an organization. One is a per se test based on the person's role in the organization and the second is a facts and circumstances test. The per se test treats the following persons as disqualified persons: (1) voting members of the governing body; 107 (2) the president, chief executive officer or chief operating officer who "has or shares ultimate responsibility for implementing decisions of the governing body or supervising the management, administration, or operation of the applicable organization"; 108 (3) treasurer or chief financial officer or any other individual who "has or shares ultimate responsibility for managing the organization's financial assets and has or shares authority to sign drafts or direct the signing of drafts, or authorizes electronic transfers of funds, from organization bank accounts"; 109 and (4) "[p]ersons with a material financial interest in a provider-sponsored organization."110 Persons in these roles are per se disqualified persons, as are the members of their family and entities in which they (individually or as a group) hold 35 percent control. Nevertheless, a transaction between an applicable tax exempt organization and a disqualified person is not an excess benefit transaction unless there is excess value for the disqualified person. It is important to understand that the first three categories are also organization managers and that they can be subject to two levels of excise tax if the transaction is an excess benefit transaction, one level of tax is that levied on disqualified persons and the other is the tax levied on organization managers. 111 A facts and circumstances test may result in treatment of certain other persons as disqualified persons based. Under the proposed regulations, factors "tending to show that a person has substantial influence over the affairs of the organization, include, but are not limited to" the following: (4) (5) the person controls or determines a significant portion of the the person has managerial authority or serves as a "key adviser" to such a (6) the person owns a controlling interest in an entity that is a disqualified person. (7) the person is a nonstock organization controlled, directly or indirectly, by one or more disqualified persons. 113 112 These factors can be established by a contractual relationship with the organization. The Temporary Regulations provide an example of a taxable entity that contracted with an applicable tax exempt organization to manage its bingo games. The contract gave the taxable entity authority to make all the decisions relating to the bingo operation, which provided over half of the exempt organization's annual total revenue. The same company “manages a discrete activity of [the exempt organization} that represents a substantial portion of [the exempt organization's] income compared to the organization as a whole"114 The management company is a disqualified person with respect to the exempt organization. 115 The temporary regulations provide an exception to the disqualified person rules for the period of the initial contract between the exempt organization and the person. This initial contract exception applies only to "fixed payments" which includes certain revenue-based compensation. 116 This "first bite rule" means that Treasury now explicitly invokes the inurement and private benefit principles as a safeguard against abuse in this area. This alone means simplification by repealing the leadership inurement provisions is no longer feasible. c. Excess Benefit Transactions Section 4958(c) defines two types of excess benefit transactions. The first and more general definition defines an excess benefit transaction is a transaction between an applicable tax exempt organization and a disqualified person "if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing it."117 The second definition relates to revenue sharing transactions that result in inurement. It is not clear why the second definition is stated separately or what relationship is intended between inurement and the excess benefit transaction provisions. Each of these provisions is discussed below. 112 113 118 Prop. Treas. Reg. § 53.4958-3(e)(2)(I)-(vi). Prop. Treas. Reg. § 53.4958-3T(a), Example 5. The excess value transactions described in section 4958 is the core of section 4958. Without an element of excess value, section 4958 does not apply to a transaction even if one of the parties to the transaction is a disqualified person. This is the essential difference between the section 4958 excess benefit transaction provisions and the section 4941self-dealing rules applicable to private foundation. The private foundation self-dealing rules prohibit transactions to which disqualified persons are parties even if those transactions are priced at fair market value and are beneficial to the organization. For example, a substantial contributor's lease of property to an exempt organization at a rent below the prevailing market rate violates the self-dealing rules simply because the substantial contributor is a disqualified persons who is a party to the transaction. If the same transaction were conducted by a section 501(c)(3) public charity or a section 501(c)(4) organization, section 4958 would not apply because the transaction produced no excess value for the disqualified person. In this sense, section 4958 is consistent with the prevailing concept of inurement, which also requires some evidence of an excess value, whether monetary or intangible. The temporary regulations applicable to excess value transactions provide guidance on determining when a transaction involves an excess benefit.119 The key inquiry is whether the contract amount is reasonable based on comparable transactions, including comparable based on transactions involving taxable entities. Determination of the reasonableness of a contract for the purchase or use of property is based on the standard defined by a transaction between "a willing buyer and a willing seller, neither being under any compulsion to buy, sell or transfer property or the right to use property, and both having reasonable knowledge of relevant facts. "121 The temporary regulations do not elaborate, but they clearly establish the need for an excess value as a precondition for the application of section 4958. Determination of the excess value of compensation for services is also based on reasonableness as determined by comparisons with amounts that "would ordinarily be paid for like services by like enterprises under like circumstances. The temporary regulations provide a list of items to be considered in determining whether compensation is reasonable. 