Intermediate Sanctions Temporary Regulations

Client Advisory

May 11, 2001

The Treasury Department has issued Temporary Regulations as guidance for the Intermediate Sanctions legislation (Internal Revenue Code Section 4958) enacted in 1996 affecting charitable organizations other than private foundations. These regulations replace the Proposed Regulations issued in 1998, and differ from them in several significant ways, most of which favor the Section 501(c)(3) public charities and Section 501(c)(4) social welfare organizations to which they apply. The new Temporary Regulations apply until January 2004.

Section 4958

Section 4958 provides penalties, less harsh than the revocation of an organization's tax-exempt status, for violations of the prohibition against an organization's assets inuring to the benefit of a private person. These Intermediate Sanctions impose taxes on the individuals involved in "excess benefit transactions" -- transactions between "disqualified persons" and organizations where the value of the economic benefit provided to the disqualified person exceeds the value of the services or property received by the organization. The taxes, based on the amount of that excess (the "excess benefit"), are (i) a 25% tax on the disqualified person who received the excess benefit, (ii) a 200% tax on that disqualified person if the transaction is not reversed and corrected in a timely manner, and (iii) a 10% tax (capped at $10,000) on any organization managers who participated in the transaction, knowing that it was an excess benefit transaction, unless such participation was not willful and was due to reasonable cause.

A disqualified person is one in a position to exercise substantial influence over the affairs of the organization, a family member of such a person, or an entity 35% of which is owned by such a person. The definition of "organization manager" includes any officer, director or trustee of an organization and any individual having powers or responsibilities similar to those of officers, directors or trustees. No tax is imposed on the organization itself under Section 4958.

Temporary Regulations

The Temporary Regulations provide further guidance to the application of Section 4958, significantly expand upon the safe-harbors provided by the Proposed Regulations and clarify many of the provisions set out in the Proposed Regulations.

"The First Bite of the Apple Is Free"

New in the Temporary Regulations is the initial contract exception to the Intermediate Sanctions rules. Fixed payments made to an individual pursuant to an initial contract between that individual and an organization, even if by virtue of that contract the individual becomes a disqualified person, are no longer subject to the Intermediate Sanctions rules. To qualify for the exception, the transaction must meet 3 requirements:

  • The payments made to the individual must be fixed -- either a fixed amount of cash or property or an amount determined by a fixed formula. An amount determined by a fixed formula may incorporate a number that depends on future events, as long as the organization has no discretion in determining that number.
  • The contract must be a written contract between the organization and an individual who is not a disqualified person prior to entering into the contract.
  • The individual must substantially perform the obligations under the contract.

If an initial contract may be terminated or canceled by the organization at will, the contract will be treated as a new contract as of the earliest date it may be canceled. Further, if a material change is made to an initial contract, it will be treated as a new contract as of the date the change is effective. For a new contract to qualify for the initial contract exception, it must pass the same 3-point test outlined above.

Fixed payments made pursuant to an initial contract may qualify for the initial contract exception, even if the contract also contains provisions for non-fixed payments. Any non-fixed payments, such as performance-based bonuses, would, however, be subject to the Intermediate Sanctions rules.

Rebuttable Presumption

Like the Proposed Regulations, the Temporary Regulations provide that a transaction is presumed reasonable, and therefore not an excess benefit transaction, if three conditions are met: First, the compensation arrangement or terms of the transaction must be approved in advance by an authorized body of the organization, no members of which have a conflict of interest with respect to the arrangement or transaction. Second, the authorized body must have obtained and relied on appropriate data as to comparability before making its determination (such as comparing the proposed compensation for an officer to that of officers of comparable organizations -- non-profit or for-profit -- for similar services under similar circumstances). Finally, the authorized body must have adequately documented the basis for its determination concurrently with making its determination.

The Temporary Regulations clarify that the IRS may only rebut the presumption with sufficient contrary evidence to rebut the probative value of the comparability data relied upon, and only with evidence relating to facts and circumstances existing at the time of the contract (for a fixed payment) or at the time of the payment (for a non-fixed payment). In other words, the IRS may not use hindsight to rebut the presumption that a transaction is not an excess benefit transaction.

Although the Temporary Regulations do not state how many comparables a larger organization must review, a safe harbor is provided for compensation paid by small organizations with annual gross receipts of less than a million dollars: Data from 3 (reduced from 5 in the Proposed Regulations) other comparable organizations is appropriate data.

Safe Harbor for Organization Managers

The Temporary Regulations expand a safe harbor for organization managers who fully disclose the facts of a transaction and rely on the written opinions of "appropriate professionals," including legal counsel, certified public accountants and independent valuation experts, that a transaction was not an excess benefit transaction. The manager would then not be considered to have knowingly participated in the excess benefit transaction and therefore would not be liable for the 10% tax. In addition, a manager will not be considered to have knowingly participated in an excess benefit transaction if he or she relies on the fact that the rebuttable presumption requirements were met.

Correcting an Excess Benefit Transaction

A disqualified person who receives an excess benefit must "correct" the transaction in order to avoid the 200% excise tax. Under the Temporary Regulations, the disqualified person must repay the excess benefit amount, plus interest computed at a rate at least as high as the applicable federal rate.

Disqualified Persons

The Temporary Regulations clarify who may be a person in a position to exercise substantial influence over the affairs of an organization (and therefore a disqualified person). Substantial influence is determined by reference to the individual's actual powers, not by title alone. A president, CEO, COO, CFO and treasurer are not, per se, persons having substantial influence. While it would be rare that a person holding such a title would not have substantial influence, the Temporary Regulations provide a senior officer the opportunity to demonstrate that he or she does not have ultimate responsibility for implementing the decisions of the governing body or for supervising the management, administration, or operation of the organization, in the case of president, CEO or COO, or for managing the finances of the organization, in the case of a treasurer or CFO.

Persons deemed not to have substantial influence are all 501(c)(3) organizations, including private foundations, and, with respect to transactions with social welfare organizations, other social welfare organizations. The list of factors tending to show substantial influence no longer includes a key advisor to a person with managerial authority. Lower-level employees whose supervisors are not disqualified persons are no longer likely to be considered disqualified persons.

Additional Points of Note

Other noteworthy provisions of the Temporary Regulations include:

  • An organization must clearly indicate its intent to treat an economic benefit as compensation for services rendered or the IRS will not take into account the value of the services in determining the reasonableness of the benefit. The Temporary Regulations require contemporaneous written substantiation of this treatment; reporting the compensation on a Form W-2 or Form 990 will satisfy this standard.
  • Government entities under Section 115 are not subject to the Intermediate Sanctions rules, even if they have a Section 501(c)(3) determination letter.
  • Specifically included in the definition of excess benefit transactions are amounts embezzled by a disqualified person from an organization.
  • Revenue-sharing transactions between a disqualified person and an organization will be evaluated under the same rules as other transactions, although the Service has reserved space for future regulations regarding the treatment of such transactions.
  • Fringe benefits excluded from income for income tax purposes are generally disregarded for purposes of the Intermediate Sanctions rules.
  • While the Temporary Regulations provide no specific guidance with respect to payments from donor-advised funds, the Service has requested comments on the issue.

For questions or further information concerning Section 4958 or the Temporary Regulations, contact M. Antoinette Thomas (212-238-8713, or Lisa Factor Fox (212-238-8866,

Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2018 Carter Ledyard & Milburn LLP.
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