[Federal Register Volume 73, Number 61 (Friday, March 28, 2008)]
[Rules and Regulations]
[Pages 16519-16525]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-6305]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 53
[TD 9390]
RIN 1545-BE37
Standards for Recognition of Tax-Exempt Status if Private Benefit
Exists or if an Applicable Tax-Exempt Organization Has Engaged in
Excess Benefit Transaction(s)
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations that clarify the
substantive requirements for tax exemption under section 501(c)(3) of
the Internal Revenue Code (Code). This document also contains
provisions that clarify the relationship between the substantive
requirements for tax exemption under section 501(c)(3) and the
imposition of section 4958 excise taxes on excess benefit transactions.
These regulations affect organizations described in section 501(c)(3)
of the Code and organizations applying for exemption as organizations
described in section 501(c)(3) of the Code.
DATES: Effective Date: These regulations are effective March 28, 2008.
FOR FURTHER INFORMATION CONTACT: Galina Kolomietz, (202) 622-7971 (not
a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
On September 9, 2005, a notice of proposed rulemaking (REG-111257-
05, 2005-42 CB 759) clarifying the substantive requirements for tax
exemption under section 501(c)(3) of the Code, and the relationship
between the substantive requirements for tax exemption under section
501(c)(3) and the imposition of section 4958 excise taxes was published
in the Federal Register (70 FR 53599). The IRS received several written
comments responding to this notice. After consideration of all comments
received, the proposed regulations under sections 501(c)(3) and 4958
are revised and published in final form. The major areas of comments
and revisions are discussed in the following preamble. (See Sec.
601.601(d)(2)(ii)(b)).
Explanation and Summary of Comments
Private Benefit
The proposed regulations added several examples to illustrate the
requirement in Sec. 1.501(c)(3)-1(d)(1)(ii) that an organization serve
a public rather than a private interest. The purpose of the examples is
to illustrate that prohibited private benefit may involve non-economic
benefits as well as economic benefits and that prohibited private
benefit may arise regardless of whether payments made to private
interests are reasonable or excessive.
One comment suggested that, rather than add three isolated examples
on private benefit to the regulations, the IRS consider a broader
revision of the regulations under section 501(c)(3) to provide a more
detailed discussion of the underlying principles of the private benefit
doctrine. In particular, this comment suggested that the regulations
address the relative quantity of private benefit that could preclude
exemption. The IRS and the Treasury Department are not revising the
existing regulations under section 501(c)(3) at this time. The new
examples in the proposed regulations clarify the principles of the
private benefit doctrine under current law. In Sec. 1.501(c)(3)-
1(d)(1)(iii), Example 1 illustrates that private benefit may involve
non-economic benefits. Example 2 illustrates that private benefit is
inconsistent with tax-exempt status under section 501(c)(3) if it is
substantial and not merely incidental to the accomplishment of the
organization's exempt purposes. Example 3 illustrates that private
benefit may exist even though the transaction is at fair market value.
Moreover, these examples are intended to illustrate the principle that
private benefit remains an independent basis for revocation even if it
does not involve economic benefit or raise fair market value issues.
Accordingly, these examples are adopted in final form without revision.
Revocation Standards
The proposed regulations provided guidance on certain factors that
the IRS will consider in determining whether an applicable tax-exempt
organization described in section 501(c)(3) that engages in one or more
excess benefit transactions continues to be described in section
501(c)(3). The comments received in response to the proposed
regulations are discussed below. Overall, the commentators reacted
favorably to the factors set forth in the proposed regulations. The
factors described in the proposed regulations are finalized without
major revisions. The application of the factors is refined by the
addition of a new example to the final regulations.
[[Page 16520]]
a. Interaction With Determination of Existence of Excess Benefit
Transaction
Two comments suggested that the final regulations clarify the
interaction between the determination of the organization's tax-exempt
status and the determination of the existence of an excess benefit
transaction. One of these comments specifically requested that the
final regulations state that the IRS will not take any action to remove
an organization's tax exemption on excess benefit transaction grounds
while the IRS's determination of the existence of an excess benefit
transaction is itself being contested in court. The final regulations
do not adopt this comment. The determination of an organization's tax-
exempt status and the determination of the existence of an excess
benefit transaction are separate determinations, involving distinct
parties, different legal elements, and separate processes, even though
they may relate to the same facts.
b. Clarification of Terms
Two comments voiced the need to clarify the terms ``significant''
and ``de minimis'' as they are used in the proposed regulations. One of
these comments suggested adding an example of a safe harbor based on
specific amounts the IRS would consider clearly insignificant, perhaps
as a percentage of overall expenditures. Because the determination of
whether an activity or an amount is ``significant'' or ``de minimis''
depends on the facts and circumstances, the final regulations do not
adopt this comment.
