Exempt Organizations Advisory - Revocation of Exempt Status for Excess Benefit Transactions: IRS Issues Final Regulations

Catherine W. Wilkinson (cwilkinson@steptoe.com)
Suzanne Ross McDowell (smcdowell@steptoe.com)
Randal T. Evans (revans@steptoe.com)

On March 27, the IRS issued final regulations under IRC sections 501(c)(3) and 4958 which explain when the IRS will not only impose excise taxes under Section 4958 but will also revoke the tax-exempt status of an organization that engages in excess benefit transactions.  The final regulations clarify the standards and examples set forth in the proposed regulations (70 Fed. Reg. 53599).
The proposed regulations described five factors which the IRS will consider, along with all other facts and circumstances, when determining if an organization should continue to be recognized as exempt.  The IRS revised the five factors in the final regulations to reflect the comments it received.  The five factors in the final regulations are:  

(A)  The size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after the excess benefit transaction or transactions occurred;

(B)  The size and scope of the excess benefit transaction or transactions (collectively, if more than one) in relation to the size and scope of the organization’s regular and ongoing activities that further exempt purposes;

(C)  Whether the organization has been involved in multiple excess benefit transactions with one or more persons;

(D)  Whether the organization has implemented safeguards that are reasonably calculated to prevent excess benefit transactions; and
(E)  Whether the excess benefit transaction has been corrected (within the meaning of section 4958(f)(6) and §53.4958-7), or the organization has made good faith efforts to seek correction from the disqualified person(s) who benefited from the excess benefit transaction.

Treas. Reg. § 1.501(c)(3)-1(f)(2)(ii).

In the final regulations, the IRS changed the language of factors (C) and (D).  In the proposed regulations factor (C) used the word “repeated” instead of “multiple.”  In the preamble to the final regulations, the IRS states that “multiple” refers to:

(1) Repeated instances of the same (or substantially similar) excess benefit transactions, 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.    

In factor (D), the IRS replaced the phrase “prevent future violations” with “prevent excess benefit transactions” to clarify that safeguards implemented by an organization either before or after it engages in an excess benefit transactions will be treated as a factor weighing in favor of continuing exempt status.  

The IRS added a new example to those in the proposed regulations that illustrates that post-audit correction and removal of the disqualified person may not be required for continued exemption if other facts favorable to the organization are present.  This new example also addresses reasonable compensation.