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IRS policing of tax-exempt organizations

By Charles R. Brodbeck, Esq. & Mark R. Stabile, Esq.

Officers, directors and administrators (including physicians) of nonprofit health care organizations should be alert to the risk of personal liability for so-called excess benefit transactions under the recently-passed Taxpayers’ Bill of Rights II (the Act).

Excess benefit transactions—similar to the familiar concept of private inurement—are prohibited under the Internal Revenue Code (Code). Unlike private inurement, which can be a serious threat to the tax-exempt status of the nonprofit organization itself, excess benefit transactions can result in the assessment of financial penalties directly against the individuals involved.

The Act permits the Internal Revenue Service (IRS) to impose stiff penalty taxes (known as “intermediate sanctions”) on anyone having substantial influence over a tax-exempt organization, who is overpaid for the goods and services he or she provides to the organization. Persons with substantial influence can include officers, directors, trustees, and in certain instances, physicians. The IRS also has the power to penalize others in the organization who authorized the overpayment, or excess benefit transaction. These sanctions apply to all 501(c)(3) public charities and 501(c)(4) social welfare organizations.

Previously, excess benefit transactions were not distinguished from other forms of private inurement. The only recourse the IRS had against such transactions (or similar forms of private inurement) was to strip the nonprofit organization of its tax-exempt status. The IRS has been reluctant to use this extreme measure because it penalizes the organization rather than the culprit and threatens the existence of an otherwise valuable nonprofit organization.

The 1993 Congressional hearings which sparked the drive for this new legislation highlighted some of the more egregious abuses to which intermediate sanctions could apply: provision of cars, club memberships, lucrative severance packages and other luxury items to organization executives and payment of “excessive” salaries (salaries greater than $200,000 per year were cited as examples).

Under the new Act, the IRS has the power to assess penalty excise taxes directly against the person who benefits from (the “disqualified person”) and persons in a position to prevent (the “organization manager”) an “excess benefit transaction.” These penalty taxes may be applied retroactively to transactions occurring on or after September 14, 1995. As indicated above, an “excess benefit transaction” is any transaction in which the economic benefit provided by a tax-exempt organization to a disqualified person is greater than the value of the consideration received from that disqualified person.

Who is at Risk?

“Disqualified persons” fall into three categories:

• Any person who at any time during the five-year period prior to the excess benefit transaction was in a position to exercise substantial influence over the affairs of the organization. Persons having “substantial influence” likely will be interpreted to include officers, directors and trustees, as well as others, such as physicians who are not necessarily named officers, but nonetheless hold influential positions at tax-exempt health care providers.

• A member of the family of a disqualified person.

• A corporation, partnership, trust or estate in which a disqualified person has a 35 percent interest.

An “organization manager” includes any officer, director or trustee of the organization as well as any individual having powers or responsibilities similar to those of an officer, director or trustee of the organization. To date, the term “organization manager” has not been interpreted by IRS regulations. As the Act is written, however, the term could include hospital chiefs of staff and medical department heads.

What are the Penalties?

Initially, a tax of 25 percent of the overpayment may be imposed upon the disqualified person. In addition, a tax of 10 percent of the overpayment (up to a $10,000 maximum per overpayment) may be imposed on any organization manger who knowingly participated in the transaction, unless that participation was unwilling or due to reasonable cause.

If corrective action is not taken within a specified time period, usually within 90 days of receiving notice from the IRS, an additional tax of 200 percent of the overpayment may be imposed upon the disqualified person. Corrective action usually will require repayment to the organization of any excess benefit and any other steps needed to ensure that the organization is in a position no worse than if the disqualified person had operated under the highest fiduciary standards.

Risks to Physicians

In general, all relations between physicians and tax-exempt health care organizations are susceptible to both excess benefit transactions and private inurement risks. Intermediate sanctions, however, will only apply if a physician participates in such a transaction as organization manager or is in a position of substantial influence over the organization and benefits from such a transaction.

For physicians in positions of substantial influence over tax-exempt organizations, excess benefit transactions can arise in a number of areas (many of which already are vulnerable to characterization as private inurement): hospitals and physicians as joint investors in PHOs; executive compensation; hospital purchase of primary care practices; physician-as-employee compensation; and rental terms for physician office space in a hospital. As these and the following examples indicate, potential problems can emerge in a number of ways and may trigger additional legal consequences:

• Payments to physicians in positions of substantial influence could give rise to excess benefit allegations, and also could be interpreted as compensation for referrals, threatening the organization’s tax-exempt status and exposing the physician to charges under Medicaid fraud and abuse statutes.

• Unreasonably high compensation to physicians in positions of substantial influence paid in return for agreeing to participate in an integrated delivery system involving a tax-exempt organization could be an excess benefit transaction.

• “Excessive business use” of hospital bond-financed facilities by a physician can threaten the tax-exempt status of a hospital’s bonds and be an excess benefit transaction if the physician is in a position of substantial influence.

• The purchase of a physician practice, with or without the hiring of the physician subsequent to the purchase, must reflect fair market value, or it could be an excess benefit transaction if the physician ultimately assumes a position of substantial influence at the tax-exempt organization.

In each of the foregoing examples, there is and always has been risk to the nonprofit organization. With the passage of the new Act, however, physicians in positions of substantial influence may now face personal liability in the form of stiff penalty taxes (as may anyone, including physicians, holding the position of organization manager who was involved in the transaction).

Minimizing Risk of Excess Benefit Excise Taxes

Physicians and tax-exempt health care institutions can avoid excess benefit transactions by negotiating all transactions with disqualified persons at arm’s length and by ensuring that payments made by the institution for the purchase of assets or services and payments received by the institution for the sale of assets or services reflect fair market value.

Tax-exempt health care institutions should consider securing a third-party analysis of key employment contracts, particularly if a physician has perceived worth above market average and is being compensated accordingly. Ideally, independent appraisers should analyze all wages, fringe benefits and purchase prices for goods, services and lease terms. Although this may not be practical in all instances, it should be easy to identify the relationships that may be at risk for excess benefit characterization. In such cases, it is important to have documentation justifying all financial terms.

In general, therefore, in light of this new IRS enforcement tool, board members, officers and administrators of nonprofit organizations particularly and physicians who serve in these roles should:

• Identify and correct any overpayment for goods or services provided by officers, directors, trustees or others with substantial influence over the organization and made on or after September 14, 1995 (the Act exempts transactions occurring prior to January 1, 1997 if pursuant to a contract made on or before September 13, 1995).

• Implement policies to assure that the consideration paid for such goods or services is based upon comparable offers or bids for similar goods or services in the same geographic location.

• Document carefully and completely reasons for payment decisions for such goods or services, especially when the person paid is in a position of substantial influence over the organization.

The Taxpayers’ Bill of Rights II is intended to curb abuses of tax-exempt status while preserving the integrity of nonprofit organization. This new law should be welcomed by officers and directors of nonprofit organizations. It provides the IRS with a sanction less severe than revocation of tax-exempt status and one which pinpoints a problem within a nonprofit organization without destroying the whole organization.

Charles R. Brodbeck, Esq., is a Director and Mark R. Stabile, Esq., is an Associate with the national law firm of Cohen & Grigsby, headquartered in Pittsburgh.

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