United States: New Temporary Regulations On Intermediate Sanctions

Co-written by Andrew M. Ferris, Travis L. Blais, Charolette F. Noel and David S. Boyce

As has been widely reported, the Treasury Department and the Internal Revenue Service recently issued comprehensive Temporary Regulations governing so-called intermediate sanctions under § 4958 of the Internal Revenue Code of 1986, as amended (the "Code"). As will be discussed, for the most part these Temporary Regulations continue the basic scheme laid out in the Proposed Regulations that have been in effect for several years, and these new Temporary Regulations provide tax-exempt health care organizations with a practical, workable regulatory scheme.

In several respects, the Temporary Regulations will make it easier for tax-exempt health care organizations to operate in today's highly competitive environment (e.g., under the Temporary Regulations, it is easier to design incentive compensation arrangements for physicians than was the case under the Proposed Regulations). On the other hand, in least one instance -- the status of physicians whose only relationship to the exempt health care provider is that of a "high admitter" to a hospital -- the Temporary Regulations are deliberately vague. Each of these situations, and other comparable situations, will be discussed in detail below.

Excess Benefit Transaction. If a "disqualified person" enters into a transaction with an applicable tax-exempt organization, and the tax-exempt organization pays that disqualified person more than fair market value for the property or services received in exchange by the tax-exempt organization, or if the tax-exempt organization receives less than fair market for property or services provided to the disqualified person, then the parties have engaged in an excess benefit transaction.

Two Potential Taxes on Disqualified Person. A disqualified person is any person who currently, or within the last five years, has been in a position to exercise "substantial influence" over the affairs of the applicable tax-exempt organization. A disqualified person who participates in an excess benefit transaction is subject potentially to two excise taxes:

• 25 Percent First-Tier Tax. The first tax is equal to 25 percent of the difference between the amount paid and the fair market value of the services or property received in exchange. Thus, if a disqualified person is paid $200,000 for services worth only $100,000, the excess benefit amount is $100,000, and the penalty is $25,000.
• 200 Percent Second-Tier Tax. The second tax is an additional tax equal to 200 percent of the excess benefit amount. On the foregoing the example, the second tax would be $200,000. If not corrected as described below, the two penalties on a combined basis would amount to $225,000.

Correction. Correction is a rescission-type remedy that requires the disqualified person to repay, in most instances in cash, an amount equal to the excess benefit plus interest at the applicable federal rate for the period over which the transaction remains uncorrected.

Abatement. The second-tier tax of 200 percent must be abated if the transaction is corrected as described above. The first-tier tax of 25 percent may be abated if the disqualified person's participation in the transaction was due to reasonable cause and not due to willful neglect.

Organization Manager Tax. In addition to the potential taxes on the "disqualified person," the "organization managers" within the applicable tax-exempt organization who authorized the tainted transaction become subject to a 10 percent penalty (capped at $10,000 per transaction) if their participation in the transaction was knowing, willful, and without reasonable cause. For the most part, organization managers who are disinterested with respect to the transaction (i.e., have no financial interest in the transaction) will not be subject to this penalty if they exercise the appropriate level of due diligence with respect to a transaction, and they make a contemporaneous record of the fact that they are disinterested and have engaged in due diligence.

No Excise Taxes on Exempt Organization. Section 4958 does not impose any excise tax on the applicable tax-exempt organization for participation in an excess benefit transaction. The taxes are only imposed on disqualified persons and organization managers.

Duty to Report Excess Benefit Transactions. The exempt organization does have duty to report any such transactions that have occurred during the year on its Form 990. As will be discussed below, this will create problems with respect to transactions with "high admitter" physicians, due to the uncertain status of "high admitters" as disqualified persons under the Temporary Regulations.

Statute of Limitations. If the transaction is reported on the exempt organization's Form 990, the statute of limitations is three years from the date of occurrence. If the transaction is not reported on the exempt organization's Form 990, the statute of limitations is six years from the date of occurrence.

Risk to Tax-Exempt Status. To the extent that an excess benefit transaction is part of a larger pattern of noncompliant behavior by the organization, it may be a significant factor in any decision by the Internal Revenue Service to seek revocation of the organization's exempt status. In general, revocation is only supposed to occur where the excess benefit transaction is part of a pattern of conduct that indicates that the organization is no longer operated as an exempt organization.