One comment suggested adding examples combining potential de
minimis values with other abating or negative factors and/or examples
containing values that are not de miminis. The final regulations
contain a new example that illustrates the application of the
revocation factors to an excess benefit transaction that is neither
significant in comparison to the size and scope of the organization's
exempt activities nor de minimis.
One comment requested clarification of the term ``repeated'' as
used in Example 3 of Sec. 1.501(c)(3)-1(g) of the proposed
regulations. The term was used in that example to correspond to the
third factor in the proposed regulations, which looked to ``whether the
organization has been involved in repeated excess benefit
transactions.'' In response to this comment, the third factor of the
proposed regulations is revised to substitute the term ``multiple'' for
the word ``repeated.'' The term ``multiple'' refers to both (1)
repeated instances of the same (or substantially similar) excess
benefit transaction, regardless of whether the transaction involves the
same or different persons; and (2) the presence of more than one excess
benefit transaction, regardless of whether the transactions are the
same or substantially similar and regardless of whether they involve
the same or different persons.
Another comment requested guidance regarding when the IRS would
consider the presence of a single excess benefit transaction to
jeopardize an organization's tax-exempt status. Because such a
determination would depend on the facts and circumstances, the final
regulations do not adopt the comment.
c. Due Diligence and Safeguards
One comment requested that evidence that an organization's board of
directors conducted appropriate due diligence or followed certain
safeguards in connection with the excess benefit transaction be treated
as a factor weighing in favor of continuing to recognize exemption. The
IRS and the Treasury Department agree that the organization's reliance
on objectively reasonable internal controls and procedures, such as the
procedures for establishing a rebuttable presumption of reasonableness,
in approving a transaction that is later determined to be an excess
benefit transaction, should be treated as a factor weighing in favor of
continuing to recognize exemption. Accordingly, the fourth factor under
the proposed regulations is revised to make clear that implementation
by an organization of safeguards that are reasonably calculated to
prevent excess benefit transactions will be treated as a factor
weighing in favor of continuing to recognize exemption regardless of
whether such safeguards are implemented in direct response to the
excess benefit transaction(s) at issue or as a general matter of
corporate governance or fiscal management. Thus, an organization may be
treated as having implemented safeguards reasonably calculated to
prevent excess benefit transactions even though the organization is
contesting the existence of the excess benefit transaction(s) at issue.
An example is added to illustrate how implementation of safeguards,
including preexisting safeguards, will be taken into account in
determining whether to continue to recognize an organization's tax-
exempt status.
One comment suggested that an organization's good faith attempt to
establish a rebuttable presumption of reasonableness within the meaning
of Sec. 53.4958-6 be treated as a factor weighing in favor of
continuing to recognize exemption. Another comment suggested that a
good faith attempt by an organization's board of directors to determine
fair market value be treated as a factor precluding revocation even if
the IRS disagrees with the board's fair market value analysis. The
fourth factor, as revised in these final regulations, takes into
account whether the organization has implemented safeguards that are
reasonably calculated to prevent excess benefit transactions. This
factor takes safeguards into account, regardless of whether they were
implemented before or after an excess benefit transaction occurred. The
comments raise the question of how this factor will apply where steps
have been taken to avoid an excess benefit transaction, but nonetheless
have failed to prevent the excess benefit transaction. The weight
afforded to this particular circumstance will depend upon the specific
facts and circumstances.
d. Requests for Additional Examples
Two comments suggested adding to the proposed regulations an
example specifically addressing reasonable compensation. In response to
these comments, the new example added by these final regulations
addresses reasonable compensation.
One comment suggested that the regulations include examples
involving health care organizations. The IRS and the Treasury
Department note that the application of sections 501(c)(3) and 4958 to
health care organizations is not unique. The examples in these
regulations, although not specifically involving health care
organizations, apply to health care organizations in the same manner as
they apply to other organizations described in section 501(c)(3).
One comment criticized the examples in the proposed regulations as
too ``black-and-white'' and suggested that the regulations be
supplemented with examples that discuss less clear facts. Specifically,
this comment requested guidance on situations involving more than de
minimis amounts in which an applicable tax-exempt organization does not
seek correction from the disqualified person involved. The new example
added by these final regulations illustrates that, in some situations,
even in the absence of correction of non-de minimis excess benefit
transactions, an organization may retain its tax-exempt status if the
other factors, in combination, warrant continued exemption. Under the
fifth factor, the IRS will take into account the organization's good
faith with respect to
[[Page 16521]]
correction. Accordingly, the reasons behind the organization's failure
to seek correction will be examined.
