Managing the Self-Disclosure Requirement on IRS Form 990 for "Excess Benefit" Transactions with Directors, Officers, and Other "Disqualified Persons"

As tax-exempt organizations gain experience with the intermediate sanctions rules, they are increasingly confronting difficult decisions about whether and how to disclose "excess benefit transactions" with directors, officers, and high-referring physicians on their annual return (Form 990) with the IRS. In some circumstances, to avoid committing a felony, a tax-exempt organization must report certain non-fair-market-value transactions with directors, officers, and, possibly, physicians. An organization’s Form 990 is a public document frequently available on the Internet, a fact that can raise the stakes and make the decision to self-report more difficult. In addition, post-Enron, both regulators and stakeholders of tax-exempt organizations can be expected to closely scrutinize transactions with "insiders" and compliance with the intermediate sanctions rules, including the obligation to report excess benefit transactions. Accordingly, whether and how to make a Form 990 disclosure can be a nettlesome issue.

This Compliance Adviser summarizes the intermediate sanctions provisions and the Form 990 reporting requirements, discusses considerations relevant to a disclosure decision, and provides affirmative measures to avoid a problem in the first instance.

What are the Intermediate Sanctions Rules?

Before 1995, if a tax-exempt organization engaged in a non-fair-market-value transaction with an "insider," the law provided only a single, often-extreme remedy – revocation of the organization's tax-exempt status. For transactions occurring after September 14, 1995, the IRS has the additional authority to impose excise tax penalties for such transactions, as an "intermediate" sanction falling short of revocation. Although the availability of intermediate sanctions does not eliminate the possibility of revocation of tax status in egregious cases, the IRS has indicated that the intermediate sanctions rules will be the primary remedy for non-fair-market-value transactions with organizational insiders.

Under the intermediate sanctions rules, if a tax-exempt organization confers an "excess benefit" upon a "disqualified person," the IRS may impose excess taxes on the disqualified persons involved equal to 25 percent of the excess benefit (200 percent if the excess benefit is not returned within a certain period). In addition, the IRS may impose excise taxes on officers, directors, or other organization managers who knowingly approved the transaction equal to 10 percent of the excess benefit ($10,000 maximum).

Who is a "Disqualified Person?"

The intermediate sanctions rules apply only to transactions with "disqualified persons." A disqualified person is: (1) any person who, within a five-year look-back period ending on the date of the transaction, was in a position to exercise substantial influence over the organization; (2) any family member of such a person; or (3) any corporation, partnership, or trust in which such a person has a 35 percent interest.

Under recently finalized regulations, some persons within an organization are automatically deemed disqualified persons, including board members and top executives. Determining disqualified person status for others requires examining the particular facts and circumstances to evaluate whether the person was in a position to exercise substantial influence over the organization within the five-year look-back period.

A health care organization may have disqualified persons within several categories of personnel, such as board members and top executives, substantial donors, medical directors, medical or operations committee members, and managers with authority over substantial activities, assets, revenues, expenses, capital expenditures, operating budgets, or compensation. The IRS may also consider a physician whose valuable referrals put him or her in a position to exercise substantial influence over the organization to be a disqualified person.

What is an Excess Benefit?

As noted, the intermediate sanctions rules apply to transactions in which a disqualified person receives an "excess benefit" from a tax-exempt organization. An excess benefit transaction is one in which the value of the benefits conferred by a tax-exempt organization exceed the value received by the organization. For example, a health care organization may confer excess benefits where it: (1) provides free or discounted goods or services to disqualified persons; (2) enters into other transactions, ranging from simple purchases of property to joint ventures, with disqualified persons on terms unduly favorable to the person; or (3) pays greater-than-reasonable compensation to the disqualified person for the person's services.

In addition, the recently finalized intermediate sanctions regulations limit an organization's ability to argue, after the fact, that the benefits were intended as compensation for the disqualified person's services. Benefits to a disqualified person will only be considered as compensation for the performance of services where there is "contemporaneous evidence" of compensatory intent, such as where the organization or disqualified person recorded the benefit as compensation paid for tax purposes (through use of Form W-2 or 1099 statements or through Form 990 or 1040 tax returns).

Addressing the Self-Reporting Obligation on Form 990

The IRS does not have the authority to impose intermediate sanctions on the organization itself. The IRS's intermediate sanctions authority applies only against individuals (disqualified persons and organization managers). The IRS, however, requires organizations to self-disclose transactions to which intermediate sanctions would apply. Line 89b of the Form 990 annual tax return requires a tax-exempt organization to identify and describe any excess benefit transaction occurring during the previous year and any excess benefit transactions occurring during prior years if the organization became aware of the transaction during the previous year.