In determining whether a person is a disqualified person with substantial influence over the organization's affairs, the Temporary Regulations create three categories: (i) persons who will always be disqualified persons, (ii) persons who will never be disqualified persons, and (iii) persons who may or may not be disqualified persons, depending upon the circumstances.

Always. Those always qualifying as disqualified persons include those who are members of the organization's governing board, chief executive and chief operating officers, treasurers, and chief financial officers.

Never. Those who are never disqualified persons are persons who do not fit within one of the foregoing categories and who earn less than $85,000 per year and who are not substantial contributors to the organization. In addition, § 501 (c)(3) organizations cannot be disqualified persons, and § 501 (c)(4) organizations cannot be disqualified persons with respect to other § 501 (c)(4) organizations, though they can be disqualified persons with respect to § 501 (c)(3) organizations.

Maybe. For those in the facts and circumstances category, factors tending to indicate that the person is a disqualified person include: (i) being a founder of an organization, (ii) being a substantial contributor to an organization, (iii) receiving compensation from the organization that is primarily based on revenues derived from activities of the organization that the person controls, (iv) having or sharing authority to control or determine a substantial portion of the organization’s capital expenditures, operating budget, or compensation for employees, and (v) managing a discrete segment or activity of the organization that represents a substantial portion of the activities, assets, income, or expenses of the organization, as compared to the organization as a whole.

Nonexclusive List. The foregoing "maybe" factors are a nonexclusive listing of the factors that may be used. This will be important with respect to the status of physicians as disqualified persons.

In General. As required by the Legislative History to § 4958, the Temporary Regulations reject the notion once espoused by the Internal Revenue Service that all physicians, regardless of relationship to the organization, are "insiders" and adopt, instead, the view that whether a physician is a disqualified person depends on where the physician fits within the foregoing always, never, and maybe categories. The examples in the Temporary Regulations contain examples of physician relationships with exempt hospitals, but those examples are generic and are not overly helpful in categorizing physician relationships.

Uncertain Status of "High Admitters." Most importantly, the Temporary Regulations are deliberately silent with respect to physicians whose only relationship to the institutions is that of a "high admitter," and when asked about this relationship in public meetings, Internal Revenue Service officials give deliberately vague and nonresponsive answers. Based on the factors in the Temporary Regulations, one can make arguments both ways about such individuals or groups.

Potential Conflicts with "High Admitters -- Duty To Report Excess Benefit Transactions." The physicians will always argue (i) that they are not overcompensated, and (ii) with some justification, that they do not fit within the definition of disqualified person. While the penalties are imposed on the disqualified person, and not the exempt organization, the exempt organization faces other risks. First, there are potential penalties on the institution's representatives, the "organization managers," who face the potential application of the 10 percent organization manager penalty. Second, there is a duty on the organization to report any excess benefit transaction to the Service on the organization's Form 990 for the year in which the transaction occurs, and there are penalties for failure to file accurate and complete returns that may be triggered if a transaction goes unreported. This will require the organization to make a determination as to whether or not to report a borderline transaction, which can cause difficulties with the physicians involved if the organization reaches a different conclusion than the physician as to the physician's status and determines it has to disclose the transaction in question on its Form 990. Third, as will be discussed below, even if the transaction is not subject to intermediate sanctions penalties, the relationship with the high admitter may create a risk to the institution's tax-exempt status under the private benefit doctrine.

Following the Seventh Circuit's opinion in the United Cancer Council case, the Temporary Regulations make clear that regardless of the terms of an initial contract between an applicable tax-exempt organization and a person who might otherwise be a disqualified person, benefits paid pursuant to an initial contract can never trigger excise taxes under § 4958 of the Code. Thus, if an organization hires a CEO who has no prior relationship with the organization, the contract with the CEO, whatever its terms, cannot give rise to intermediate sanctions penalties.

