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Exempt Organizations

Exempt Organizations
December 2001

The intermediate sanctions legislation that was enacted in 1996 has resulted in a heightened effort by exempt organizations to scrutinize compensation arrangements with key individuals. Intermediate sanctions requires §§501(c)(3) and (c)(4) organizations (with the exception of private foundations and governmental entities) to determine whether economic benefits provided to “disqualified persons” are reasonable. Benefits that are not reasonable result in an “excess benefit” and the potential for imposition of excise taxes upon the individual involved.

The recently-released IRS Continuing Professional Education text for 2002 (“CPE text”) includes a chapter devoted to intermediate sanctions. It outlines the basic steps in assessing whether economic benefits provided to a disqualified person qualify as reasonable compensation:

  • All compensation must be taken into account in assessing whether a disqualified person is receiving reasonable compensation. Compensation is broadly defined to include all cash and noncash compensation, as well as taxable and nontaxable fringe benefits.
  • An economic benefit is not treated as compensation unless the organization clearly indicates its intent to treat the benefit as compensation when the benefit is paid.
  • Intent is demonstrated by written, contemporaneous substantiation.
  • If a benefit is not substantiated as required, the benefit is an excess benefit. It cannot be argued after the fact that the benefit was a component of the compensation package.

The CPE text also reviews the proper treatment of fringe benefits under the intermediate sanctions regime. This is an area of some confusion due to the interplay between intermediate sanctions and other income tax rules. While fringe benefits constitute compensation, some fringe benefits are taxable, while others are not. Unlike taxable fringe benefits that are reported on Forms W-2 or 1099, nontaxable fringe benefits may not be subject to any reporting requirement. The question arises whether fringe benefits that are nontaxable for income tax purposes must be taken into account for intermediate sanctions. Not surprisingly, the answer is yes - and no.

The CPE text prescribes the following steps in identifying the components of compensation that must be taken into account for intermediate sanctions purposes:

  • Identify the disqualified persons. It is transactions with these individuals that must be scrutinized under intermediate sanctions.
  • Identify all the benefits, monetary and nonmonetary received by each disqualified person.
  • Identify benefits that are fully excludable from income tax under IRC §132. These benefits can be ignored for intermediate sanctions purposes; substantiation* (described below) is not required (although the organization may wish to substantiate in case the benefits fail to qualify for exclusion).
  • Identify benefits that are fully excludable from income tax under other sections of the code (e.g., IRC §119). These benefits must be taken into account in evaluating whether compensation is reasonable, however, substantiation is not required. (The organization may want to substantiate, just in case).
  • Identify benefits that are described under nontaxable fringe benefit provisions but do not qualify for full exclusion (e.g., personal use of an automobile). These benefits must be taken into account in the reasonable compensation assessment and must be substantiated.

Nontaxable fringe benefits excluded by IRC §132 include the following.

  • Working condition fringe benefits
  • De minimis fringe benefits
  • No additional costs services
  • Qualified employee discounts
  • Qualified transportation fringe benefits
  • Qualified moving expense reimbursements
  • Qualified retirement planning services

Nontaxable fringe benefits that are excluded under sections other than IRC §132 include:

  • Employer-provided health benefits
  • Contribution to pension plans
  • Meals and lodging under IRC §119
  • Tuition reduction plans under IRC §117(d)

Finally, taxable fringe benefits not covered by a statutory exclusion could include items such as:

  • Interest-free loans
  • Accounting and financial counseling
  • Housing assistance payments
  • Employer-provided vacation travel

The intermediate sanctions rules require that components of compensation be substantiated, unless specifically relieved from this requirement. Substantiation may be accomplished by:

  • A signed written employment contract;
  • Reporting the benefit as compensation on Form W-2, 1099 or Form 990;
  • The disqualified person reports the benefit as income on his or her Form 1040;
  • In the case of fringe benefits that are claimed to be excludable from income, contemporaneous substantiation includes any written evidence that the benefits were intended as excludable compensation (e.g., a contract; board minutes; employee handbook; opinion by a benefits company, attorney, CPA or enrolled agent that the benefits are excludable from income).

The CPE text also contains sample checklists that can be used in the compensation evaluation process. The checklists are intended to include the steps necessary to enable organizations to satisfy the rebuttable presumption of reasonableness and shift the burden of proof to the IRS. We would be pleased to furnish a copy of the checklists to you upon your request.

Should you have any questions regarding the foregoing, please contact John Kikuchi at (925) 944-7666 or by email.

* For purpose of intermediate sanctions, "substantiation" refers to evidence that a fringe benefit was intended to be part of the compensation package. This is a separate requirement from the substantiation that may be required in the organization's books and records to support the exclusion.

The information contained in this newsletter is general in nature and does not constitute tax advice or opinion. Applicability to specific situations should be determined through consultation with your tax advisor.

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