123 ,,122 Section 4958(c)(2) refers to revenue sharing transactions that result in inurement. There has been much confusion over the intended purpose of this provision and its relation to the general excess value definition of an excess benefit transaction. The possibility exists that this is simply a drafting mistake added late in the drafting process to ensure that revenue sharing transactions would not be prohibited per se under the general excess value standard. In practice, this statutory provision has raised questions about revenue sharing transactions and about whether the reasonableness standard applies to them. In sum, it may have a result directly contrary to the intent of the drafters. This second definition of an excess benefit transaction should logically be part of the first definition. 124 Whether the excess benefit is defined as a share of an organization's revenue or as a fixed sum or by some other measure should all be variants of the general principle that an excess benefit arises where all the value received by a disqualified person exceeds the consideration that the disqualified person provided. In the Proposed Regulations, the Treasury treated the second definition of an excess benefit transaction as a definition of structural inurement in which the disqualified person benefits at the expense of the exempt organization. 125 The logic for this position is that in revenue sharing each party receives a share of a fixed amount, so that as the amount received by the disqualified person increases, the amount received by the exempt organization necessarily decreases. The same is true, however, of any payment for goods or services. The Proposed Regulations then treat the entire amount received by the disqualified person, not simply the excess benefit, as subject to the excise tax sanctions. This position is based on the definition of the excess benefit in terms of the inurement. Section 4958(c)(2) states that in this case "the excess benefit shall be the amount of the inurement not so permitted." The Treasury's position would mean that inurement is defined in terms of the entire amount received and not as the excess over any reasonable amount for the goods or services provided. Section 4958(c)(2) states that it applies "to the extent provided in regulations." The consequence of this position is that inurement is defined without any reasonableness component. The history of inurement as a general antiabuse provision that supports revocation of exemption means that questions of extent of inurement have not been addressed. It does appear, however, that inurement turned not on control but on an excess over a reasonable amount. The issue that Treasury highlighted in its Proposed Regulations on structural excess benefit transactions is one that does not fit within either inurement as currently understood or 124 One reasonable reading of Sec. 4958(c)(2) is that is serves to highlight revenue sharing transactions as one type of excess benefit transaction because it states that "the term 'excess benefit transaction' includes" revenue sharing transactions that constitute inurement. (Emphasis added) Under this reading, the reasonableness limitation that is part of the definition of an excess benefit transaction in Sec. 4958(c)(1)(A) would be read into Sec. 4958(c)(2). 125Prop. Treas. Reg. § 53.4958-5. 126 section 4958 as currently drafted. The reference to inurement in section 4958(c)(2) simply compounds the confusion and complexity. The problem with the regulations is that they represent an effort to translate the issue of the absence of a public benefit into the presence of an excess benefit transaction. Treasury did not issue these proposed regulations in temporary form. 127 Whether Treasury and the Service now offer guidance on the relationship between excess benefit transactions and public benefit remains to be determined. This paper suggests that the proposed regulations provide a beginning for such an analysis. 6. Approaches to Simplification Three private benefit doctrines apply to at least some exempt organizations. Might it be possible to remove one or two of these doctrines from the Code, at least in the case of section 501(c)(3) and section 501(c)(4) organizations? The answer appears to be no. The most likely simplification would be to repeal inurement and rely solely on section 4958. However, the new temporary regulations issued in January 2001 created situations where the regulations explicitly rely on inurement as an anti-abuse provision. 128 There is one change to section 4958 that would constitute both simplification and clarification. This is the recommended repeal of section 4958(c)(2), which includes in the definition of an excess benefit transaction a revenue-sharing transaction that constitutes inurement. This is the only time that section 4958 refers explicitly to inurement. It is not clear why there is a special rule for revenue sharing transactions. It would appear that the intent of section 4958(c)(2) is to provide that revenue sharing transactions are treated like any other transaction. The proposed regulations, however, used section 4958(c)(2) as the statutory authority for a special rule for revenue sharing transactions that had a very different result. Whatever one thinks of the proposed regulation, any statutory provision capable of such misinterpretation should be repealed. The most reasonable explanation of this provision is that it was a drafting error. Assuming the original intent was to treat revenue sharing transactions under the general rules, no special rule is needed. 130 129 126 127 Prop. Treas. Reg. § 53.4958-5. Temp. Treas. Reg. § 53.4958-5T simply notes that it is "reserved". The preamble to the temporary regulations states that the general excess benefit transaction standards will apply unless or until regulations applying specifically to revenue sharing transactions are issued. 66 Fed. Reg. 2144, 2153 (Jan. 10, 2001). 130 The temporary regulations apply the general excess benefit transaction provisions to revenue sharing transactions. See Temp. Treas. Reg. §53.4958-4T. |