One comment suggested adding an example that would illustrate what
factors, in addition to post-audit correction, would be sufficient to
avoid revocation. The example that has been added illustrates a case
where factors other than correction support continued exemption. The
IRS and the Treasury Department may consider publication of future
guidance on the application of the factors based on other specific fact
patterns that the IRS encounters in the course of tax administration.
One comment requested adding an example discussing the effect of
``automatic excess benefit transactions'' that are not de minimis on
the organization's tax-exempt status. The term ``automatic excess
benefit transaction'' refers to a transaction in which a disqualified
person provides services to an organization and receives economic
benefits from the organization that are not substantiated,
contemporaneously and in writing, as compensation within the meaning of
Sec. 53.4958-4(c). After the enactment of the Pension Protection Act
of 2006, Public Law 109-280 (120 Stat. 780 (2006)), the term
``automatic excess benefit transaction'' also refers to any grant,
loan, compensation or other similar payment from a donor advised fund
to a donor or donor advisor with respect to such fund and from a
supporting organization to any of its disqualified persons. See section
4958(c)(2) and (3). Although not in the context of an automatic excess
benefit transaction, the new example in the final regulations involves
an excess benefit transaction that is not de minimis.
e. Removal of Disqualified Person
One comment suggested that the regulations address whether and
under what circumstances removal of a disqualified person may be
necessary to avoid revocation. The new example added by these final
regulations illustrates that removal of a disqualified person is not a
necessary condition for continued exemption. In the example, the
organization implemented safeguards designed to prevent future excess
benefit transactions involving the same disqualified persons.
f. Best Practices
One comment described specific actions that boards of applicable
tax-exempt organizations should be required to take to improve
governance and to prevent excess benefit transactions at their
organizations. This comment was not adopted because the purpose of
these regulations is to set forth an analytical framework for
determining whether to revoke tax-exempt status if an organization
engages in one or more excess benefit transactions.
Special Analyses
It has been determined that this regulation is not a significant
regulatory action as defined in Executive Order 12866. Therefore, a
regulatory assessment is not required. It also has been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
does not apply to this regulation, and because this regulation does not
impose a collection of information on small entities, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to
section 7805(f) of the Code, the notice of proposed rulemaking
preceding this regulation was submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on its impact
on business.
Drafting Information
The principal authors of these regulations are Galina Kolomietz and
Phyllis Haney, Office of Division Counsel/Associate Chief Counsel (Tax
Exempt and Government Entities). However, other personnel from the IRS
and the Treasury Department participated in their development.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 53
Excise taxes, Foundations, Investments, Lobbying, Reporting and
recordkeeping requirements.
Amendments to the Regulations
0
Accordingly, 26 CFR parts 1 and 53 are amended as follows:
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 continues to read, in
part, as follows:
Authority: 26 U.S.C. 7805 * * *
0
Par. 2. Section 1.501(c)(3)-1 is revised by:
0
1. Redesignating paragraph (d)(1)(iii) as paragraph (d)(1)(iv) and
adding a new paragraph (d)(1)(iii).
0
2. Redesignating paragraph (f) as paragraph (g) and adding a new
paragraph (f).
The additions read as follows:
Sec. 1.501(c)(3)-1 Organizations organized and operated for
religious, charitable, scientific, testing for public safety, literary,
or educational purposes, or for the prevention of cruelty to children
or animals.
* * * * *
(d) * * *
(1) * * *
(iii) Examples. The following examples illustrate the requirement
of paragraph (d)(1)(ii) of this section that an organization serve a
public rather than a private interest:
Example 1. (i) O is an educational organization the purpose of
which is to study history and immigration. O's educational
activities include sponsoring lectures and publishing a journal. The
focus of O's historical studies is the genealogy of one family,
tracing the descent of its present members. O actively solicits for
membership only individuals who are members of that one family. O's
research is directed toward publishing a history of that family that
will document the pedigrees of family members. A major objective of
O's research is to identify and locate living descendants of that
family to enable those descendants to become acquainted with each
other.
(ii) O's educational activities primarily serve the private
interests of members of a single family rather than a public
interest. Therefore, O is operated for the benefit of private
interests in violation of the restriction on private benefit in
paragraph (d)(1)(ii) of this section. Based on these facts and
circumstances, O is not operated exclusively for exempt purposes
and, therefore, is not described in section 501(c)(3).
