Weinberg, Jacobs & Tolani, LLP
Separate Penalty Taxes On Management:
A Close Look At How Managers Are Jeopardized
By Intermediate Sanctions
By Mark B. Weinberg, Esquire 1996
September 25, 1996
The new legislation attempts to build upon lessons learned from administration of the
Private Foundation rules that have been in place for over 25 years, plugging loopholes
that appeared over that time. As with the Private Foundation rules, however,
administrative difficulties will be encountered in applying the Intermediate Sanctions.
Some of these are obvious now, others will appear in time. An Organization Manager is
at risk for transactions in which he or she participates that provided excess benefit either
to a disqualified person or to themselves. The interrelationship between the two
exposures is complex and confusing; considerable effort by the Service, counselors and
the leaders of nonprofit organizations will be required to clarify this situation.
Parallels To and Differences From The Private Foundation Rules
Initial Taxes. As regards the imposition of Initial Taxes against Organization
Managers, the statutory standards are identical to those contained in the Private
Foundation provisions of Chapter 42.
Imposition of the 10% tax upon Organization Managers by Code
§4958(a)(2) occurs only when a tax is imposed under Code §4958(a)(1). If
the Foundation tax provisions are any guide (and in this respect I think they are),
this does not require assessment or notice of a tax against a Disqualified Person,
but merely that Congress, through the statutory provision, has imposed a tax
liability that can be enforced by the Service. Wasie v. Commissioner, 86 T.C. 962
(1986). In other words, if a tax could be asserted for an Excess Benefit
transaction and an Organization Manager knowingly participated in it, wilfully
and without reasonable cause, he or she can be hit with the 10% tax, even though
no tax is proposed by the Service against any Disqualified Person. This would be
the case, for example, where the disqualified person is judgement proof.
Foundation Managers are subject to a tax on their "participation" (in an act of
self-dealing under Code Section 4941 or a jeopardizing investment under Code
Section 4944) or their "agreement" (to a taxable expenditure under Code Section
4945) "knowing that it is [an act of self-deal, a jeopardizing investment, or a
taxable expenditure, respectively], unless such participation or agreement "is not
wilful and is due to reasonable cause." Those taxes are to be paid by any
foundation manager who participated in the self-dealing or the jeopardizing
investment or agreed to the taxable expenditure.
Organization Managers are subject, under the new law, to tax on their
"participation" in the excess benefit transaction , knowing that it is such a
transaction . . ., unless such participation is not willful and is due to reasonable
cause." Code § 4958(f)(2). That tax "shall be paid by any organization manager
who participated in the excess benefit transaction. Id.
It appears that this 10% tax can be in addition to any 25% tax imposed on the
individual as a Disqualified Person, for example in the case of an Excess Benefit
Transaction that directly benefits a Chairman of the Board of Directors of a public
charity or social action group.
While a literal reading of Section 4958(a)(1) and (f)(1) could subject an
Organization Manager to both the 25% tax and to the 10% tax on transactions in
which he or she did not receive a personal benefit, this seems to be at odds with
the overall structure of those provisions; indeed, one would have expected either
the statute or the House Report to clearly state an intention to double up these
penalties in virtually every case if that was their intention.
Definition of Organization Manager
The new law defines differently from the Private Foundation Rules just who is a
member of management with respect to a given action. A Foundation
Manager is an officer, director, or trustee of a foundation [or an individual
having powers or responsibilities similar to those of such persons], and as to any
act or omission, "the employees of the foundation having authority or
responsibility with respect to that act [or omission]." Code §4946(b). An
Organization Manager is merely any officer, director or trustee of such
organization [or any person having similar powers or responsibilities]." Code
§4958(f)(2).
In other words, responsibility for the action taken is not part of the definition of
an Organization Manager. Nevertheless, in determining who is an Organization
Manager, the House Report states that "the Committee intends that principles
similar to those set forth in regulations issued under section 4946 and 4955 with
respect to final authority or responsibility for an expenditure be applied. (See
Treas. Reg. Secs. 534946-1(f)(1)(ii), 53.4946-1(f)(2), 53.4955-1(b)(2)(ii)(B),
and 53.4955-1(b)(2)(iii))." id. at n.13. Without such a reference, the Service
might have contended that this difference in the language between the
Foundation rules and those for intermediate sanctions would justify holding more
people responsible for an action, including an "innocent bystander" such as the
Secretary who takes minutes of the Executive Committee meeting at which he or
she is unable to vote. A more reasonable reading of this history would be that it
was intended to reduce the number of persons subject to the 25% tax on
disqualified persons; if a responsible officer participated knowingly and wilfully in
the excess benefit transaction, the 25% tax would still apply, regardless of
whether they were an officer or not, but there is no need to make them
responsible based upon their office.
Another question: Who precisely has authority equivalent to that of a director,
trustee or officer of a given public charity or social action group? The universe of
private foundations is very limited compared to that of other 501(c)(3) groups
and their 501(c)(4) brothers and sisters. With such a diversity of organizational
structures, the Service may be tempted to reach out and touch people far from the
center of the organization's nominal leaders. Some have questioned whether
standards as broad as those employed by agents seeking to impose liability on
"responsible persons" under Code §6672 might be employed; In any event, it is a
good bet that this inherently factual question will lead to litigation and
speculation among members of the Service, the bar, accountants and the
nonprofit community.
Once a person ceases to be an officer, director, trustee or person holding such
powers, his or her actions will no longer be subject to the 10% tax of Code
§4958(a)(2). This does not mean they are out of the woods, however; if their
previous position gave them substantial influence over the organization's affairs,
they are subject to the 25% tax under Code §4958(f)(1) for 5 years as
Disqualified Persons.
