are generally considered to have worked well.

The Treasury Department came forward with a proposal for the enactment of intermediate sanctions to be applied to "excess benefit" transactions entered into by public charities. While there may be some members of the charitable community that oppose any form of intermediate sanctions, Independent Sector, a charity lobbying group, supports the adoption of "carefully crafted" intermediate sanctions legislation. ²⁶ Some members of the charitable community that oppose intermediate sanctions believe that violations are not sufficiently widespread to warrant the enactment of remedial legislation, while others object to any government interference in the operations of public charities. ²⁷

SHOULD INTERMEDIATE SANCTIONS APPLY ONLY TO HEALTH CARE ORGANIZATIONS?

The intermediate sanctions provisions in the House and Senate health care bills applied only to exempt health care organizations. But abuses of the private inurement and private benefit prohibitions are not limited to health care providers. The Oversight hearings disclosed that such abuses are also committed by other section 501(c)(3) organizations, including universities, charities that gave assistance to the poor, organizations headed by a television evangelist, and organizations whose charitable receipts were consumed by fundraising fees. Consistency suggests that any intermediate sanctions legislation be made applicable to all section 501(c)(3) and section 501(c)(4) organizations, not just to health care organizations. ²⁸

SHOULD INTERMEDIATE SANCTIONS BE REGULATORY OR BASED ON AN ARM'S LENGTH STANDARD?

There are different ways of implementing a policy to impose intermediate sanctions. Based on past experience with private foundations, the two principal alternatives appear to be between the adoption of regulations or market reforms, both to be backed by tax penalties. A regulatory provision prohibits certain "self-dealing" transactions by subjecting them to penalty excise taxes regardless of whether consideration was adequate or interest rates were reasonable. Market reforms rely on an arm's length approach and penalize only payments of compensation that are unreasonable, or transfers or leases of property by an organization for which an insider pays inadequate consideration, or payments of excessive compensation by an organization for transfers or leases of property from an insider. The Ways and Means Committee bill contained a combination of arm's length provisions and a regulatory provision. The Senate Finance Committee bill had the same arm's length provisions but omitted the regulatory provision. The regulatory provision in the Ways and Means Committee bill imposed penalty excises taxes if an organization lends money or otherwise extends credit to one of its officers, directors or other managers. For example, if an exempt hospital were to make a 10-year interest free loan of $600,000 to its president for the purchase of a house, ²⁹ under the Ways and Means Committee bill penalty excise taxes would be imposed on the president and on any of the hospital's officers, directors or other managers who participated in the transaction knowing that it is improper. If the loan, instead of being interest-free, had carried a reasonable rate of interest the result would be the same. Presumably the main reason for this prohibition is that an exempt hospital, or other public charity is not in the business of lending money, and that to use charitable receipts or income from the performance of services for loans to insiders amounts to a diversion of funds from the organization's charitable purposes. There is also the problem of attempting to determine whether an alleged "loan" is, in fact, a bona fide loan or an open-ended advance or gratuitous transfer. Making such determinations would place a difficult enforcement burden on the IRS. The points made in the Treasury's 1965 report on the 1950 private foundation arm's length rules may also apply here: The public does not receive an overall benefit from allowing an insider to borrow from his or her [public] charity, an outright prohibition on such loans would eliminate the undue administrative burden placed on the IRS to determine the reasonableness of interest rates and other loan terms; an officer, director or other manager of a public charity has fiduciary obligations to the charity that make it inappropriate to borrow from it.

In omitting the lending prohibition from its bill, the Senate Finance Committee presumably believed that abusive loans to insiders can be prevented without prohibiting arm's length lending transactions, the same position that it took in 1950 with respect to self-dealing transactions between private foundations and their donors. Another possible objection to outright prohibitions of certain kinds of transactions, as in the Ways and Means bill, is that they may constrain not only transactions that are not in the public interest, but also some that are. ³⁰ For example, exempt hospitals and universities often extend secured housing loans to staff physicians or faculty members as a standard recruiting practice. Under the Ways and Means bill such loans would be barred if the borrowers are deemed to be managers of the organization. The ABA report believes that because private foundations are more passive grant-making type organizations outright prohibitions on self- dealing do not constrain their charitable operations as they would the more active operations of public charities. ³¹