Example 2. (i) O is an art museum. O's principal activity is
exhibiting art created by a group of unknown but promising local
artists. O's activity, including organized tours of its art
collection, promotes the arts. O is governed by a board of trustees
unrelated to the artists whose work O exhibits. All of the art
exhibited is offered for sale at prices set by the artist. Each
artist whose work is exhibited has a consignment arrangement with O.
Under this arrangement, when art is sold, the museum retains 10
percent of the selling price to cover the costs of operating the
museum and gives the artist 90 percent.
(ii) The artists in this situation directly benefit from the
exhibition and sale of their art. As a result, the sole activity of
O serves the private interests of these artists. Because O gives 90
percent of the proceeds from its sole activity to the individual
artists, the direct benefits to the artists are substantial and O's
provision of these benefits to the artists is more than incidental
to its other purposes and activities. This arrangement causes O to
be operated for the benefit of private interests in violation of the
restriction on private benefit in paragraph (d)(1)(ii) of this
section. Based on these facts and circumstances, O is not operated
exclusively for exempt purposes and, therefore, is not described in
section 501(c)(3).
Example 3. (i) O is an educational organization the purpose of
which is to train individuals in a program developed by P, O's
president. The program is of interest to academics and
professionals, representatives
[[Page 16522]]
of whom serve on an advisory panel to O. All of the rights to the
program are owned by Company K, a for-profit corporation owned by P.
Prior to the existence of O, the teaching of the program was
conducted by Company K. O licenses, from Company K, the right to
conduct seminars and lectures on the program and to use the name of
the program as part of O's name, in exchange for specified royalty
payments. Under the license agreement, Company K provides O with the
services of trainers and with course materials on the program. O may
develop and copyright new course materials on the program but all
such materials must be assigned to Company K without consideration
if and when the license agreement is terminated. Company K sets the
tuition for the seminars and lectures on the program conducted by O.
O has agreed not to become involved in any activity resembling the
program or its implementation for 2 years after the termination of
O's license agreement.
(ii) O's sole activity is conducting seminars and lectures on
the program. This arrangement causes O to be operated for the
benefit of P and Company K in violation of the restriction on
private benefit in paragraph (d)(1)(ii) of this section, regardless
of whether the royalty payments from O to Company K for the right to
teach the program are reasonable. Based on these facts and
circumstances, O is not operated exclusively for exempt purposes
and, therefore, is not described in section 501(c)(3).
* * * * *
(f) Interaction with section 4958--(1) Application process. An
organization that applies for recognition of exemption under section
501(a) as an organization described in section 501(c)(3) must establish
its eligibility under this section. The Commissioner may deny an
application for exemption for failure to establish any of section
501(c)(3)'s requirements for exemption. Section 4958 does not apply to
transactions with an organization that has failed to establish that it
satisfies all of the requirements for exemption under section
501(c)(3). See Sec. 53.4958-2.
(2) Substantive requirements for exemption still apply to
applicable tax-exempt organizations described in section 501(c)(3)--(i)
In general. Regardless of whether a particular transaction is subject
to excise taxes under section 4958, the substantive requirements for
tax exemption under section 501(c)(3) still apply to an applicable tax-
exempt organization (as defined in section 4958(e) and Sec. 53.4958-2)
described in section 501(c)(3) whose disqualified persons or
organization managers are subject to excise taxes under section 4958.
Accordingly, an organization will no longer meet the requirements for
tax-exempt status under section 501(c)(3) if the organization fails to
satisfy the requirements of paragraph (b), (c) or (d) of this section.
See Sec. 53.4958-8(a).
(ii) Determination of whether revocation of tax-exempt status is
appropriate when section 4958 excise taxes also apply. In determining
whether to continue to recognize the tax-exempt status of an applicable
tax-exempt organization (as defined in section 4958(e) and Sec.
53.4958-2) described in section 501(c)(3) that engages in one or more
excess benefit transactions (as defined in section 4958(c) and Sec.
53.4958-4) that violate the prohibition on inurement under section
501(c)(3), the Commissioner will consider all relevant facts and
circumstances, including, but not limited to, the following--
(A) The size and scope of the organization's regular and ongoing
activities that further exempt purposes before and after the excess
benefit transaction or transactions occurred;
(B) The size and scope of the excess benefit transaction or
transactions (collectively, if more than one) in relation to the size
and scope of the organization's regular and ongoing activities that
further exempt purposes;
(C) Whether the organization has been involved in multiple excess
benefit transactions with one or more persons;
(D) Whether the organization has implemented safeguards that are
reasonably calculated to prevent excess benefit transactions; and
(E) Whether the excess benefit transaction has been corrected
(within the meaning of section 4958(f)(6) and Sec. 53.4958-7), or the
organization has made good faith efforts to seek correction from the
disqualified person(s) who benefited from the excess benefit
transaction.
