The Privilege of Tax Exemption
"A matter of legislative grace - not constitutional right."

By James E. Guinn & David O. Middlebrook 1996
Published in the January/February issue of "Ministries Today" Magazine

Many believe that the First Amendment to the United States Constitution requires the government to grant tax exempt status to churches and other religious organizations. However, while it is true that our tax system has long granted tax exempt status to religious organizations, nothing in the Constitution actually commands the granting of such tax exemptions. In fact, in recent years, numerous courts have held that it is constitutionally permissible for the government to tax the income of religious and charitable organizations. Therefore, only those organizations that comply with the organizational and operational requirements set forth by Congress in sections 501(c)(3) of the Internal Revenue Code may avail themselves of the privilege of federal tax exemption.

It would be difficult to overstate the value of the privilege of tax-exempt status. Accordingly, religious organizations should always be cognizant of the need to protect this asset. As a crucial first step in protecting its tax exempt status, an organization must clearly recognize that this exemption is benevolently granted by the government. As such, the government possesses the right and the authority to revoke it. Where the resources of the organization are not used for "exempt" purposes, what was freely given by the government can be quickly taken away.

In the past, the only punishment for improper expenditures was the imposition of the "death penalty" -- IRS revocation of the entity's tax exempt status. Often times, however, the punishment did not fit the "crime". If the worst happened and an organization lost its tax-exempt status, then, by definition, the organization would be treated like any other business -- filing tax returns and paying taxes on earnings. In our last article, (See "Church Tax Bill Becomes Law", November/December 1996), we discussed the new "tax payer's bill of rights" legislation.

The centerpiece of this law, from the perspective of the non-profit community, is the provision allowing the IRS to impose "intermediate sanctions" in lieu of, or in addition to, revocation of an organization's tax exempt status. Although revocation of tax-exempt status is still available to the IRS, this new law will certainly impact, if not revolutionize, the operation of many tax-exempt organizations as the IRS becomes accustomed to pulling this new arrow out of its quiver. Intermediate sanctions can only be imposed by the IRS in cases involving excess benefit transactions (EBT).

An EBT occurs when a disqualified person (a person in a position to exert a substantial influence over the organization) receives an economic benefit from a tax-exempt organization that exceeds the value received by the organization. In other words, an EBT occurs when the organization compensates a disqualified person and does not get its money's worth. Although the intermediate sanctions law was enacted on July 30, 1996, its provisions generally apply to all transactions entered into on or after September 14, 1995. An EBT is most likely to occur in the payment of "unreasonable compensation," when "personal expenses" of an employee are paid by the organization, and in "not-fair-market value" transactions. The remainder of this article sets forth guidelines for avoiding the problem areas of unreasonable compensation and not-fair-market value transactions.
Reasonable Compensation

Paying reasonable compensation to employees for services rendered is a legitimate exempt purpose expenditure, paying unreasonable compensation to a disqualified person is not. Disqualified persons may include pastors, officers, directors, trustees, founders, key employees, major donors, and their family members. In determining the reasonableness of a disqualified person's compensation, the IRS will look at all elements of the disqualified person's compensation (salary, housing, all forms of insurance including insurance to pay excise taxes, automobiles, royalties, etc.) To help make the case that the compensation paid by the organization is reasonable, the organization should maintain documentation to support the reasonableness of compensation paid to all key employees and to all family members of those employees. This documentation should include a description of the duties performed by the employee, the employee's qualifications for the position, and support for the amount of compensation paid for the duties performed.

To assure such documentation is adequate, many organizations hire outside experts to review the compensation paid to disqualified persons and to issue an opinion as to a reasonable salary range for the employee. Before relying on the expert's opinion, it is critical that the organization confirm the expert's usage of accurate comparability data for functionally comparable positions. Additionally, the legislative history accompanying the intermediate sanctions law provides that the compensation paid to a disqualified person should be presumed to be reasonable if the compensation agreement is approved by an independent board or committee:

1. composed of persons unrelated to and not controlled by the disqualified person;
2. that relied on appropriate compatibility compensation data; and
3. that adequately documented the basis of the determination.

To gain the benefit of the presumption of reasonableness, all elements of the compensation must be reviewed and approved by the independent board or the committee prior to receipt by the employee. This legislative history indicates that Congress intended to encourage organizations paying "above average" compensation to a disqualified person to have the compensation package approved by an independent compensation committee in the hope that examples of grossly unreasonable compensation would be reduced. We expect that the Treasury Department will formalize this legislative history, in the form of Treasury Regulations, in early 1997. At the same time, the Treasury Department will provide formal guidelines, including examples of EBTs. Assuming that the forthcoming Treasury Regulations match the legislative history of the law, the IRS will be prohibited from imposing the excise taxes provided for in the new law when the organization can establish it was in compliance with the three step process set out above, except where the IRS can develop sufficient contrary proof to rebut the presumption.
Not-Fair-Market Value Transactions

Included within the definition of what constitutes an EBT is not-fair-market value transactions between the organization and a disqualified person. Example of such an EBT include below market value sales of the organization's property to a disqualified person and sales of goods and services to a tax exempt organization by a disqualified person at an inflated price. As with compensation, it is expected that with respect to the purchase/sale of goods and services, a presumption of reasonableness will apply if the deal is approved by a board or committee:

1. composed of persons unrelated to and not controlled by the disqualified person;
2. that relied on appropriate comparability data, and
3. that adequately documented the basis of the determination.

Conclusion

As shown above, the key to avoiding liability for an EBT is to have all transactions with disqualified persons approved by an independent board or committee. However, it is important that this independent committee be fully informed of all facts concerning the transaction and that the committee obtain objective and reliable market data upon which to rely in making their determination.

James E. Guinn, CPA, is a founding partner of Guinn, Smith & Company, 2408 Texas Drive, Irving, Texas, 972-255-7120. Mr. Guinn is also a regular columnist of "Ministries Today Magazine".

David O. Middlebrook is an attorney in the non-profit corporation section of the Irving law firm of Brewer, Anthony, Middlebrook, Burley & Dunn, 5215 N. O'Connor Road, Suite 700, Irving, Texas, 75039, 972-556-0902.