THE PROBLEM OF DETERMINING REASONABLE COMPENSATION

The reasonableness of compensation paid by exempt organizations to insiders is at the heart of many, if not most, private inurement problems. One approach would be to impose by statute a cap (possibly indexed for inflation) on the allowable compensation of a public charity's executives. Any amount in excess of the cap would be treated as an excess benefit subject to penalty excise taxes. A salary or total compensation cap would not be without precedent as it would be analogous to the $1,000,000 ceiling under new Code sec. 162(m) placed on the deductibility of the cash and noncash compensation paid by a public corporation to its senior executives. There appears to be little enthusiasm for salary caps in the charitable community. There also appears to be little, if any, support for salary caps in Congress, and neither the Ways and Means nor the Senate Finance bills adopted such caps. Even under the self- dealing prohibitions applicable to private foundations, determinations of reasonable compensation are based on arm's length standards. ³² Determinations of reasonable compensation under the Ways and Means and Senate Finance bills would also be based on a facts-and-circumstances determination using arm's length standards.

Neither bill defines what is reasonable compensation though the committee reports state that current law standards are to apply. Code section 162 allows a business to deduct payments for ordinary and necessary business expenses, including salaries or other compensation to the extent they are reasonable (and subject to the $1,000,000 ceiling on the salaries of senior executives of public corporations). Just what constitutes reasonable compensation has been the subject of extensive litigation between taxpayers and the IRS and each case turns on its particular facts and circumstances. Factors that the courts have found relevant include the taxpayer's duties, his or her background and experience, the time devoted to the organization, the organization's size, general and local economic conditions, and the amounts paid to the heads of similar organizations. Presumably these factors would also be relevant for purposes of reasonable compensation determinations in connection with the private inurement prohibition.

REBUTTABLE PRESUMPTION OF REASONABLENESS

In addition to relying on current law, the Senate Finance Committee report would also establish a rebuttable presumption of reasonableness with respect to a compensation arrangement between an exempt organization and a disqualified person that was approved by an independent board (or an independent committee approved by the board) whose action was based on appropriate comparability data, including compensation levels paid by similar taxable and tax-exempt organizations. Creating such a rebuttable presumption presumably represents a well-intentioned effort to limit the large number of disputes that otherwise may arise between organization insiders and the IRS over the meaning of the reasonable compensation standard. On the other hand, considering that the effect of the presumption is to shift to the IRS the burden of proving the unreasonableness of compensation by clear and convincing evidence, one may wonder whether under such a presumption ". . . anyone will ever be found in receipt of 'unreasonable compensation'". ³³ A rebuttable presumption may also place too much faith in the actions of an independent board. As pointed out by Leslie B. Samuels, the Assistant Secretary of the Treasury for Tax Policy, a nominally independent board may be comprised of close friends of the organization's chief executive who routinely endorse his or her proposals, though the board members are unrelated to the chief executive and not under his or her control. ³⁴ On the other hand, some independent boards may have a demonstrated record of taking their duties seriously and of acting with true independence. The weight to be given to approval by an independent board, according to the Treasury, should depend on the particular circumstances: not only the board's composition, but also its record of prior actions is relevant.

The Senate Finance Committee report states that in evaluating a compensation agreement the comparability data an independent board should examine includes comparisons of compensation levels in similarly situated for-profit as well as nonprofit entities. The Ways and Means Committee's report does not take a similar position. The comparability of compensation levels in for-profit with those in nonprofit entities is an important issue yet to be resolved in the nonprofit compensation area. ³⁵ Can for-profit companies be situated similarly to nonprofit section 501(c)(3) organizations; and if they can, in what sectors? Are for-profit compensation packages, which often include incentive compensation such as stock, stock options and bonuses, comparable to nonprofit compensation packages? Do nonprofits usually select their senior executives from the same recruitment pool as for-profits, or do they draw from a separate pool? In considering the comparability issue these are some of the questions to be examined.