(iii) All factors will be considered in combination with each
other. Depending on the particular situation, the Commissioner may
assign greater or lesser weight to some factors than to others. The
factors listed in paragraphs (f)(2)(ii)(D) and (E) of this section will
weigh more heavily in favor of continuing to recognize exemption where
the organization discovers the excess benefit transaction or
transactions and takes action before the Commissioner discovers the
excess benefit transaction or transactions. Further, with respect to
the factor listed in paragraph (f)(2)(ii)(E) of this section,
correction after the excess benefit transaction or transactions are
discovered by the Commissioner, by itself, is never a sufficient basis
for continuing to recognize exemption.
(iv) Examples. The following examples illustrate the principles of
paragraph (f)(2)(ii) of this section. For purposes of each example,
assume that O is an applicable tax-exempt organization (as defined in
section 4958(e) and Sec. 53.4958-2) described in section 501(c)(3).
The examples read as follows:
Example 1. (i) O was created as a museum for the purpose of
exhibiting art to the general public. In Years 1 and 2, O engages in
fundraising and in selecting, leasing, and preparing an appropriate
facility for a museum. In Year 3, a new board of trustees is
elected. All of the new trustees are local art dealers. Beginning in
Year 3 and continuing to the present, O uses a substantial portion
of its revenues to purchase art solely from its trustees at prices
that exceed fair market value. O exhibits and offers for sale all of
the art it purchases. O's Form 1023, ``Application for Recognition
of Exemption,'' did not disclose the possibility that O would
purchase art from its trustees.
(ii) O's purchases of art from its trustees at more than fair
market value constitute excess benefit transactions between an
applicable tax-exempt organization and disqualified persons under
section 4958. Therefore, these transactions are subject to the
applicable excise taxes provided in that section. In addition, O's
purchases of art from its trustees at more than fair market value
violate the proscription against inurement under section 501(c)(3)
and paragraph (c)(2) of this section.
(iii) The application of the factors in paragraph (f)(2)(ii) of
this section to these facts is as follows. Beginning in Year 3, O
does not engage primarily in regular and ongoing activities that
further exempt purposes because a substantial portion of O's
activities consists of purchasing art from its trustees and dealing
in such art in a manner similar to a commercial art gallery. The
size and scope of the excess benefit transactions collectively are
significant in relation to the size and scope of any of O's ongoing
activities that further exempt purposes. O has been involved in
multiple excess benefit transactions, namely, purchases of art from
its trustees at more than fair market value. O has not implemented
safeguards that are reasonably calculated to prevent such improper
purchases in the future. The excess benefit transactions have not
been corrected, nor has O made good faith efforts to seek correction
from the disqualified persons who benefited from the excess benefit
transactions (the trustees). The trustees continue to control O's
Board. Based on the application of the factors to these facts, O is
no longer described in section 501(c)(3) effective in Year 3.
Example 2. (i) The facts are the same as in Example 1, except
that in Year 4, O's entire board of trustees resigns, and O no
longer offers all exhibited art for sale. The former board is
replaced with members of the community who are not in the business
of buying or selling art and who have skills and experience running
charitable and educational programs and institutions. O promptly
discontinues the practice of purchasing art from current or former
trustees, adopts a written conflicts of interest policy, adopts
written art valuation
[[Page 16523]]
guidelines, hires legal counsel to recover the excess amounts O had
paid its former trustees, and implements a new program of activities
to further the public's appreciation of the arts.
(ii) O's purchases of art from its former trustees at more than
fair market value constitute excess benefit transactions between an
applicable tax-exempt organization and disqualified persons under
section 4958. Therefore, these transactions are subject to the
applicable excise taxes provided in that section. In addition, O's
purchases of art from its trustees at more than fair market value
violate the proscription against inurement under section 501(c)(3)
and paragraph (c)(2) of this section.
(iii) The application of the factors in paragraph (f)(2)(ii) of
this section to these facts is as follows. In Year 3, O does not
engage primarily in regular and ongoing activities that further
exempt purposes. However, in Year 4, O elects a new board of
trustees comprised of individuals who have skills and experience
running charitable and educational programs and implements a new
program of activities to further the public's appreciation of the
arts. As a result of these actions, beginning in Year 4, O engages
in regular and ongoing activities that further exempt purposes. The
size and scope of the excess benefit transactions that occurred in
Year 3, taken collectively, are significant in relation to the size
and scope of O's regular and ongoing exempt function activities that
were conducted in Year 3. Beginning in Year 4, however, as O's
exempt function activities grow, the size and scope of the excess
benefit transactions that occurred in Year 3 become less and less
significant as compared to the size and extent of O's regular and
ongoing exempt function activities. O was involved in multiple
excess benefit transactions in Year 3. However, by discontinuing its
practice of purchasing art from its current and former trustees, by
replacing its former board with independent members of the
community, and by adopting a conflicts of interest policy and art
valuation guidelines, O has implemented safeguards that are
reasonably calculated to prevent future violations. In addition, O
has made a good faith effort to seek correction from the
disqualified persons who benefited from the excess benefit
transactions (its former trustees). Based on the application of the
factors to these facts, O continues to meet the requirements for tax
exemption under section 501(c)(3).
