United States: IRS Proposes Regulations Outlining When Intermediate Sanction Violations Warrant Revocation of Exemption

Since the beginning of the federal income tax laws until 1995, revocation of tax exemption was the only penalty available to the Internal Revenue Service ("IRS") when a Section 501(c)(3) organization engaged in activities that violated the requirements for exemption. Concern that the draconian nature of revocation limited its use and that, at least for private inurement violations, revocation punished the organization and the community it served and not those who wrongfully benefited from, or were responsible for the transaction, led Congress to enact the intermediate sanctions rules in 1995. For the first time the IRS was armed with monetary penalties that could be lodged against private individuals who unfairly benefited in inurement transactions with exempt organizations, as well as against officers, directors and others who approved or otherwise participated in the transaction.

Committee reports accompanying the 1995 legislation clarified that intermediate sanctions were not intended to supplant the revocation of exemption, but were an additional weapon in the enforcement of the exempt organization laws.

In the preamble to the intermediate sanction regulations proposed in 1998, the IRS listed four factors that it would consider in determining whether intermediate sanction violations also warranted revocation of exemption.

In the preamble to re-proposed and temporary regulations issued in 2001, the IRS similarly noted its intent to publish additional guidance regarding the factors it would consider in determining whether revocation was warranted.

On September 9th of this year, the IRS published proposed regulations outlining these factors. They are:

• The size and scope of an organization's regular and ongoing activities that further its exempt purposes;

• The size and scope of the organization .s intermediate sanction violations relative to the size and scope of its activities that further exempt purposes;

• Whether the organization has been involved in repeated excess benefit transactions;

• Whether the organization has adopted safeguards reasonably designed to prevent future intermediate sanction violations; and

• Whether the organization has corrected (or made reasonable efforts to correct) intermediate sanction violations once discovered by recovering the ill-gotten gain.

This new enumeration of relevant factors differs from those outlined in the preamble to the 1998 proposed regulations by also considering the size and scope of an organization's activities in furtherance of its exemption, and whether the organization has taken appropriate corrective action. By considering corrective action once wrongdoing is discovered (and the size and scope of an organization's exempt activities), the new proposed regulations attempt to strike a fair balance between an organization.s good and bad actions and, particularly in this era of heightened tax law enforcement, refreshingly encouraging rehabilitation rather than punishment.

The proposed new regulations illustrate these factors with a series of positive and negative examples. One involved an art museum that had received a determination of exemption under Section 501(c)(3). Soon after its formation, the organization.s board was dominated by local art dealers, who repeatedly caused the organization to purchase art from them at inflated prices, in clear violation of intermediate sanctions. Applying the foregoing factors, the IRS reasoned that the size and scope of the organization.s regular and ongoing activities, which were limited to the display and sale of art purchased from its directors, did not further exempt purposes, that the organization's intermediate sanctions violations were frequent and significant in size and scope, that the organization undertook no corrective action, and therefore, that the exemption was properly revoked. Another example involved the same facts except that after one year of operation as just described, the organization replaced its board with community members skilled in the operation of educational programs and institutions with no ties to art dealers, adopted a general conflict of interest policy which specifically prohibited the purchase of art from former or current directors, adopted art valuation guidelines and hired a lawyer to recover the excess purchase amounts paid to its former directors. The IRS reasoned, based on the altered facts, that because the museum revised its operating policies and practices, the organization had became engaged in substantial regular and ongoing activities in furtherance of its exempt purposes; and while its former practices constituted substantial and repeated intermediate sanction violations, its revised policies and practices provided adequate safeguards to prevent future violations so that, over time, the former violations would become less and less significant in relation to its exempt activities; and with the hiring of counsel to recover the excess amounts previously paid, the IRS concluded that the museum had taken sufficient good faith corrective efforts, and that revocation of its exemption was not warranted. Other examples take a similar approach.

If the proposed regulations are to be faulted, it is in their presentation of black and white examples, without the nuance or shading that confounds the "real world." For example, what if an art museum operated in a manner consistent with the revised set of facts except that it had no conflict of interest policy or art valuation guidelines, and had one art dealer on its board who sold one painting to the museum at a somewhat inflated price. Upon discovering the inflated price, to the surprise of both the museum and director, they promptly and voluntarily arranged for a return of the excess amount paid, but the museum did not remove the director from its board or take any other corrective action. In addition, neither party reported the transaction under the intermediate sanctions regulations or paid any penalties, preferring instead to "keep it quiet." Whether revocation would be warranted under these facts is not so clear under the proposed new regulations. Nonetheless, given the paucity of cases that have considered when revocation is justified, and the inherent limitations of prescribing clear guidance in an area dependent on a weighing of all the relevant facts and circumstances, the IRS can hardly be faulted for not including more in the way of "real life" situations.

In addition, and somewhat enigmatically, the proposed regulations also address the private benefit doctrine by proposing to add some new examples to the existing Section 501(c)(3) regulations. These proposed examples are enigmatic because, unlike private inurement, which can occur only if there is a transfer of exempt assets without fair market value consideration given in exchange, private benefit can occur, as the new examples amply illustrate, regardless of the existence of any "excess benefit." transaction.

A good example of the private benefit doctrine is the American Campaign Academy case, which involved an educational organization that instructed in the mechanics of running political campaigns. The case held that while the organization had an educational function, it failed to qualify for exemption because it limited its programs to the members of a single political party, and therefore primarily served private interests more than incidentally, even though the students fairly compensated the school for the instruction provided, and no private inurement was involved. In short, the connection between the new private benefit examples, on the one hand, and private inurement and intermediate sanctions, on the other, is not apparent.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.