Report on Exempt Organization Compensation Released;
IRS: Non-Compliance "Huge"

Approximately 46% of the inquiries sent by the Internal Revenue Service in connection with its recent exempt organization compensation initiative resulted in the filing of amended returns or selection for audit, an amount that the IRS describes as "huge". In connection with this initiative, the IRS assessed $21,000,000 in excise taxes against 40 disqualified persons and organization managers.

The IRS initiated a two-phase compensation initiative in 2004 focusing on the level of compliance with compensation reporting (Phase I) and the intermediate sanctions rules (Phase II) by exempt organizations. Based on the responses provided by organizations in the first two phases, the IRS initiated Part III to perform an additional 200 compliance checks and 50 single-issue examinations focusing on insider loans.

According to a preliminary report released by the IRS, the initiative revealed the existence of "significant reporting issues" by exempt organizations, as 31% of the 1,123 organizations contacted in Phase I filed amended returns and an additional 15% were selected for audit based on their responses. However, as only 25 of the 782 organizations selected for audit in Phase II were assessed excise taxes, the IRS believes there is no cause for "widespread concern" about compensation abuses involving exempt organizations, although "continued work" in the area is warranted.

Among the more significant findings by the IRS;

• Only 51% of organizations attempted to satisfy all three-prongs necessary to establish a rebuttable presumption of reasonableness for intermediate sanctions purposes, and only 54% obtained comparability data;

• None of the 50 large public charities contacted who reported compensation in excess of $250,000 filed schedules detailing the compensation of their officers and employees as required by Form 990;

• Only 11% of the excess benefit transactions reported by public charities were corrected before the organization was contacted by the IRS and none of the disqualified persons involved reported the transactions; and

• 53% of the loans made by public charities to disqualified persons were made on more favorable terms that commercial loans, and 31% of these loans were not repaid in accordance with their stated terms.

The IRS is very concerned about the compensation practices of tax-exempt organizations, and all indications are that it will continue to heavily scrutinize this area. Common problems identified by the IRS include the failure to report all compensation, such as spousal travel, personal automobiles and non-accountable plan reimbursements. In addition, the almost total failure of organizations to correct or report excess benefit transactions suggests that the IRS will develop enforcement mechanism to ensure compliance in this arena. The low-level of compliance with reporting indicates that additional guidance on Form 990 is also warranted.

Surprisingly, the initiative revealed that fewer tax-exempt organizations than anticipated properly invoked the rebuttable presumption of reasonableness to avoid the application of the intermediate sanctions excise tax. Generally, use of the rebuttable presumption is considered to be a "best practice" for exempt organizations. As a result, the fact that only 51% of organizations contacted even tried to establish the rebuttable presumption is cause for some concern.

Tax-exempt organizations should carefully consider and review their compensation practices in light of these developments. Organizations and board members should ensure that they understand their tax reporting obligations and the compensation packages approved for disqualified persons. Organization should pay particular attention to ensure that all elements of compensation that are considered for intermediate sanctions purposes are considered to avoid the creation of an "automatic" excess benefit.

To assist tax-exempt organizations, Bricker & Eckler LLP has developed a compensation resource center . This resource center provides information about the various laws limiting their ability to provide deferred compensation to executives. Over time, this resource center will be expanded to include additional information specific to tax-exempt organizations, including a discussion of intermediate sanctions.

Revised 990 Instructions Released;
Compensation from "Related Organizations" Clarified

The Internal Revenue Service has provided information about the 2006 Form 990 information returns, highlighting some of the major changes. The information is available through the IRS website.

Form 990 requires organizations to disclose the amount of compensation provided to officers, directors/trustees, key employees and other "disqualified persons". Disclosure must also be made for former officers, directors/trustees and key employees, if they received compensation in the reporting period. The most significant changes to the 2006 Form 990 relate to the disclosure of compensation paid to these insiders by related organizations.

Form 990 has historically required organizations to disclose the compensation paid to insiders by related organizations. In 2005, the IRS proposed an extremely broad definition of related organization that included six categories of organizations it felt has a sufficiently "close connection" to be related. Ambiguities in the 2005 Form 990 led to widespread criticism, and the IRS revised the 2006 Form 990 to clarify the relationships requiring disclosure of compensation.