Example 3. (i) O conducts educational programs for the benefit
of the general public. Since its formation, O has employed its
founder, C, as its Chief Executive Officer. Beginning in Year 5 of
O's operations and continuing to the present, C caused O to divert
significant portions of O's funds to pay C's personal expenses. The
diversions by C significantly reduced the funds available to conduct
O's ongoing educational programs. The board of trustees never
authorized C to cause O to pay C's personal expenses from O's funds.
Certain members of the board were aware that O was paying C's
personal expenses. However, the board did not terminate C's
employment and did not take any action to seek repayment from C or
to prevent C from continuing to divert O's funds to pay C's personal
expenses. C claimed that O's payments of C's personal expenses
represented loans from O to C. However, no contemporaneous loan
documentation exists, and C never made any payments of principal or
interest.
(ii) The diversions of O's funds to pay C's personal expenses
constitute excess benefit transactions between an applicable tax-
exempt organization and a disqualified person under section 4958.
Therefore, these transactions are subject to the applicable excise
taxes provided in that section. In addition, these transactions
violate the proscription against inurement under section 501(c)(3)
and paragraph (c)(2) of this section.
(iii) The application of the factors in paragraph (f)(2)(ii) of
this section to these facts is as follows. O has engaged in regular
and ongoing activities that further exempt purposes both before and
after the excess benefit transactions occurred. However, the size
and scope of the excess benefit transactions engaged in by O
beginning in Year 5, collectively, are significant in relation to
the size and scope of O's activities that further exempt purposes.
Moreover, O has been involved in multiple excess benefit
transactions. O has not implemented any safeguards that are
reasonably calculated to prevent future diversions. The excess
benefit transactions have not been corrected, nor has O made good
faith efforts to seek correction from C, the disqualified person who
benefited from the excess benefit transactions. Based on the
application of the factors to these facts, O is no longer described
in section 501(c)(3) effective in Year 5.
Example 4. (i) O conducts activities that further exempt
purposes. O uses several buildings in the conduct of its exempt
activities. In Year 1, O sold one of the buildings to Company K for
an amount that was substantially below fair market value. The sale
was a significant event in relation to O's other activities. C, O's
Chief Executive Officer, owns all of the voting stock of Company K.
When O's board of trustees approved the transaction with Company K,
the board did not perform due diligence that could have made it
aware that the price paid by Company K to acquire the building was
below fair market value. Subsequently, but before the IRS commences
an examination of O, O's board of trustees determines that Company K
paid less than the fair market value for the building. Thus, O
concludes that an excess benefit transaction occurred. After the
board makes this determination, it promptly removes C as Chief
Executive Officer, terminates C's employment with O, and hires legal
counsel to recover the excess benefit from Company K. In addition, O
promptly adopts a conflicts of interest policy and new contract
review procedures designed to prevent future recurrences of this
problem.
(ii) The sale of the building by O to Company K at less than
fair market value constitutes an excess benefit transaction between
an applicable tax-exempt organization and a disqualified person
under section 4958 in Year 1. Therefore, this transaction is subject
to the applicable excise taxes provided in that section. In
addition, this transaction violates the proscription against
inurement under section 501(c)(3) and paragraph (c)(2) of this
section.
(iii) The application of the factors in paragraph (f)(2)(ii) of
this section to these facts is as follows. O has engaged in regular
and ongoing activities that further exempt purposes both before and
after the excess benefit transaction occurred. Although the size and
scope of the excess benefit transaction were significant in relation
to the size and scope of O's activities that further exempt
purposes, the transaction with Company K was a one-time occurrence.
By adopting a conflicts of interest policy and significant new
contract review procedures and by terminating C, O has implemented
safeguards that are reasonably calculated to prevent future
violations. Moreover, O took corrective actions before the IRS
commenced an examination of O. In addition, O has made a good faith
effort to seek correction from Company K, the disqualified person
who benefited from the excess benefit transaction. Based on the
application of the factors to these facts, O continues to be
described in section 501(c)(3).