An interesting quandary: Are the leaders of wholly or partially owned subsidiaries
of public charities and 501(c)(4)groups Organization Managers or otherwise
subject to the Intermediate Sanctions. The statute makes it clear that
corporations, partnerships and trusts in which Disqualified Persons and their
families have at least a 35-Percent interest, are themselves Disqualified Persons.
Code §4958(f)(1)(C). The legislative history implies that a person cannot avoid
responsibility for influencing a parent nonprofit to undertake an Excess Benefit
Transaction merely because he or she is employed only by the subsidiary. See H.
Rep. No. 104-506, 104th Cong., 2d. Sess. 59, fn. 3 (1996). It is not clear,
however, whether the ability to influence decisions in a wholly or partially owned
subsidiary is itself an independent ground for being classed a Disqualified Person
vis a vis the parent(s). It seems clear that the subsidiary itself, if it is neither a
public charity nor a 501(c)(4) organization, can deal with its directors and
officers who are not in a position to influence the nonprofit parent, without being
affected by the Intermediate Sanctions. Aside from the literal language of the
statute (which I believe dictates this result), it would be anomalous to restrict
subsidiaries from dealing with their own executives in this way, since a major
policy behind permitting nonprofits to invest in subsidiaries is to allow them to
separate out functions that would otherwise endanger the parent's exempt status
and, in the case of for-profit subs, to put them on an equal footing with privately
owned businesses.
Knowledge & Willfulness Required to Impose Tax
What must an Organization Manager know and when must he or she know it for
the Initial Tax to be imposed? If the Private Foundation rules are any indication,
as I believe they are, the manager must (i) have actual knowledge of facts that
would support treating the action as an Excess Benefit transaction, (ii) be aware
that there are limit on Excess Benefit transactions and (iii) negligently fail to
make reasonable attempts to ascertain whether this was an Excess Benefit
transaction. Private Foundation Reg. §53.4945-1(a)(2)(iii). Some have
characterized this rule as rewarding ignorance. In reality, it is unlikely (though
possible) that the fundamental facts needed to determine a tax is due will evade
an Organization Manager in the usual case.
Willfulness, for private foundation purposes, merely requires that the act of the
manager be undertaken voluntarily, consciously and intentionally, not that there
be evil intent. Private Foundation Reg. §53.4945-1(a)(2)(iv). In a cryptic bit of
hair splitting, the Private Foundation regulations state as follows:
"No motive to avoid the restrictions of the law or the incurrence of any tax
is necessary to make an agreement willful, however, a foundation
manager's agreement to a taxable expenditure is not willful if he does not
know that it is a taxable expenditure."
That means, if the person does not know facts that would make an act a taxable
expenditure, he lacks the necessary knowledge and willfulness. Since knowledge
of market conditions and comparative value is much more subjective than merely
knowing whether an act has taken place, it will be more difficult to prove this
type of knowledge in an excess benefits case than it is to prove the objective
knowledge called for in many self-dealing cases.
From another view, however, this reduces willfulness to little more than a second
knowledge requirement. The knowledge and willfulness provisions appear to
have been so narrowly viewed in the 4945 regulations, as endorsed by the courts
(Thorne v. Commissioner, 99 T.C. 67 (1992), that they will save only those who
are truly clueless or have gotten extremely bad tax advice from qualified
professionals. In short, if the Private Foundation approach is adopted in
interpreting these qualifiers ("knowing and willful"), they will require a level of
knowledge that will be absent in many cases, but little more than that.
The burden of proof as to whether an Organization Manager "knowingly"
participated in an Excess Benefit transaction is on the government. Code
§7454(b). It has been debated as to whether this merely means the government
must first establish a prima facie case, or must establish the existence of
knowledge by clear and convincing evidence. Rule 142(c) of the Tax Court,
which is derived from Code §7454(b) makes it clear that, if the Private
Foundation rules are to serve as an example, the government will have to meet
the clear and convincing evidence rule. See, Larchmont Foundation, Inc. v.
Commissioner, 72, T.C. 131 (1979).
Additional Taxes
As with the Private Foundation provisions, the new Intermediate Sanctions
impose an Additional Tax if there is no "Correction" of the transaction within
the "Taxable Period." For this purpose, "Correction" means undoing the excess
benefit transaction to the extent possible and taking any added measures needed
to place the organization in a financial position no worse than it would have
enjoyed if the disqualified person were dealing under the highest fiduciary
standards; this definition is drawn almost verbatim from Code § 4941(e)(3).
Interestingly, however, the new law calls for "additional measures necessary" to
place the organization in that financial position, whereas Section 4941(e)(3) calls
for "placing the private foundation in that position." It is not clear from the
House Report whether the changed language was intended to modify the level of
activity required of the offending parties.
Abatement of Tax
The new law intended to permit abatement of the initial tax where the taxpayer
can establish to the satisfaction of the Service that the taxable event was due to
reasonable cause and not to willful neglect, and the event was corrected within the
correction period for such event. Code §4962. Unfortunately, Code §4962 operates off
of a definition of Qualified First tier tax, which §4962(b) defines without reference to
the new tax under Subchapter D; in short, there technically is no abatement available for
the new initial taxes under the statute. This appears to be a technical error that ought to
be corrected when the various fixes required by this legislation are addressed.
Abatement of the additional taxes can occur only if the taxable transaction is corrected
during the correction period (i.e., before the Service issues its notice of proposed
deficiency or "90 Day Letter"). Code §4961.
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