Intermediate sanctions

What Are Intermediate Sanctions?

Intermediate sanctions are a form of penalty imposed by the Internal Revenue Service (IRS) on individuals who receive excessive benefits from certain tax-exempt status organizations, such as public charity and social welfare organizations. These penalties fall under the broader category of regulatory enforcement and aim to deter abuses of an organization's tax-exempt status without resorting to the drastic measure of revoking its exemption entirely. Instead of punishing the entire non-profit organization, intermediate sanctions target specific individuals—known as "disqualified persons"—who engage in "excess benefit transactions" with the organization.

##²³, ²⁴ History and Origin

Prior to 1996, the IRS's primary tool for addressing abuses within tax-exempt status organizations was the severe step of revoking the organization's tax exemption. This "all or nothing" approach often proved disproportionate, particularly when the organization itself was largely compliant, and only a few individuals had engaged in misconduct. Recognizing this limitation, Congress enacted Section 4958 of the Internal Revenue Code as part of the Taxpayer Bill of Rights 2, effective July 30, 1996, though it applied retroactively to transactions occurring on or after September 14, 1995. Thi²⁰, ²¹, ²²s legislation provided the IRS with a more flexible range of enforcement action known as intermediate sanctions, allowing the agency to impose excise tax penalties directly on the individuals responsible for the abuses, rather than penalizing the entire organization or its beneficiaries.

##¹⁹ Key Takeaways

Intermediate sanctions are penalties levied by the IRS on "disqualified persons" and "organization managers" of tax-exempt entities.
They specifically target "excess benefit transactions," where insiders receive unreasonable economic benefits.
These sanctions offer the IRS an alternative to the more drastic measure of revoking an organization's tax-exempt status.
The penalties primarily involve excise taxes imposed on the individuals involved, with potential additional taxes if the transaction is not corrected.
Intermediate sanctions apply to most public charities and certain other tax-exempt organizations, but generally not to private foundations, which are subject to different rules.

Penalty Structure

While intermediate sanctions do not involve a formula in the traditional sense, they are calculated as excise taxes based on the amount of the "excess benefit." The penalty structure is as follows:

Initial Tax on Disqualified Person: A disqualified person who benefits from an excess benefit transaction is subject to an excise tax equal to 25% of the excess benefit.
¹⁸ Additional Tax on Disqualified Person: If the excess benefit transaction is not corrected (i.e., the disqualified person does not return the excess benefit to the organization) within a specified period, an additional excise tax of 200% of the excess benefit may be imposed.
¹⁷ Tax on Organization Managers: An organization manager who knowingly participates in an excess benefit transaction is subject to an excise tax of 10% of the excess benefit, up to a maximum of $10,000 per transaction. This liability is joint and several if multiple managers are involved.

##¹⁶ Interpreting the Intermediate Sanctions

Intermediate sanctions are interpreted and applied by the IRS when it determines that a "disqualified person" has engaged in an "excess benefit transaction" with an "applicable tax-exempt organization." An excess benefit transaction occurs when an economic benefit provided by the organization to a disqualified person exceeds the value of the consideration received by the organization in return. Thi¹⁵s often involves situations such as excessive compensation, favorable loans, or inflated contracts. A "disqualified person" generally refers to any individual who was in a position to exercise substantial influence over the affairs of the organization at any time during the five-year period ending on the date of the transaction. This includes officers, directors, trustees, and their family members.

Th¹⁴e IRS conducts an investigation to ascertain whether an excess benefit transaction has occurred. If such a transaction is identified, the regulatory body then determines the amount of the excess benefit and applies the corresponding excise taxes. The¹³ intent is to claw back the undue benefit and penalize those responsible, reinforcing the principle that tax-exempt assets must serve the organization's charitable purpose, not private interests.

Hypothetical Example

Consider "Helping Hands Charity," a non-profit organization dedicated to providing humanitarian aid. The CEO, who is also a member of the Board of directors, arranges for the charity to purchase a property owned by his spouse for $2 million, significantly above its fair market value of $1.2 million.

Upon review, the IRS launches an investigation. The IRS determines that the CEO is a "disqualified person" due to his substantial influence over the charity's operations and that the transaction represents an "excess benefit transaction" because the charity paid $800,000 more than the property's market value.

The IRS would then impose intermediate sanctions:

CEO's Initial Tax: The CEO, as the disqualified person, would face an initial excise tax of 25% of the $800,000 excess benefit, totaling $200,000.
Organization Manager Tax: If other members of the board, acting as organization managers, knowingly approved this transaction without exercising proper due diligence, they could each face a 10% excise tax on the $800,000 excess benefit, up to a maximum of $10,000 each.
Correction Period: The IRS would require the CEO to return the $800,000 excess benefit to Helping Hands Charity. If the CEO fails to do so within the specified correction period, an additional 200% excise tax (amounting to $1.6 million) would be imposed on the CEO.