COMPENSATION BASED ON A SHARE OF PROFITS

An important issue in determining reasonable compensation levels is how to treat profit-sharing arrangements between an exempt organization and individuals employed by the organization. The issue arises frequently in connection with an exempt hospital's compensation arrangements with its staff physicians where part or all of the compensation is based on a share of the profits of one or more of the hospital's departments. In a General Counsel's Memorandum, the MS takes the position that if an exempt hospital enters into a joint- venture with staff physicians and sells to them the gross or net revenue stream derived from operations of one of the hospital's departments, it is engaging in prohibited private inurement and prohibited private benefit and jeopardizes its tax exemption, notwithstanding that the arrangements were negotiated at arm's length. ³⁶ It states, "Giving (or selling) medical staff physicians a proprietary interest in the net profits of a hospital . . . creates a result that is indistinguishable from paying dividends on stock." ³⁷ That a profit-sharing arrangement may satisfy an arm's length fair market fair value standard appears to be irrelevant, as the private inurement prohibition is a statutory requirement that an exempt organization cannot negotiate away.

The Ways and Means and Senate Finance bills provide that payments to a disqualified person based on the gross or net revenues of one or more activities of an exempt health-care organization shall be subject to intermediate sanctions. In other words, giving an insider a share in a hospital's gross or net revenue stream constitutes a per se violation of the private inurement prohibition. The Senate Finance Committee report states that the Secretary of the Treasury is to issue guidance regarding prohibited transactions and arrangements. ³⁸ For example, the bills apply to gross as well as net revenue sharing arrangements, and the Committee report appears to leave it to the Treasury to spell out the kinds of gross revenue sharing arrangements that would be subject to intermediate sanctions. Similarly, it will be up to the Treasury to provide guidance as to whether some revenue sharing arrangements would not be subject to intermediate sanctions if caps are placed on the amounts of shared revenues.

PAYMENTS FOR PERSONAL EXPENSES

Another important issue in determining a nonprofit's reasonable compensation levels is how to treat an organization's payments of an insider's personal expenses. Most of the cases cited in the Oversight hearings involved substantial payments for such expenditures, including credit card payments, the leasing of vehicles for personal use, educational expenses, vacations, home improvements, rentals of resort property, household expenses, country club dues, down-payments on a home, and other expenditures. If payments for personal expenses are treated as part of a compensation package the question becomes one of determining whether the total package, including the payments for personal expenses, is reasonable. The Senate Finance bill and the Ways and Means report provide that an organization's payments of an insider's personal expenses may be treated as part of a total compensation package only if contemporaneously with such payments it is clearly intended that they be so treated, as evidenced by the board's approval of the payments and the proper reporting of the amounts on Forms W-2 or 1099, the recipient's Form 1040, and the organization's Form 990. Except for nontaxable fringe benefits described in Code section 132, an organization would not be allowed to establish the requisite intent without such contemporaneous substantiation at the time of the payments. ³⁹

WHO SHOULD BE SUBJECT TO INTERMEDIATE SANCTIONS?

The issue here is whether penalty excise taxes for violations should be imposed on the public charity itself as well as on insiders and managers. The private foundation taxes on self-dealing are imposed under section 4941 only on the self-dealer and any foundation manager who knowingly participated in the act of self-dealing. ⁴⁰ However, intermediate sanctions may be directly imposed on private foundations under section 4945 for "taxable expenditures" not furthering a charitable purpose. With respect to private inurement transactions, both the Ways and Means and Senate Finance bills would tax only the disqualified person who benefited from an excess benefit transaction and any manager who participated in the transaction with guilty knowledge. The Ways and Means bill, however, allows the imposition of penalty excise taxes on a tax-exempt medical organization if it fails to satisfy certain new exemption requirements included in the bill, including requirements to provide community outreach services, make a community needs assessment and plan, and establish an independent board. The amount of the excise tax or monetary penalty for failure to satisfy one or more of the new statutory requirements would be equal to the greater of $25,000, or 5 percent of the organization's net investment income. The bill also provides for abatement of the excise tax if the organization can establish that the violation was due to reasonable cause and not due to willful neglect and that it has taken steps to prevent future violations.

The excise tax in the Ways and Means bill that would be imposed on the medical organization itself is intended to put teeth into the bill's new tax-exemption requirements. The Senate Finance bill contains the same new tax-exemption requirements but without the teeth. There is opposition to the idea of imposing penalties on a public charity, as it would penalize the charity's beneficiaries and yet may allow the wrong-doers to remain in control. ⁴¹ The ABA report appears to support economic penalties that can be imposed on public charities but abated in appropriate cases. ⁴² If economic penalties were imposed on a public charity because of its failure to comply with any of the new exemption requirements, they would be imposed precisely because it had failed to provide its beneficiaries with required charitable care.

