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of the members upon dissolution or if distributed to some subset of members in redemption distributions.75 The Service has ruled that liquidating distributions to the members upon the dissolution of the social club and the sale of its assets did not constitute inurement. Redemption of one member's stock at book value at the time of redemption did not constitute inurement even though book value at the time of the redemption exceeded the purchase price."

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Many of the same issues arise with respect to inurement in the context of section 501(c)(8) fraternal benefit societies. Differential benefits to members that are disproportionate to the dues paid by various categories of members constitute inurement. In most cases, a social club will not jeopardize its exempt status on inurement grounds if it has a class of members that receives no benefits. However, the Tax Court has held that a fraternal benefit society organized in a way that results in 90 percent of the members' receiving no benefits did violate the inurement prohibition and thus was not exempt. The principle is that the dues paid by members who do not receive benefits may not be used to fund benefits for other members.79

78

Cemetery associations described in section 501(c)(13) are also subject to an inurement prohibition.80 Excess payments of whatever form to organizational insiders will be treated as prohibited inurement, but it is not clear whether every instance of such inurement will trigger revocation. In addition, cemetery associations are generally organized as stock corporations. Issuance of dividend with respect to common stock constitutes prohibited inurement. A cemetery association may not issue preferred sock, but there are transition rules relating to the retirement of outstanding preferred stock.81

Various revenue-sharing arrangements are treated as inurement in the context of section 501(c)(13) cemetery associations. The most common are so-called equity sales arrangements in which sales of property are made to a cemetery for a percentage of the association's net

75 These distributions of assets to members of section 501(c)(3) organizations would

violate the dissolution clause.

76 Rev. Rul. 58-501, 1958-2 C.B. 262. Gen. Couns. Mem. 39658 (Aug. 27, 1987) takes the position that liquidating distributions of the net proceeds from the sale of a social club's assets used in the performance of the club's exempt function does not jeopardize the club's exempt status, but the social club its taxable on the sale.

77 Rev. Rul. 68-639, 1968-2 C.B. 220.

78

Polish Army Veterans Post 147 v. commissioner, 24 T.C. 891 (1951), remanded, 236 F.2d 509 (3rd Cir. 1956).

79 Rev. Rul. 64-194, 1964-2 C.B. 149.

80

Sec. 501(c)(13) expresses its inurement prohibition in the familiar language stating that "no part of the net earnings of which inures to the benefit of any private shareholder or individual."

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earnings. In addition, any debt obligation that provides for an interest payment in whole or in part defined as a percentage of net earnings will be treated as inurement.

Voluntary Employee Beneficiary Associations ("VEBAS") are also subject to an inurement prohibition. Under section 501(c)(9) VEBAs exempt purpose is to pay "life, sick, accident, or other benefits to the members" or the members' dependents or designated beneficiaries. The VEBA will be exempt "if no part of the net earnings of such association inures (other than through such payments) to the benefit of any private shareholder or individual." The regulations define inurement as "[t]he disposition of property to, or the performance of services for less than the greater of fair market value or cost (including indirect costs) to the association.' »84 Whether any transaction constitutes inurement depends on the facts and circumstances of each case. As in the case of other mutual benefit associations, inurement in the context of a section 501(c)(9) VEBA includes both excessive compensation to insiders and disproportionate benefits among members.

85

Payment of disproportionate benefits to the members constitutes inurement in the context of a section 501(c)(9) VEBA.86 The regulations provide that "the payment to any member of disproportionate benefits, where such payment is not pursuant to objective and nondiscriminatory standards, will not be considered a benefit...»87 As an example of this principle, the regulations provide that "payment to highly compensated personnel of benefits that are disproportionate in relation to benefits received by other members of the association will constitute prohibited inurement."88 A second type of disproportionate benefits involves distinctions among benefits to members who are not otherwise distinguishable. The regulations state that "payment of similarly situated employees of benefits that differ in kind or amount will constitute prohibited inurement unless the difference can be justified on the basis of standards adopted pursuant to the terms of a collective bargaining agreement.' 89 The concept of disproportionate benefits turns largely on the concepts sets forth in the provisions relating to discrimination in favor of highly compensated employees." The regulations state that “[i]n

85

Id., which states that the regulations provide "guidelines" that "are not an exhaustive list of the activities that may constitute prohibited inurement, or the persons to whom the association's earnings could impermissibly inure."

C

general, benefits paid pursuant to standards or subject to conditions that do not provide for disproportionate benefits to officers, shareholders, or highly compensated employees will not be considered disproportionate."

,,91

92

9,93

As is the case for most membership mutual benefit associations, including social clubs, a VEBA may make liquidating distributions to its members upon dissolution of the organization without having such distributions treated as inurement." The limitations are that such distributions must be made "pursuant to criteria that do not provide for disproportionate benefits to officer, shareholders, or highly compensated employees of the employer.' The regulations further provide that "a distribution to members upon dissolution of the association will not constitute prohibited inurement if the amount distributed to members are determined pursuant to the terms of a collective bargaining agreement or on the basis of objective and reasonable standards which do not result in either unequal payments to similarly situated members or in disproportionate payments to officers, shareholders, or highly compensated employees of an employer contribution to or otherwise funding the employees' association."94

5. Excess Benefit Transactions

a. Background and Overview

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In 1996 Congress added section 4958 to the Code.95 Section 4958 defines a new concept described as an excess benefit transaction and levies sanctions on "disqualified persons" and "organization managers' who engage in such transactions. The sanctions levied on the disqualified persons and organization managers are excise taxes on the amount of the excess benefit.98 The exempt organization itself is not subject to these excise tax sanctions under section 4958.

