Weinberg & Jacobs, LLP; Commentary

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.