Example 5. (i) O is a large organization with substantial assets
and revenues. O conducts activities that further its exempt
purposes. O employs C as its Chief Financial Officer. During Year 1,
O pays $2,500 of C's personal expenses. O does not make these
payments pursuant to an accountable plan, as described in Sec.
53.4958-4(a)(4)(ii). In addition, O does not report any of these
payments on C's Form W-2, ``Wage and Tax Statement,'' or on a Form
1099-MISC, ``Miscellaneous Income,'' for C for Year 1, and O does
not report these payments as compensation on its Form 990, ``Return
of Organization Exempt From Income Tax,'' for Year 1. Moreover, none
of these payments can be disregarded as nontaxable fringe benefits
under Sec. 53.4958-4(c)(2) and none consisted of fixed payments
under an initial contract under Sec. 53.4958-4(a)(3). C does not
report the $2,500 of payments as income on his individual Federal
income tax return for Year 1. O does not repeat this reporting
omission in subsequent years and, instead, reports all payments of
C's personal expenses not made under an accountable plan as income
to C.
(ii) O's payment in Year 1 of $2,500 of C's personal expenses
constitutes an excess benefit transaction between an applicable tax-
exempt organization and a disqualified person under section 4958.
Therefore, this transaction is subject to the applicable excise
taxes provided in that section. In addition, this transaction
violates the proscription against inurement in section 501(c)(3) and
paragraph (c)(2) of this section.
(iii) The application of the factors in paragraph (f)(2)(ii) of
this section to these facts is as follows. O engages in regular and
ongoing activities that further exempt purposes. The payment of
$2,500 of C's personal expenses represented only a de minimis
portion of O's assets and revenues; thus, the size and scope of the
excess benefit transaction were not significant in relation to the
size and scope of O's activities that further exempt purposes. The
reporting omission that resulted in the excess benefit transaction
in Year 1 occurred only once and
[[Page 16524]]
is not repeated in subsequent years. Based on the application of the
factors to these facts, O continues to be described in section
501(c)(3).
Example 6. (i) O is a large organization with substantial assets
and revenues. O furthers its exempt purposes by providing social
services to the population of a specific geographic area. O has a
sizeable workforce of employees and volunteers to conduct its work.
In Year 1, O's board of directors adopted written procedures for
setting executive compensation at O. O's executive compensation
procedures were modeled on the procedures for establishing a
rebuttable presumption of reasonableness under Sec. 53.4958-6. In
accordance with these procedures, the board appointed a compensation
committee to gather data on compensation levels paid by similarly
situated organizations for functionally comparable positions. The
members of the compensation committee were disinterested within the
meaning of Sec. 53.4958-6(c)(1)(iii). Based on its research, the
compensation committee recommended a range of reasonable
compensation for several of O's existing top executives (the Top
Executives). On the basis of the committee's recommendations, the
board approved new compensation packages for the Top Executives and
timely documented the basis for its decision in board minutes. The
board members were all disinterested within the meaning of Sec.
53.4958-6(c)(1)(iii). The Top Executives were not involved in
setting their own compensation. In Year 1, even though payroll
expenses represented a significant portion of O's total operating
expenses, the total compensation paid to O's Top Executives
represented only an insubstantial portion of O's total payroll
expenses. During a subsequent examination, the IRS found that the
compensation committee relied exclusively on compensation data from
organizations that perform similar social services to O. The IRS
concluded, however, that the organizations were not similarly
situated because they served substantially larger geographic regions
with more diverse populations and were larger than O in terms of
annual revenues, total operating budget, number of employees, and
number of beneficiaries served. Accordingly, the IRS concluded that
the compensation committee did not rely on ``appropriate data as to
comparability'' within the meaning of Sec. 53.4958-6(c)(2) and,
thus, failed to establish the rebuttable presumption of
reasonableness under Sec. 53.4958-6. Taking O's size and the nature
of the geographic area and population it serves into account, the
IRS concluded that the Top Executives' compensation packages for
Year 1 were excessive. As a result of the examination, O's board
added new members to the compensation committee who have expertise
in compensation matters and also amended its written procedures to
require the compensation committee to evaluate a number of specific
factors, including size, geographic area, and population covered by
the organization, in assessing the comparability of compensation
data. O's board renegotiated the Top Executives' contracts in
accordance with the recommendations of the newly constituted
compensation committee on a going forward basis. To avoid potential
liability for damages under state contract law, O did not seek to
void the Top Executives' employment contracts retroactively to Year
1 and did not seek correction of the excess benefit amounts from the
Top Executives. O did not terminate any of the Top Executives.