Section 4958 was the end product of a call for an "intermediate sanction" in the case of inurement. The original concept was that some sanction other than revocation of exempt status

91

92

Id., which cross-references Treas. Reg. § 1.501(c)(9)-2(a)(2) and (3) on this point.

Treas. Reg. § 1.501(c)(9)-4(d).

93 Id., which cross-references Treas. Reg. § 1.501(c)(9)-2(a)(2) for definition of highly compensated employees of the employer.

94 Id.

95 The excess benefit transactions provisions were part of the Taxpayer Bill of Rights 2, Pub. L. 104-168, 110 Stat. 1452 (1996).

was required because revocation could be either inappropriately harsh or unacceptably inconsequential. It may appear counterintuitive to suggest that revocation can be too harsh or too inconsequential, but that result is the heart of the problem of relying solely on revocation. Revocation is an inappropriately harsh sanction when it applies to an organization with established programs of exempt and the amount involved in the inurement transaction is very small compared with the scope of the public benefit being provided. In these cases, revocation disrupts relationships with the contributors and deprives the public of the benefits of the organization's activities consistent with its exempt purposes.

Revocation is unacceptably inconsequential, amounting to no more than temporary inconvenience, in the case of organizations that serve nonspecific beneficiaries, such as "the public" in a very general sense, and have one or two funders who regard the organization as the equivalent of an alter ego. Revocation does not disrupt the relationship with the funding sources since they will simply establish a new organization to conduct the same activities. Revoking the exempt status of an organization that no longer operates and no longer has resources is meaningless with respect to the organization. The process is meaningful only if the Service is prepared to deny the charitable contribution deduction in cases where these organizations operated as section 501(c)(3) organizations.

Monetary sanctions, so-called intermediate sanctions, addressed both of these cases. In cases where revocation is inappropriately harsh, monetary sanctions can be levied on those who benefited from the inurement without imposing sanctions on the beneficiaries of the organization's programs. In cases where revocation is unacceptably inconsequential, sanctions can be levied on those who manipulated exemption for their own benefit.

Section 4958 attempts to clarify the two unresolved issues that arise under inurementthe identity of the insiders and the nature of the transactions that trigger sanctions. In addressing these issues, section 4958 draws on elements of the private foundation self-dealing provisions as well as on elements of the inurement concept applicable to public charities. The self-dealing provisions prohibit persons with certain relationships to the organization from engaging in certain identified transactions. Inurement is a facts and circumstances determination in which the reasonableness of the compensation is taken into account. Section 4958 seeks to identify disqualified persons and transactions requiring special scrutiny but unlike the private foundation self-dealing provisions, it is based on facts and circumstances determinations in which reasonableness of the end result is one of the factors considered.

Section 4958 applies only to section 501(c)(3) and section 501(c)(4) organizations or to any organization that was such an organization during the five-year period ending on the date of

99 Sec. 4941.

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the excess benefit transaction. Section 4958 does not apply to a foreign organization that receives "substantially all of its support from sources outside the United States."101

Disqualified Persons and Organization Managers

The parties to an excess benefit transaction are disqualified persons and organization managers. Both concepts have been derived from the self-dealing provisions applicable to private foundations. The organization manager concept is also based in part on the definition of an organization manager for purposes of the section 4955 excise tax on excess campaign activity by a section 501(c)(3) organization. A transaction entered into by an organization manager with a person who is not a disqualified person does not trigger the excise taxes of section 4958. It is rather less straightforward to claim that a transaction between a disqualified person and the organization entered into by a person who is not an organization manager would not trigger section 4958. The answer in this second case depends on whether an organization manager is defined by position or whether the actual ability to bind the organization means, in effect, that any transaction entered into by an employee can be an excess benefit transaction if the organization in fact performs pursuant to the agreement entered into by the employee, even if the agreement was beyond the scope of the employee's normal authority.

b. Disqualified Persons

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A disqualified person is any person "in a position to exercise substantial influence over the affairs of the organization" at any time during the five-year period ending on the date of such transaction102 and the members of such person's family. 103 Family is defined for this purpose as the disqualified person's spouse, siblings and their spouses, ancestors, and descendants through great grandchildren and their spouses. An entity in which one or more disqualified persons holds at least 35 percent control is also a disqualified person. Control is defined for this purpose as "combined voting power" in a corporation, a profits interest in a partnership and a beneficial interest in the case of a trust or an estate. The regulations set forth two tests for determining whether a person is in a position to exercise substantial influence over the affairs of

100

101

Sec. 4958(e).

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105

Temp. Treas. Reg. § 53.4958-2T(a)(2) applies this exception to section 501(c)(3) organizations and Temp. Treas. Reg. § 53.4958-2T(a)(3) applies this exception to section 501(c)(4) organizations.

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Temp. Treas. Reg. § 53.4958-3T(b)(2). Constructive ownership rules apply so that control is based on both direct and indirect ownership. Temp. Treas. Reg. §53.4958-3T(b)(2)(iii).