Non-profit exempt organization tax problems

IRS Regs clarify Code Sec. 501(c)(3) exempt status and impact of excise taxes

Mike Habib, EA

T.D. 9390, 03/27/2008; Reg. § 1.503(c)(3)-1, Reg. § 53.4958-2

IRS has issued final regs clarifying the substantive requirements for tax exemption under Code Sec. 501(c)(3) and the relationship between those requirements and the imposition of Code Sec. 4958 excise taxes. The final regs adopt proposed regs issued in 2005 with some modifications.

Background. To qualify for tax exemption under Code Sec. 501(c)(3), an organization must be organized and operated exclusively for religious, charitable, scientific, or educational purposes. In addition, no part of its net earnings may inure to the benefit of any private shareholder or individual, no substantial part of its activities may include attempts to influence legislation, and the organization may not intervene in political campaigns. Under preexisting regs, an organization isn’t exempt under Code Sec. 501(c)(3), if it is organized or operated for the benefit of private interests such as designated individuals, its creator or his family, the organization’s shareholders, or persons controlled, directly or indirectly, by such interests. (Reg. § 1.501(c)(3)-1(d)(1)(ii))

Code Sec. 4958 imposes excise taxes on transactions that provide excess economic benefits to disqualified persons with respect to public charities and social welfare organizations described in Code Sec. 501(c)(3) and Code Sec. 501(c)(4) (certain social welfare organizations), which are collectively referred to by Code Sec. 4958(e) as “applicable tax-exempt organizations.”

Final regs. Adopting the proposed regs, the final regs add several examples to illustrate the requirement that an organization serve a public rather than a private interest. They show that prohibited private benefits may involve non-economic benefits as well as economic benefits. In addition, they indicate that a prohibited private benefit may arise regardless of whether payments made to private interests are reasonable or excessive. (Reg. § 1.501(c)(3)-1(d)(1)(iii))

The proposed regs provided guidance on certain factors that IRS will consider in determining whether an applicable tax-exempt organization described in Code Sec. 501(c)(3) that engages in one or more excess benefit transactions continues to qualify for exemption. Two comments voiced the need to clarify the terms “significant” and “de minimis” as used in the proposed regs. 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 minimis. The final regs 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. (Reg. § 1.501(c)(3)-1(f)(2)(iv), Example 6)

One comment requested clarification of the term “repeated” as used in Example 3 of Prop Reg § 1.501(c)(3)-1(g). IRS says the term was used in that example to correspond to the third factor in the proposed regs, 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 regs has been revised to substitute the term “multiple” for the word “repeated.” (Reg. § 1.501(c)(3)-1(f)(2)(ii)) 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. (T.D. 9390, 03/27/2008)

The fourth factor under the proposed regs has been 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. (Reg. § 1.501(c)(3)-1(f)(2)(ii)) 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. (T.D. 9390, 03/27/2008) 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. (Reg. § 1.501(c)(3)-1(f)(2)(iv), Example 6)

Observation: Thus, affected organizations should consider implementing such safeguards to help preserve exempt status should they engage in an excess benefit transaction.

Two comments suggested adding an example specifically addressing reasonable compensation. The new example added by these final regs does that. (Reg. § 1.501(c)(3)-1(f)(2)(iv), Example 6)

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