Exempt Organizations Advisory - IRS Issues Proposed Regulations on Interaction Between IRC Sections 501(c)(3) and 4958

The IRS has published proposed regulations on the standards for recognition of tax-exempt status if private benefit exists or if an applicable tax-exempt organization has engaged in excess benefit transactions.

IRC Section 1.501(c)(3)-1(d)(1)(ii) states that if an organization is organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests, then that organization is not a 501(c)(3) organization. The proposed regulations amend current 501(c)(3) regulations, adding several examples to illustrate the requirement in Section 1.501(c)(3)-1(d)(1)(ii) that an organization serve a public rather than private interest.

The proposed regulations also add a new paragraph (g) to Section 1.501(c)(3)-1 which addresses the interaction between IRC Section 501(c)(3) and IRC Section 4958. Section 4958 imposes an excise tax on a disqualified person who engages in a transaction with a 501(c)(3) organization that provides an excess economic benefit to the disqualified person. Heretofore, the IRS’ position has been that "the imposition of excise taxes under Section 4958 does not foreclose revocation of tax-exempt status in appropriate cases." The proposed regulations clarify that the IRS also has discretion to refuse to issue a ruling recognizing 501(c)(3) status to any applicant whose purpose or activities violate any provision of Section 501(c)(3), including the inurement prohibition and the limitation on private benefit, even though such violation could serve as grounds for imposing a Section 4958 excise tax if the applicant’s tax-exempt status were recognized.

New paragraph (g) of the proposed regulations also provides guidance as to how the IRS will determine whether revocation of tax-exempt status is appropriate when Section 4958 excise taxes also apply. In determining whether to continue to recognize the tax-exempt status of a 501(c)(3) organization that engages in one or more excess benefit transactions that violate the prohibition on inurement, the Commissioner will consider all relevant facts and circumstances, including, but not limited to, the following:

• 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;
• 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;
• Whether the organization has been involved in repeated excess benefit transactions;
• Whether the organization has implemented safeguards that are reasonably calculated to prevent future violations; and
• Whether the excess benefit transaction has been corrected, or the organization has made good faith efforts to seek correction from the disqualified persons who benefited from the excess benefit transaction.

Written comments regarding these proposed regulations and requests for a public hearing must be received by December 8, 2005. Comments may be submitted electronically or via the Federal eRulemaking Portal at IRS-REG-111257-05.

For more information on this topic, please contact Catherine W. Wilkinson or Suzanne Ross McDowell.

The Exempt Organization Advisory is a general summary of the law and is not intended as specific legal advice for any organization.

Internal Revenue Service - Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.

For more information on this topic, please contact the authors or the attorneys with whom you usually work at Steptoe.

Questions and comments about the Exempt Organizations Advisory are always welcome and should be sent to bstone@steptoe.com.