This example illustrates how intermediate sanctions directly penalize the individuals responsible for the abuse, aiming to deter such prohibited transactions and recover the misused funds for the charity.

Practical Applications

Intermediate sanctions are primarily a tool for the IRS to ensure compliance and accountability within the tax-exempt sector. Their practical applications include:

Executive Compensation Oversight: The IRS frequently uses intermediate sanctions to scrutinize executive compensation packages in public charity and other non-profits. If the compensation is deemed excessive relative to comparable organizations for similar services, the individual receiving the excess pay can be penalized.
¹² Preventing Insider Dealings: They serve as a deterrent against "excess benefit transactions" where disqualified persons, such as board members or senior staff, engage in financial arrangements that benefit themselves at the expense of the organization. This helps maintain the integrity of corporate governance within non-profits.
¹¹ Promoting Good Governance: By holding individuals accountable, intermediate sanctions encourage organizations to implement robust internal controls and sound governance practices to prevent potential abuses. The¹⁰ American Bar Association (ABA) has highlighted intermediate sanctions as a tool for good governance, emphasizing the importance of diligence in transactions involving insiders.

##⁹ Limitations and Criticisms

While intermediate sanctions offer a more nuanced approach than outright revocation of tax-exempt status, they are not without limitations and criticisms. One challenge lies in the complexity of determining what constitutes an "excess benefit," particularly in areas like executive compensation, where market rates can vary widely. Organizations and individuals must exercise significant due diligence to establish a "rebuttable presumption of reasonableness" for compensation and other benefits, which can be resource-intensive.

Cr⁸itics also point out that while these financial penalty mechanisms are designed to deter, their effectiveness can be debated. Some argue that the penalties may not always be severe enough to truly deter well-resourced individuals from engaging in prohibited transactions, especially if the potential gains far outweigh the initial excise tax. The legal and administrative processes involved in enforcing intermediate sanctions can also be lengthy and complex. Furthermore, issues arise when individuals fail to correct the transaction, leading to the higher 200% tax, which may be difficult to collect. Des⁷pite these challenges, intermediate sanctions remain a key component of the IRS's efforts to regulate the integrity of the tax-exempt sector.

##⁶ Intermediate Sanctions vs. Civil Penalties

While both intermediate sanctions and civil penalties are forms of non-criminal punishment for violating laws or regulations, they differ significantly in their scope and application.

Intermediate Sanctions are highly specific penalties primarily imposed by the IRS under Internal Revenue Code Section 4958. They exclusively target "disqualified persons" and "organization managers" within applicable non-profit organizations (e.g., public charity and certain social welfare organizations) who engage in "excess benefit transactions." The purpose is to correct the abuse and penalize the individuals responsible, without necessarily revoking the organization's tax-exempt status.

⁵Civil Penalties, on the other hand, represent a much broader category of non-criminal sanctions that can be imposed by various government agencies for a wide array of legal and regulatory violations. These can range from traffic fines and environmental violations to consumer protection breaches or securities fraud. Civil penalties typically aim to punish wrongdoing, deter future violations, or compensate for damages, and they apply across all types of entities—individuals, corporations, and organizations—not just tax-exempt ones. The key⁴ distinction lies in the narrow, tax-exempt-focused application of intermediate sanctions compared to the expansive, general regulatory and legal enforcement scope of civil penalties.

FAQs

What types of organizations are subject to intermediate sanctions?

Intermediate sanctions primarily apply to public charities and certain other tax-exempt organizations, such as 501(c)(4) social welfare organizations. They generally do not apply to private foundations, which are governed by a different set of rules regarding self-dealing and other abuses.

Who is considered a "disqualified person" in the context of intermediate sanctions?

A "disqualified person" is an individual who has significant influence over a tax-exempt status organization. This typically includes individuals like the organization's CEO, president, chief operating officer, chief financial officer, or any other person who holds substantial power, as well as their family members. Entities controlled by such persons are also considered disqualified.

Wh³at triggers an "excess benefit transaction"?

An "excess benefit transaction" is triggered when a disqualified person receives an economic benefit from a tax-exempt organization that exceeds the fair market value of the goods, services, or other consideration provided in return. This commonly arises in situations involving excessive executive compensation, unreasonable loans, or asset sales at inflated prices to insiders.

Ca²n an organization avoid intermediate sanctions if an excess benefit transaction occurred?

An organization itself does not directly pay the intermediate sanctions; the disqualified persons and potentially organization managers do. However, an organization can help mitigate potential issues by ensuring that transactions with insiders are conducted at fair market value and are properly documented. Establishing a "rebuttable presumption of reasonableness" for compensation, through proper corporate governance and independent review, can also help. Correcting an excess benefit transaction by returning the undue benefit can prevent the imposition of the higher 200% excise tax.¹