However, again following the Seventh Circuit's opinion in United Cancer Council, it is also clear that while the initial contract may not trigger excise tax penalties, it may constitute excessive private benefit, thus jeopardizing the organization's tax-exempt status. In addition, while the "first bite" protection from penalties lasts the life of the initial contract, the exemption from penalty taxes is subject to a variety of important qualifications and limitations, including the following:

• Substantial Performance. The "first bite" protection disappears if the disqualified person does not substantially perform under the contract.
• Material Modification. The "first bite" protection disappears if the contract is substantially modified after it is initially entered into.
• Unilateral Termination Rights. If the contract gives the exempt organization the unilateral right to terminate the contract at a certain time without substantial penalty, then the Temporary Regulations treat the contract as being a new contract entered into at the first point the organization could excise such termination rights, thus triggering the application of the intermediate sanctions rules from that point forward. For example, if the contract has an initial term of three years, with the organization having the right to terminate at the end of the first year on 90 days' notice, then the contract would cease to be exempt from intermediate sanctions penalties at the end of the first year.
• Fixed Payments. The "first bite" protection extends only to "fixed payments" under the contract. Fixed payments include fixed annual amounts and variable amounts determined by reference to a known index (e.g., a percentage of revenues). Nonfixed payments are any payments where the organization has the ability to exercise discretion as to whether to pay an amount or how much to pay. Contracts may contain both fixed payments subject to the first bite protection, and non-fixed payments subject to scrutiny under the Temporary Regulations.

Approach under Proposed Regulations. The Proposed Regulations contained a series of rules dealing with revenue-based compensation. These rules were the subject of much discussion and controversy during the pendancy of the Proposed Regulations. Essentially, the Proposed Regulations stated that revenue-based compensation arrangements would be permitted if they provided benefits to the service provider that were proportional to the benefits received by the exempt organization from the arrangements. Benefits would be proportional if the only way the service provider could benefit from the arrangement was to provide a concomitant, and proportional, benefit to the exempt organization in a manner that advanced the exempt purposes of the organization.

Structural Nature of Proposed Regulation Approach. The Proposed Regulations also provided that the proportionality rules were structural in nature, and that an arrangement could fail the proportionality test even though the service provider did not receive more than fair market value for the services provided under the arrangement. In that regard, the Proposed Regulations stated that while the Regulations were in Proposed form, only the excess benefit would be subject to penalty (i.e., the difference between fair market value and the amount received). However, once the Regulations became final, the entire amount of the benefit received by the service provider, again, whether or not in excess of fair market value, would be subject to intermediate sanctions penalties.

Fair Market Value Approach of Temporary Regulations. The Temporary Regulations "reserve" for future issuance the portion of the Regulations dealing with revenue-based compensation. The Preamble also makes clear that during the tenure of the Temporary Regulations, revenue-based compensation will be judged by the same standards as fixed compensation. That is, these arrangements will be judged by whether or not they produce fair market value compensation. This approach will make it much easier to create incentive compensation arrangements that will pass muster under the applicable rules. In general, if the correct process is used to review and approve the arrangement (see discussion below), and if the service provider is being paid only for services personally provided by the service provider, the arrangement should pass muster as long as the compensation is not excessive and the arrangement does not otherwise contain unreasonable or noncommercial terms and conditions.

Role of "Caps" under Temporary Regulations. The Temporary Regulations also make clear that caps on the amount of compensation received will be a favorable factor in determining whether or not compensation is reasonable. On the other hand, caps are not an absolute requirement, and we believe that incentive compensation arrangements that do not contain hard dollar caps can pass muster under these rules as long as the arrangement does not result in excessive compensation and contains a variety of structural safeguards to protect the interests of the exempt organization.

The Basics of Triggering the Presumption. The Temporary Regulations make no material changes in the process for obtaining the rebuttable presumption of reasonableness. The basic process is still as follows: (i) ensure that the decisions are made by detached and disinterested representatives of the organization who do not have a conflict of interest with respect to the transaction, (ii) ensure that the representatives engage in proper due diligence as to the fair market value nature of the transaction, and (iii) ensure that the decision-making process is contemporaneously documented in the manner set for in the Temporary Regulations.

Use of Internally Generated Comparability Data. With respect to the due diligence as to fair market value, the Temporary Regulations make it clear that organizations do not have to hire expensive outside consultants to generate legitimate comparability data. Organizations can use internally generated data as long as (i) the individuals compiling the data have the appropriate expertise for the task at hand, (ii) the individuals compiling the data are disinterested (i.e., do not have a conflict with respect to the transaction), (iii) the individuals are supervised by an individual or committee that does not have a conflict, and (iv) the board or committee reviewing the data compiled either have the expertise themselves to interpret the data presented or have access to someone to advise them with respect to the data.