SHOULD IMMEDIATE SANCTIONS APPLY TO PRIVATE BENEFIT TRANSACTIONS?

The Ways and Means and Senate Finance bills impose penalty excise taxes on transactions that violate the private inurement prohibition. ⁴³ They do not impose any penalty excise taxes on private benefit transactions that are not also private inurement transactions, with the possible exception that taxes can be imposed on individuals who were insiders during the five years prior to the transaction at issue. ⁴⁴ A private benefit transaction is a transaction between an exempt organization and private parties in which the benefits received by the private parties (who may be but need not be insiders) are more than incidental to the public benefits received by the organization. ⁴⁵ For example, one of the cases highlighted during the Oversight hearings involved a fundraiser whose fees ate up virtually all the money it had raised for exempt organizations, leaving the organizations with virtually no funds for its charitable activities. Should intermediate sanctions apply here? The facts suggest that the fundraiser benefited from the fundraising more than the charities. The House and Senate bills apparently would not reach such a transaction as the fundraiser was not an insider of the exempt organization. It is not uncommon for fundraising campaigns to raise an issue of whether private benefits to a fundraiser exceed the public benefits received by the charity.

Suppose a group of physicians sell their practice at a grossly inflated price to an exempt hospital. The intermediate sanctions bills seemingly would not apply because at the time of the sale the physicians had no insider relationships to the hospital. If after the sale the physicians entered into employment contracts with the hospital, probably the bills would still not apply: although under the bills physicians who enter into employment contracts with a hospital can be classified as insiders, and although insiders include any person who was an insider at any time during the five years PRIOR TO the transactions, the bills seemingly do not apply to individuals who at the time of the transactions were not insiders and qualified as such at a LATER date. The bills probably could be made to apply to these kinds of transactions by expanding the definition of an insider to include a person who became an insider at any time during the five years AFTER the transactions.

Suppose an exempt hospital leases at market rates a vacant medical office building for which it has no current use from several physicians who are under contract on its medical staff. The bills probably would not apply. While the transaction involves a lease of property by individuals who may be classified as insiders, the hospital is not paying excessive consideration. Under the Stark bill, H.R. 3697, the lease would be a prohibited act of self-dealing with the lessor staff physicians, automatically triggering the imposition of excise taxes.

The supreme sanction of revocation of a public charity's tax exemption is available to punish the kinds of prohibited private benefit transactions just described. Still, as with private inurement transactions, Congress may want to consider an intermediate sanction for violations of the private benefit prohibition. To prevent routine arm's length transactions from being caught within the net of such legislation, the furnishing of certain goods, services, or facilities on a fair market basis could be excluded, just as such transactions by a private foundation to a disqualified person are now excluded under section 4941(d)(2)(D) from the self-dealing prohibitions applicable to private foundations.

CONCLUDING OBSERVATIONS

Under present law, if a public charity violates the private inurement or private benefit prohibitions the only sanction that may be imposed is revocation of its tax exemption. Because revocation is a drastic step that the IRS invokes only infrequently, violations of these prohibitions often go unpunished. The health care bills reported in 1994 by the House Ways and Means and Senate Finance committees included provisions imposing intermediate sanctions in the form of penalty excise taxes on insiders for violation of the private inurement prohibition.

The intermediate sanction provisions in the Senate Finance Committee bill, and to a lesser extent, in the Ways and Means Committee bill opt for a subjective arm's length approach rather than a regulatory one for determining whether private inurement violations have occurred. For example, rather than prohibiting a lease of property by insiders to an exempt organization, they would impose penalty excise taxes only if the rental payments under the lease exceeded market rates. Under a regulatory approach such a lease would be prohibited and automatically result in the imposition of excise taxes regardless of whether the lease terms were at market rates. The Ways and Means bill, while not prohibiting leases or transfers of property between an exempt organization and insiders, would prohibit the lending of money by an exempt organization to one of its officers, directors or other managers. The Senate Finance bill contains no such prohibition and would impose intermediate sanctions in the case of such a loan only if it did not carry a reasonable rate of interest and other reasonable loan terms, or if the concessionary terms of such a loan were not part of a total compensation package that meets arm's length standards.