(ii) O's payments of excessive compensation to the Top
Executives in Year 1 constituted excess benefit transactions between
an applicable tax-exempt organization and disqualified persons under
section 4958. Therefore, these payments are subject to the
applicable excise taxes provided under that section, including
second-tier taxes if there is no correction by the disqualified
persons. In addition, these payments violate the proscription
against inurement under section 501(c)(3) and paragraph (c)(2) of
this section.
(iii) The application of the factors in paragraph (f)(2)(ii) of
this section to these facts is as follows. O has engaged in regular
and ongoing activities that further exempt purposes both before and
after the excess benefit transactions occurred. The size and scope
of the excess benefit transactions, in the aggregate, were not
significant in relation to the size and scope of O's activities that
further exempt purposes. O engaged in multiple excess benefit
transactions. Nevertheless, prior to entering into these excess
benefit transactions, O had implemented written procedures for
setting the compensation of its top management that were reasonably
calculated to prevent the occurrence of excess benefit transactions.
O followed these written procedures in setting the compensation of
the Top Executives for Year 1. Despite the board's failure to rely
on appropriate comparability data, the fact that O implemented and
followed these written procedures in setting the compensation of the
Top Executives for Year 1 is a factor favoring continued exemption.
The fact that O amended its written procedures to ensure the use of
appropriate comparability data and renegotiated the Top Executives'
compensation packages on a going-forward basis are also factors
favoring continued exemption, even though O did not void the Top
Executives' existing contracts and did not seek correction from the
Top Executives. Based on the application of the factors to these
facts, O continues to be described in section 501(c)(3).
(3) Applicability. The rules in paragraph (f) of this section will
apply with respect to excess benefit transactions occurring after March
28, 2008.
* * * * *
PART 53--FOUNDATION AND SIMILAR EXCISE TAXES
0
Par. 3. The authority citation for part 53 continues to read, in part,
as follows:
Authority: 26 U.S.C. 7805 * * *
0
Par. 4. In Sec. 53.4958-2, paragraph (a)(6) is added to read as
follows:
Sec. 53.4958-2 Definition of applicable tax-exempt organization.
(a) * * *
(6) Examples. The following examples illustrate the principles of
this section, which defines an applicable tax-exempt organization for
purposes of section 4958:
Example 1. O is a nonprofit corporation formed under state law.
O filed its application for recognition of exemption under section
501(c)(3) within the time prescribed under section 508(a). In its
application, O described its plans for purchasing property from some
of its directors at prices that would exceed fair market value.
After reviewing the application, the IRS determined that because of
the proposed property purchase transactions, O failed to establish
that it met the requirements for an organization described in
section 501(c)(3). Accordingly, the IRS denied O's application.
While O's application was pending, O engaged in the purchase
transactions described in its application at prices that exceeded
the fair market values of the properties. Although these
transactions would constitute excess benefit transactions under
section 4958, because the IRS never recognized O as an organization
described in section 501(c)(3), O was never an applicable tax-exempt
organization under section 4958. Therefore, these transactions are
not subject to the excise taxes provided in section 4958.
Example 2. O is a nonprofit corporation formed under state law.
O files its application for recognition of exemption under section
501(c)(3) within the time prescribed under section 508(a). The IRS
issues a favorable determination letter in Year 1 that recognizes O
as an organization described in section 501(c)(3). Subsequently, in
Year 5 of O's operations, O engages in certain transactions that
constitute excess benefit transactions under section 4958 and
violate the proscription against inurement under section 501(c)(3)
and Sec. 1.501(c)(3)-1(c)(2). The IRS examines the Form 990,
``Return of Organization Exempt From Income Tax'', that O filed for
Year 5. After considering all the relevant facts and circumstances
in accordance with Sec. 1.501(c)(3)-1(f), the IRS concludes that O
is no longer described in section 501(c)(3) effective in Year 5. The
IRS does not examine the Forms 990 that O filed for its first four
years of operations and, accordingly, does not revoke O's exempt
status for those years. Although O's tax-exempt status is revoked
effective in Year 5, under the lookback rules in paragraph (a)(1) of
this section and Sec. 53.4958-3(a)(1) of this chapter, during the
five-year period prior to the excess benefit transactions that
occurred in Year 5, O was an applicable tax-exempt organization and
O's directors were disqualified persons as to O. Therefore, the
transactions between O and its directors during Year 5 are subject
to the
[[Page 16525]]
applicable excise taxes provided in section 4958.
* * * * *
Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
Approved: March 19, 2008.
Eric Solomon,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. E8-6305 Filed 3-27-08; 8:45 am]
BILLING CODE 4830-01-P