The Importance of Process. It is important to try to trigger the presumption where possible. However, actually triggering the presumption may not be as important as engaging in a good-faith effort to do so. It is our view that the process an organization follows in determining whether an excess benefit transaction has occurred is every bit as important as the conclusion the organization reaches after following the process. To a very large degree, if the process is proper (even if the presumption is not technically triggered), the conclusion the organization reaches will not be second-guessed by the Internal Revenue Service, and if it is second-guessed, the parties involved will be more likely to prevail against IRS challenge, to protect the organization's tax-exempt status, and to obtain abatement of any penalties that ultimately may be imposed.

The Temporary Regulations continue the uneasy and uncertain relationship between imposition of excise taxes under the intermediate sanctions rules and the continuation or revocation of the organization's tax-exempt status.

Excise Taxes Generally the Sole Penalty. On the one hand, no penalties are imposed on the organization under § 4958, and the Preamble to the Temporary Regulations, following the Legislative History to § 4958 of the Code, indicates that generally, the excise taxes under § 4958 will be the sole penalty imposed in most circumstances. Revocation of tax-exempt status will be triggered only where the transaction giving rise to the intermediate sanctions penalty is part of a larger pattern of noncompliance that causes the institution no longer to be operated as a tax-exempt institution.

General Substantive Standards Apply as Well. On the other hand, the Temporary Regulations also make clear that § 4958 does not affect the substantive standards for tax exemption under § 501(c)(3) or (4), including the requirements that the organization be organized and operated exclusively for exempt purposes, and that no part of its net earnings inure to the benefit of any private shareholder or individual. Thus, regardless of whether a particular transaction is subject to excise taxes under § 4958, existing principles and rules may be implicated, such as the limitation on private benefit. For example, transactions that are not subject to § 4958 because of the initial contract exception discussed above may, under certain circumstances, jeopardize the organization’s tax-exempt status. This fact, coupled with the somewhat ambiguous status of "high admitters" as disqualified persons, will make the "private benefit" doctrine more important today than either excess benefits under § 4958 or traditional private inurement.

Private Benefit Standard. Private benefit does not require insider or disqualified person status. As applied by the IRS, private benefit requires that the benefit to the person dealing with the exempt organization be both "qualitatively" and "quantitatively" "incidental." In the hospital-physician context, it is usually relatively easy to establish that the arrangement is qualitatively incidental, as physicians are a necessary concomitant to providing health care services. However, whether the arrangement is quantitatively incidental is often more difficult to determine. This will include whether the arrangement provides for more than fair market value, and in addition, it will include inquiries into whether other aspects of the arrangement provide unnecessary benefits to the physician.

Relationship of Private Benefit and Excess Benefit Taxes. In many cases, the analysis under the new Temporary Regulations will, therefore, be the initial step in determining whether an arrangement is proper. In addition, the transaction will also have to be vetted under the private benefit rules, which are (i) more murky and less certain than the private inurement and excess benefit rules, (ii) do not result in penalties for the persons dealing with the institution, thus lessening the incentive of those individuals to be sensitive to the exempt organization's need to comply with these rules, and (iii) do carry with them the risk of revocation of tax-exempt status.

Current IRS Approach to Excess Benefit Transactions. Therefore, depending on how the IRS approaches the uncertain relationship between excise taxes under § 4958 and revocation of tax-exempt status, it remains to be seen whether the intermediate sanctions rules will produce the level of certainty about tax-exempt status that was anticipated when § 4958 of the Code was first enacted. So far, the Service has moved slowly and deliberately. It has asserted the penalties so far only in what appear to egregious cases, and on audit, any assertion of penalties under §  4958 is required to go to mandatory technical advice at the national office level of the Service, thus ensuring careful consideration and uniform application of these rules.

Temporary Regulations have the force and effect of Final Regulations, except that they are effective only for a three-year period from date of issuance. The Temporary Regulations were also issued in Proposed Regulation Form, enabling the Treasury and Internal Revenue Service to continue to take comments on the manner in which the Temporary Regulations operate in practice and to make changes if warranted. The Service has urged practitioners and exempt organizations subject to the Regulations to submit comments on where the new rules work and where they cause problems. Internal Revenue Service officials have stated that they anticipate that the Temporary Regulations will be issued in final form prior to the expiration of their three-year life, perhaps as early as the end of 2001.