An arm's length standard may preserve certain flexibilities useful to charities but entails two significant costs: first, determinations of fair market value and of the reasonableness of compensation often involve subjective judgments over which reasonable persons can disagree; and second, largely because of the subjectivity and vagueness of the applicable concepts, the determinations give rise to frequent disputes between taxpayers and the IRS resulting in costly and time-consuming IRS enforcement with frequently unforeseeable results. A regulatory approach brings greater certainty to the law and may more effectively prevent abusive transactions. At the same time it may also prevent a charity from engaging in some transactions that may be in the public interest, though those probably can be minimized by careful drafting. For example, the prohibition in the Ways and Means Committee bill of lending money by an exempt organization to one of its managers does not extend to lending by a manager to the organization; it also does not prohibit lending by an exempt organization to persons other than managers.

While recently some publicity has been given to surprisingly high compensation paid to certain senior executives of exempt organizations, there seems to be little, if any, Congressional support at this time for a statutory cap on such compensation. Thus, the reasonableness of executive compensation will continue to be determined on the basis of a facts and circumstances analysis using an arm's length standard.

The divergent House and Senate approaches to the imposition of intermediate sanctions have historic parallels. In 1950 Congress enacted arm's length rules to curb abuses by private foundations and their donors. At the time, the House Ways and Means Committee had adopted outright prohibitions on certain self-dealing transactions, while the Senate Finance Committee believed that abuses could best be prevented by the adoption of less stringent arm's length standards. The Senate version prevailed in conference. In 1969 Congress concluded that the arm's length rules were largely ineffective and adopted outright prohibitions by imposing penalty excise taxes on certain acts of self-dealing between private foundations and their donors.

The intermediate sanctions provisions were included in the health care bills introduced in the 103d Congress. It has been widely noted, however, that as problems of private inurement are not limited to exempt health care providers, intermediate sanctions can be enacted as a free-standing bill or as part of any other appropriate legislative vehicle.

Violations of the private benefit prohibition appear also to present notable enforcement problems. Congress may want to consider extending any intermediate sanctions legislation applicable to private inurement to cover also private benefit transactions.

² Treas. Reg. sec. 1.501(c)(3)-(1)(d)(1).

³ Pub. Law 814 (H.R. 8920), sec. 321, 81st. Cong., 2d. Sess. An arm's length standard refers to the pricing of goods or services based on actual marketplace transactions between unrelated parties dealing with each other at arm's length.

⁴ Treasury Department Report on Private Foundations, Committee Print, Committee on Finance, United States Senate, Feb. 2, 1965, 89th Cong. 1st. Sess.

⁵ id. at 21.

⁶ id.

⁷ Secs. 4941, 4946(a). (Section references are to the Internal Revenue Code.)

⁸ Sec. 4941(d).

⁹ Sec. 4941(a) and (b).

¹⁰ Sec. 4941(e)(3).

¹¹ Statement of John Chapoton, Assistant Secretary of the Treasury for Tax Policy, Hearings on the Tax Rules Governing Private Foundations, 41, 45 (June 27, 1983), House Committee on Ways and Means, Subcommittee on Oversight, 98th Cong., 1st. Sess.

¹² In 1987 Congress adopted intermediate sanctions for improper political expenditures by public charities (sec. 4955).

¹³ Hearings on Federal Tax Laws Applicable to the Activities of Tax-Exempt Charitable Organization, House Committee on Ways and Means, Subcommittee on Oversight, June 15 and August 2, 1993; March 16, 1994, 103d. Cong. 1st. and 2d. Sess. (Serials 103-39 and 103-72). (hereinafter Oversight hearings and appropriate date).

¹⁴ id. at 147-151.

¹⁵ Sec. 6033(a).

¹⁶ Report on Reforms to Improve the Tax Rules Governing Public Charities, House Ways and Means Subcommittee on Oversight, May 5, 1994, 103d. Cong., 2d. Sess. (WMCP 103-26).