Failure to disclose excess benefit transactions could trigger civil penalties related to the failure to file a correct and complete tax return. Moreover, depending on the circumstances, deliberate noncompliance with the reporting obligations could subject the organization to criminal sanctions for tax fraud, false statement, aiding and abetting the evasion of excise taxes, perjury, conspiracy, and other offenses. In addition, officers, directors, attorneys, accountants, and others involved in preparing and filing the Form 990 could be personally liable for their role in submitting a false tax return.

Complicating the reporting process is the fact that a tax-exempt organization's tax return, in which non-fair-market-value transactions would be disclosed, is a public document. A public disclosure of an excess benefit transaction could embarrass the organization, discourage donors and other community supporters, and trigger an IRS excise tax audit of the disqualified persons involved.

An organization confronting a possible excess benefit transaction, and considering whether disclosure is necessary, should examine carefully the facts and circumstances of the transaction in question. It may be appropriate to conduct an investigation under attorney-client privilege. Before any final decision to report the transaction is made, the organization must consider the following:

• Was the person involved truly a "disqualified person?" In the case of officers and directors, it may be easy to determine that the person is a per se disqualified person. For others – particularly for physicians who lack an official title at the hospital but who account for a large volume of referrals – the inquiry is more complex.
• Was the transaction on other than fair-market-value terms? Is the organization eligible for a "rebuttable presumption" (see below) that the transaction was consistent with fair-market value? In some instances, it may be possible to conclude that the director or other disqualified person in question actually provides uncompensated services, and the transaction in question can be viewed as a quid pro quo for the uncompensated services. As noted, however, the IRS' recent regulations impose limits on when this theory can be pursued.
• If disclosure is required, how much detail must be provided? Must all the known facts and circumstances be disclosed? Must the identity(ies) of the disqualified person(s) be disclosed? Must the indentity(ies) of the organization manager(s) responsible for approving the transaction be disclosed?

These are difficult questions for which there is scant regulatory guidance. Yet, as noted, the penalties for submitting a false or misleading tax return can be severe, including criminal penalties.

Preventing Exposure through the "Rebuttable Presumption" Procedure

The intermediate sanctions regulations provide a procedure by which tax-exempt organizations may head off excess benefit problems. By following this process, the organization may obtain a "rebuttable presumption" that a particular transaction was on fair-market-value terms.

There are three requirements for triggering the rebuttable presumption for a particular transaction. First, the transaction must be approved by an "authorized body" of the organization composed entirely of persons with no conflict of interest for the transaction. The "authorized body" may be the organization's board but may also a board committee, another group of officials, or even a single person designated by the board to review the transaction. Second, the authorized body must obtain and rely upon appropriate valuation and/or other comparability data prior to approving the transaction. Ideally, comparability data should be in the form of appraisals, compensation studies, or other sources of expertise. Third, the authorized body's approval and the basis for that approval must be contemporaneously recorded in the authorized body's records. In minutes or other records, the authorized body should record the terms of the transactions, the date of approval, the members of the authorized body who participated in the discussion and approval, the comparability data obtained and relied upon, and any participation in the discussion and approval process by anyone with a conflict of interest for the transaction.

If the organization triggers the rebuttable presumption, the IRS will not assert that the transaction was on non-fair-market-value terms and will not impose excise tax penalties except under extremely limited circumstances. In addition, directors, officers, and/or other organization managers will not be considered to have "knowingly" approved an excess benefit transaction, and thus will not be subject to excise taxes, if the organization followed the rebuttable presumption procedures.

Recommendations

Create List of Disqualified Persons. Develop and continuously maintain a list of all persons who have been disqualified persons at any time in the last five years. Make the list available to counsel, officers and directors who negotiate and approve transactions, and compliance personnel. Inform individuals of their inclusion on the list and what inclusion on the list means.

Use Rebuttable Presumption Procedure. Before the organization enters into an agreement or compensation arrangement with a disqualified person, use the rebuttable presumption procedure to evaluate and approve the transaction. To make this possible, the organization's board of directors should designate a permanent "authorized body" to review all such transactions. The authorized body should always obtain reliable fair-market-value data before making its decision, and the authorized body should keep contemporaneous records of its deliberations.

Audit Current Transactions with Disqualified Persons. Review a sample of current agreements and compensation arrangements with disqualified persons. If a non-fair-market-value transaction is identified, terminate or modify the arrangement. In addition, consider the need to engage counsel to conduct a privileged investigation as to whether an excess benefit transaction has in fact occurred and must be disclosed on the organization's tax return.

Educate Officers and Directors. Ensure that the organization's officers and directors are educated regarding the intermediate sanctions rules, the rebuttable presumption procedures, and their duties to identify and report possible excess benefit transactions that the organization must disclose on its tax return.

This Health Care Compliance Adviser is a publication of Jones, Day, Reavis & Pogue and should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general informational purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at its discretion. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship.