- Sales Tax
- Charitable Contributions
- Unrelated Business Income
- Form W-9
- Foreign Vendors
- Employment Issues
- Fringe Benefits
- Independent Contractor versus Employee Status
- Intermediate Sanctions (Private Benefit/Private Inurement)
- Cellular Phone Policy & Procedures
Baylor University has been granted federal income tax exemption from the IRS by being classified as a 501(c)(3) organization. To qualify for and maintain this federal exemption status, Baylor must be both organized and operated exclusively for one or more tax exempt purposes. To satisfy the IRS’s organizational test, an organization’s documents of creation must limit its activities to exempt purposes and structure the organization properly. Baylor University’s Articles of Incorporation and Bylaws satisfy these requirements. To satisfy the operational test, an organization must meet the following three prongs: (1) the organization must engage primarily in activities that accomplish one or more of the exempt purposes listed in IRC §501(c)(3), including religious, charitable, scientific, literary, and educational purposes; (2) the organization’s net earnings cannot inure in whole or in part to the benefit of private shareholders or individuals; and (3) the organization cannot be an action organization, meaning the organization cannot devote a substantial part of its activities to attempting to influence legislation or participate in political campaigns. Satisfaction of this operational test depends on the day-to-day operations of Baylor University. The first two prongs of this test are discussed more in depth in the sections below, as the consequences of not complying with each can vary. Baylor University meets the third prong by not acting as an action organization.
Restated from above, to satisfy the first prong of the operational test, Baylor University must engage primarily in activities that accomplish one or more of its exempt purposes. As to this prong, the United States Supreme Court has ruled that the presence of a single non-exempt purpose, if substantial, will destroy tax exemption regardless of the number or importance of exempt purposes. 326 U.S. 279 (1945). To act for the benefit of private parties is not an exempt purpose; therefore, an organization is not operated exclusively for one or more exempt purposes if it operates for the benefit of private parties. To determine whether an organization operates for the benefit of private parties, the IRS has developed a two part test, discussed below. The analysis involved in this test is a factual determination of the relationship between the tax-exempt organization and one or more for-profit entities as a whole, not just looking at a single transaction. In addition, the IRS looks at many factors in determining whether these two prongs are satisfied. One factor is the determination of who controls the exempt organization and how that control impacts private benefits. Another factor is the motivation for the formation of the exempt organization, and to what degree it affects the integration of the charity’s activities with private entities’ business. A final factor is the number of private persons benefiting from the activities of the organization. If private benefit is found, the IRS may revoke the exempt organization’s tax exemption status. (Top)
The first part of the private benefit test requires that an exempt organization may not benefit the private interests of particular individuals unless the benefit is qualitatively incidental. A benefit is qualitatively incidental when the benefit to the individual is only a by-product of providing the benefit to the public. An example of such is Revenue Ruling 70-186, in which a tax-exempt organization was formed to preserve and enhance a lake as a public recreation facility. The IRS held that private benefits gained by lake front property owners were only incidental to those gained by the public at large, and it would be impossible for the organization to accomplish its purposes without benefiting these private property owners. (Top)
The second part of the private benefit test requires the private benefit to be quantitatively incidental. This means the private benefit in question must be insubstantial in amount when compared to the public benefit of the activity. For example, in Revenue Ruling 75-286, an organization was formed by residents within a city block to preserve and beautify the block. Membership in the group was restricted to individuals living on the block and those owning or operating businesses there. The IRS held the restrictive nature of the membership and the limited areas of improvements indicated the organization was formed and operated to benefit the private interests of the members more than to benefit the general public. Because of such, the organization failed the test and lost its exempt status. (Top)
The second prong of the operational test, restated from above, is that the organization’s net earnings cannot inure in whole or in part to the benefit of private shareholders or individuals. This second prong differs from the first in that private inurement is a benefit provided only to “insiders”, individuals who have the opportunity to direct the organization’s resources to themselves, to family members, or to entities in which they have an interest. The IRS has stated there is no permissible level of private inurement, no matter how small.
When a transaction is determined to generate private inurement, if the individual involved is a disqualified person, the transaction is also deemed an excess benefit transaction. If an excess benefit transaction is found, the IRS will impose penalty excise taxes (intermediate sanctions) on the individual, and the organization may lose its tax exempt status along with the imposition of the penalty taxes.
The IRS has issued proposed regulations listing the following factors that it will use to determine when revocation of the exempt status is proper: (1) The size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after the excess benefit transaction(s) occurred; (2) The size and scope of the excess benefit transaction(s) in relation to the size and scope of the organization’s regular and ongoing activities that further exempt purposes; (3) Whether the organization has been involved in repeated excess benefit transactions; (4) Whether the organization has implemented safeguards that are reasonably calculated to prevent future violations; and (5) Whether the excess benefit transaction has been corrected or the organization has made good faith efforts to seek correction from the disqualified persons who benefit from the excess benefit transaction. (Top)
Intermediate sanctions are excise penalty taxes imposed in three different situations: (1) when the IRS finds private inurement in the form of excess benefit transactions occurring between disqualified persons and certain tax-exempt organizations; or (2) when the IRS finds an “automatic excess benefit transaction”; or (3) when both occur. (Top)
A disqualified person is any person in a position to exert substantial influence over the organization’s affairs at any time in the five years before the transaction occurred. Family members and any entities controlled by the disqualified person are considered disqualified persons. Control is defined as owning more than 35% voting power of the organization. The following powers are considered by the IRS to be the ability to exert substantial influence: (1) a voting member of the organization’s governing body; (2) a person with ultimate responsibility for implementing the governing body’s decisions or for supervising the management, administration or operation of the organization; (3) a person with ultimate responsibility for managing the organization’s finances. The IRS also considers certain individuals as not being in the position to exert considerable influence; these persons are: (1) other 501(c)(3) or (c)(4) organizations; and (2) organization employees who receive less than $100,000 in economic benefits in a taxable year as long as they are not (1) family members of a disqualified person; (2) persons considered to be in a position to exercise substantial influence over the organization’s affairs; or (3) substantial contributors to the organization. (Top)
An excess benefit transaction is defined as a transaction in which an economic benefit is provided by an organization, directly or indirectly, to or for the use of a disqualified person, and the value of the benefit provided by the organization exceeds the value of the consideration received by the organization in return. A questionable benefit must be properly categorized as either (1) intended as compensation for services rendered or (2) not intended as compensation. For a benefit to be categorized as “intended to be compensation”, the organization must provide contemporaneous written substantiation of such intent, discussed below. If a benefit is intended as compensation for services rendered, the benefit is included in a reasonableness comparison, where the benefit is compared to the value of services that would ordinarily be paid for like services by a like organization under the circumstances. If the benefit is greater, an excess benefit transaction exists. If a benefit is not intended as compensation, it is considered an excess benefit transaction, unless the disqualified person can prove it was properly excludable from income for income tax purposes or it involved a legitimate transaction with the organization and fair market value was given in trade.
If a benefit is categorized as “intended to be compensation”, a few additional rules exist. First, an excess benefit is not present in a transaction consisting of fixed payments made by an organization to a disqualified person under an initial contract. However, if the organization and the disqualified person make a material change to the initial contract, it is treated as a new contract as of the effective date of the change. Second, certain benefits are not included in the reasonable compensation analysis, including in-kind fringe benefits excluded from gross income, and expense reimbursements under an accountable plan. (Top)
An economic benefit will be treated as compensation under the excess benefit analysis only if the organization clearly indicated its intent to treat the benefit as compensation for services when the benefit was paid. The organization clearly indicates its intent when it provides contemporaneous written substantiation of its intent upon the transfer of the benefit.
Such substantiation must be created before the start of an IRS examination or receipt of written documentation by the IRS of a potential excess benefit transaction. The requirement of contemporaneous substantiation can be met in one of three ways. The first method is for the organization to report the economic benefit as compensation on the original Federal tax information return, such as the Form 990, Form W-2 or Form 1099, or for the disqualified person to report the benefit as income on his/her original Federal tax return. The second method exists where no reporting by either the organization or the disqualified person was completed, but this was due to reasonable cause. To establish reasonable cause, it must be proven that there were significant mitigating factors as to the failure to report or that the failure to report arose from events beyond the organization’s control and the organization acted in a responsible manner both before and after such events. The third method is to use other written contemporaneous evidence showing the organization, through an appropriate decision-making body or an officer authorized to approve compensation, approved the transfer as compensation under established procedures, including (1) an approved written employment contract executed on/before the date of transfer; (2) appropriate documentation indicated authorized body approved the transfer as compensation on or before the date of the transfer; or (3) written evidence, existing on or before the date of the federal tax return, of a reasonable belief by the organization that under the IRC the benefit was excludable from the disqualified person’s income.
If the organization does not provide contemporaneous written substantiation, the IRS will treat the benefit as an automatic excess benefit transaction, unless the organization can prove it provided the benefit in exchange for consideration other than services. This means the IRS can impose intermediate sanctions even without the finding of private inurement, if the organization did not provide the required written contemporaneous substantiation for a transaction between a disqualified person and the organization. (Top)
The proper analysis of fringe benefits is important to determine if any compensation received, including such fringe benefits, is reasonable or instead, an excess benefit transaction. IRC 132 gives the following list of fringe benefits that are excluded from an employee’s gross income: no-additional cost services, qualified employee discounts, working condition fringe benefits, de minimis fringe benefits, qualified transportation fringe benefits, and qualified moving expense reimbursements. These excluded fringe benefits are not included in the determination of reasonable compensation, unless a disqualified person used a portion of the benefit for personal use. The personal use portion is then included in the reasonable compensation calculation. Conversely, other fringe benefits that are excluded from income under different sections of the IRC are included in the reasonable compensation calculation.
Working condition fringe benefits are those benefits that are provided to an employee and would be allowed as a deduction under IRC §162 or 167 if the employee had instead paid for the benefit. Examples of working condition fringes are business travel, entertainment and transportation, spousal or dependent travel for business purposes, use of entertainment facilities, etc. Travel and transportation include not only automobile usage but also Baylor plane trips to different events To be excludable as a working condition fringe, not only must the property or service relate to the employer’s business, but the benefit must be substantiated by proper documentation. The exclusion for working condition fringe benefits is available to employees, independent contractors and directors.
De minimis fringe benefits are those benefits of which the value and the frequency of which similar fringes are provided by the employer is so small to make accounting for them unreasonable or administratively impracticable. The exclusion for de minimis fringe benefits applies to any recipient of the benefit, not just employees. Some examples of de minimis fringe benefits are local telephone calls, coffee, doughnuts, soft drinks, occasional sporting event tickets, flowers or similar property provided under special circumstances, etc. Examples of items that do not qualify as de minimis fringe benefits include cash, gift certificates, season tickets, memberships in private country clubs, use of University facilities for a weekend, etc. If Baylor provides a benefit that exceeds de minimis status, the entire benefit is taxed to the employee and will be included in the reasonable compensation excess benefit analysis.
Qualified transportation benefits include transportation in a commuter highway vehicle, transit passes and qualified parking. The exclusion for such fringe benefits is only allowed for employees of Baylor. Qualified employee discounts are discounts given to employees, retired employees, and their spouses for the purchase of the qualified goods and services of the employer. Certain limits are set for the amount of such an excludable discount. Qualified moving expenses are those amounts received by an employee from an employer in payment for expenses that would have been deductible as moving expenses under IRC §217 if the employee had paid the expenses. Again, certain limitations apply as to the amount of moving expenses.
Fringe benefits that are excluded from an employee’s gross income under certain other sections of the IRC, including §119, 127, and 137, are included in the reasonable compensation calculation. They are not, however, required to be contemporaneously substantiated as to the employer’s intent to treat the benefit as compensation. Examples of such benefits include employer-provided meals, employer-provided lodging, and qualified tuition reductions. However, if the fringe benefit is not included in either §132 or one of these certain other sections, the benefit must be substantiated as compensation to be included in the calculation of reasonable compensation. (Top)
All benefits that are documented as required above are included in the reasonable compensation calculation. Under this calculation, if a compensation arrangement is reasonable, or a transfer of property is at fair market value, then by definition the transaction cannot be an excess benefit transaction. An organization can establish a rebuttable presumption that payments it made to a disqualified person under a compensation arrangement are reasonable, or a transfer of property is at fair market value, by satisfying a three prong test. Failure to meet this test does not mean the transaction is automatically an excess benefit transaction, however. The first requirement is that the transaction was approved in advance by an authorized body of the organization, composed entirely of individuals who do not have a conflict of interest for the transaction. The second requirement is that the authorized body obtained and relied on appropriate data for comparison purposes when making its decision. The third requirement is that the authorized body adequately documented the basis for its decision concurrently with making that decision. It should be noted that the IRS can still rebut this presumption by developing sufficient evidence to the contrary, however. (Top)
If the IRS determines that an excess benefit transaction has occurred, there is a two-tier penalty excise tax system. The first tier is a tax of 25% of the excess benefit resulting from each such transaction that goes against the disqualified person who received the excess benefit. If the disqualified person does not correct the transaction within the taxable period, a tax of 200% of the excess benefit is charged against the disqualified person. A disqualified person may correct an excess benefit transaction by undoing the excess benefit to the greatest extent possible and taking any additional steps to place the organization in a financial position not worse than the position it would have been in if the disqualified person had been dealing with the organization under the highest fiduciary standards. Correction can be made by cash payment or by return of property transferred. The correction amount is the total of the excess benefit amount and interest on the excess benefit.
In addition, the IRC imposes a tax of 10% of the excess benefit on the participation of an organization manager in an excess benefit transaction, if three requirements are met. An organization manager is an officer, trustee, or director of an organization, or any individual having powers or responsibilities similar to officers, trustees, or directors, regardless of that person’s title. A person who has the authority to merely recommend particular administrative or policy decisions but not the authority to implement them is not an organization manager. The three requirements are as follows: (1) the 25% tax has been imposed on the disqualified person; (2) the organization manager knowingly participated in the excess benefit transaction; and (3) the organization’s manager’s participation was willful and not due to reasonable cause. The maximum 10% penalty that can be imposed is $10,000. An organization manager who is a disqualified person can be liable for both the 25% and the 10% tax.
An example of the application of the excess benefit penalty taxes is as follows: An exempt organization paid its President a salary of $60,000 a year for five years. In addition, the President received a vacation from the organization valued at $40,000. The organization intended this vacation to be compensation for the services of its President, allocated at $8,000 per year for the five years. The organization did not report this $40,000 payment in the proper year however, either by the President’s W-2 or the Form 990. The President also did not report this payment as compensation on his personal tax return. The exempt organization therefore did not satisfy the written contemporaneous substantiation requirements described above. Because of this, all of the $40,000 payment was an automatic benefit transaction in the year of payment. The President is liable for the 25% excise tax, or $10,000, and the 200% excise tax, or $80,000. If the President meets the requirements in the discussion below, the IRS may abate some or all of these taxes.
The IRS will abate the 25% and the 200% penalty taxes under certain circumstances. The 25% tax will be abated if the disqualified person corrects the excess benefit transaction within the correction period and the disqualified person can establish the transaction was due to reasonable cause and not to willful neglect. The correction period begins when the transaction occurs and ends 90 days after the IRS mails a notice of deficiency to the disqualified person that contains the 200% tax. The 200% tax will be abated if the disqualified person corrects the transaction in the taxable period. The taxable period begins when the transaction occurred and ends when a deficiency notice for the 25% tax is mailed to the disqualified person or when the 25% tax is assessed on the disqualified person, whichever happens first. (Top)