¹⁷ Comments on Compliance with the Tax Laws by Public Charities by the Exempt Organizations Committee of the American Bar Association's Tax Section (hereinafter ABA report), reproduced in Oversight hearings at 50, March 16, 1994. Generally, closing agreements are not made public, but the IRS recently required the Hermann hospital of Houston to make public its closing agreement with the IRS. 65 Tax Notes 395, Oct. 24, 1994.

¹⁸ Statement of Leslie B. Samuels, Assistant Secretary of the Treasury, Oversight hearings at 19-20, March 16, 1994.

¹⁹ Report 103-601, Part 1, on the Health Security Act, H.R. 3600, 586-587, House Ways and Means Committee, July 14, 1994, 103d. Cong. 2d. Sess.

²⁰ The Ways and Means and Senate Finance bills both use substantially the same definition of a "disqualified person": 1) an officer, director or other manager of the organization; 2) an individual (other than a manager) who is in a position to exercise substantial influence over the affairs of the organization, including physicians performing substantial services under contract to the organization; 3) certain family members and 35 percent owned entities of any person in 1) or 2); and 4) any person who was a disqualified person at any time during the five years prior to the transaction at issue. Essentially a "disqualified person" is or was an organization insider who is or was in a position to control or influence the conduct of the organization's affairs.

²¹ Rept. 103-323 on the Health Security Act, S. 2351, 160-161, Senate Committee on Finance, Aug. 2, 1994, 103d. Cong., 2d. Sess. (hereinafter Sen. Rep. 103-323).

²² id. at 161.

²³ id.

²⁴ id.

²⁵ ABA report at Oversight Hearings, 47, March 16, 1994.

²⁶ Letter of Brian O'Connell, Independent Sector, to Sam Gibbons, Chairman of the House Ways and Means Committee, dated June 13, 1994, reproduced at 10 Exempt Org. Tax Rev. 14 (July 1994).

²⁷ Marion R. Fremont-Smith, Current Proposals for Public Charity Intermediate Sanctions, 10 Exempt Org. Tax Rev. 115, 116 (July 1994)(hereinafter Fremont-Smith).

²⁸ The House Ways and Means Committee offer on the Uruguay Round GATT implementing legislation included a proposal for intermediate sanctions applicable to all sec. 501(c)(3) public charities and sec. 501(c)(4) organizations. (156 Daily Tax Rept., G3- 4, Aug. 16, 1994.)

²⁹ The Philadelphia Enquirer in its issue of April 22, 1993, reported that Children's Hospital of Philadelphia made a 10-year interest-free loan of $600,000 to its president for the purchase of a house. Congressman Stark also publicly disclosed that Georgetown University loaned a senior officer of the Medical Center $107,700 at 5 percent interest and $644,380 with no interest charged. 139 Cong. Rec., E3057 (November 24, 1993).

³⁰ ABA report, at Oversight hearings, 50-51, March 16, 1994.

³¹ id.

³² Sec. 4941(d)(1)(E).

³³ Paul Streckfus, News Analysis III: Health Care Lobbyists Score Big with Moynihan Mark, 10 Exempt Org. Tax Rev. 18 (July 1994).

³⁴ Statement of Leslie B. Samuels, Assistant Secretary of the Treasury for Tax Policy, at Oversight hearings, 21, March 16, 1994.

³⁵ Fremont-Smith, at 10 Exempt Org. Tax Rev. 116 (July 1994).

³⁶ GLM 39862, Nov. 22, 1991.

³⁷ id.

³⁸ Senate Rept. 103-323, at 161.

³⁹ id.

⁴⁰ Sec. 4941.

⁴¹ Fremont-Smith states ". . . I admit to a strong basis against imposing any taxes on a charitable organization under any circumstances. It serves only to punish the beneficiaries and in most cases would permit the wrong-doers to remain in control of the organization." 10 Exempt Org. Tax Rev. 115, 118.

⁴² ABA report, at Oversight hearings, 53, March 16, 1994.

⁴³ Secs. 501(c)(3) and 501(c)(4) (as amended by the bills) provide that no part of the net income of an exempt organization may inure to the benefit of any private shareholder or individual.

⁴⁴ Fremont-Smith, 10 Exempt Org. Tax Rev. 117 (July 1994).

⁴⁵ Treas. Regs. Sec. 1.501(c)(3)-1(d)(1).