The 2006 Form 990 now defines a "related organization", for purposes of the compensation disclosure rules, to include the following eight specific relationships:

1. One organization owns or controls the other organization;

2. The same person(s) owns or controls both organizations;

3. The organizations have a relationship as supporting and supported organizations under section 509(a)(3);

4. The organizations use a common paymaster;

5. The other organization pays part of the compensation that the organization would otherwise be contractually obligated to pay;

6. The organizations are partners in a partnership or members in an LLC or other joint venture (other than a publicly traded partnership);

7. The organizations conduct joint programs or share facilities or employees; and

8. One or more persons exercise "substantial influence" over both organizations.

For purposes of making these disclosures, the IRS defines:

• "Disqualified person" by reference to the intermediate sanctions rules;

• "Substantial influence" by the intermediate sanction rules;

• "Ownership" to mean the hold holding (directly or indirectly) of 50% or more of the voting power in a corporation, profits interest in a partnership, or beneficial interest in a trust; and

• "Control" to mean having 50% or more of the voting power in a governing body, or the power to appoint 50% or more of an organization's governing body, or the power to approve an organization's budgets or expenditures (an effective veto power over the organization's budgets and expenditures). Also, control can be indirect by owning or controlling another organization with such power.

The 2006 Form 990 contains several reporting exceptions for:

• Banks or financial institution trustees: If the organization and the other organization are related only because they are both controlled or substantially influenced by a common trustee that is a bank or financial institution, the organization does not need to report either the relationship or the trustee's compensation from the related organization;

• Common independent contractors: If an independent contractor listed in Schedule A, Part II-A or II-B does not exercise substantial influence, as defined above, over either the organization or the related organization, the organization does not need to report either the relationship or the independent contractor's compensation from the related organization. However, this exception does not apply to a management services company that performs for the organization functions similar to those of president, chief executive officer, chief operating officer, treasurer or chief financial officer. Compensation paid by a related organization to such a management company must be reported by the organization unless another exception applies; and

• Volunteers: If Relationship #2 is met only because the same individuals control both the tax-exempt organization and a for-profit organization that is not owned or controlled directly or indirectly by one or more tax-exempt organizations, and Relationships #1, #3 and #6 do not apply, then the tax-exempt organization does not have to report the compensation from the for-profit organization of any persons serving the tax-exempt organization as a volunteer without compensation

Organizations are required to report the name of the insider receiving compensation from a related organization, the name and EIN of each related organization paying compensation to an insider, and a description of the relationship. For Relationships #1 through #6, the organization must also disclose the amount of compensation (and allocate it among various categories as well); organizations are not required to disclose the amount of compensation paid to insiders in Relationship #7 and #8.

IRS Clarifies Exempt
Organization Shelter Penalties

The Tax Increase Prevention Reconciliation Act of 2005 added section 4965 to the Internal Revenue Code imposing excise taxes on each tax-exempt organization who is a "party" to a prohibited tax shelter and the organization "knew or had reason to know" the transaction was prohibited.

The IRS issued Notice 2007-18 on February 7, 2007 clarifying the definition of "party" for purposes of these rules. According to the notice, a "party" is a tax-exempt organization that enters into a prohibited tax shelter reducing its liability for federal taxes, such as employment, excise and unrelated business income tax. The IRS did not, however, that the term "party" used in the statute is broader than the interim definition provided in the notice.

The notice appears to clarify that normal investment activity by tax-exempt organizations, such as participation in tax-credit partnerships, need not be disclosed.

Quick Hits

• Track pending state legislation and other federal and state developments on our website.

• Internal Revenue Service issues "suggested" governance practices for tax-exempt organizations. Find a link to the special alert on our website.

• The Senate Finance Committee introduced federal legislation (S. 469) that would make the charitable deduction available for qualified conservation easements, enacted by the Pension Protection Act of 2006 and set to expire on December 31, 2007, permanent.

• On February 6, 2007, the IRS issued Notice 2007-21 and invited interested parties to comment on issues required for study by the Pension Protection Act for donor advised funds and supporting organizations. The IRS is seeking input on how the charitable contribution deduction should be calculated for contributions to a donor a dvised fund and about the appropriate payout requirements.

• IRS has provided information about "group exemptions" for tax-exempt organizations. The group exemption is a useful tool that organizations such as parent-teacher and booster organizations, large national organizations with many local offices, and churches. The publication is available through the IRS website.

• Abuses involving the improper use of tax-exempt organizations and charitable deductions remains on the IRS's annual "Dirty Dozen" of tax. The IRS specifically identified donations to donor advised funds and supporting organizations, the overvaluation of property donations, and disguised tuition payments as areas of concern. The full list is available on the IRS website.