November 2, 1998
In response to the Notice of Proposed Rulemaking, the Free Speech Coalition hereby submits the following comments on the proposed regulations relating to the provisions regarding excess benefit transactions contained in Section 4958 of the Internal Revenue Code. These comments are joined by the following organizations: 60 Plus Association, American Target Advertising, Inc., English First, Squire & Heartfield Direct, Inc., and the TREA Senior Citizens League.
The Free Speech Coalition, Inc. ("FSC") is an alliance of liberal, conservative and non-ideological issue-activists who are particularly concerned with the preservation of the rights of nonprofit advocacy organizations. This diverse group, which came together in 1993 and ranges ideologically from American Conservative Union to the Coalition to Stop Gun Violence, has felt compelled to band together to defend the interests of Americans who want to participate fully in the formation of public policy in this country without undue governmental interference and restriction.
The proposed regulations also expand the definition of disqualified persons far beyond the statutory definition at IRC section 4946. Presumably, the proposed regulations seek to stretch the statutory element "substantial influence over the affairs of an organization" to include: receiving compensation based on revenues derived from activities of the organization that the person controls (e.g., outside fundraisers), managerial authority (beyond the section 4946 definition: responsibility with respect to a certain act or failure to act), or even service as a key advisor to a person with managerial authority.
Specifically, the IRS' efforts to characterize outside fundraisers as disqualified persons &emdash; unless the fundraising activities are micromanaged and physically performed by the tax-exempt organization's board &emdash; are destructive. Not every section 501(c)(3) and (4) organization has either the resources or a sufficiently broad focus to compete successfully for large foundation and government grants. The proposed regulations would seek to cut off alternative means of survival.
Additionally, the standards governing revenue-sharing transactions, where the compensation can even be less than the value provided by the fundraiser and still be deemed both an excess benefit transaction and private inurement, raise troublesome questions regarding the intent of the IRS. The proposed regulations governing revenue-sharing transactions would appear to jeopardize the tax-exempt status of many nonprofit groups.
Overall, the proposed standards governing both the IRS' imposition of Section 4958 excise taxes and the revocation of tax-exempt status grant excessive discretion to the Service, raising constitutional issues as to their vagueness and overbreadth. The following comments point to additional, specific areas, where the IRS proposal needs to be reconsidered.
Definition of Disqualified
Nonprofit employees and volunteers can easily qualify both as a "key advisor" to the executive director and a substantial contributor (i.e., one who contributes more than $5,000 where such amount is more than 2 percent of the total contributions). Perhaps, to be generous, these proposed regulations were written with an eye to nonprofits with dozens of full time staff members, and annual revenues in the millions of dollars &emdash; but these regulations could be literally life-threatening for smaller nonprofits.
Since independent compensation surveys compiled by independent firms are the only example provided of what would constitute adequate data (except for small nonprofits), the proposed regulations may effectively "require" such surveys &emdash; imposing an additional administrative cost on nonprofits which would only serve to reduce funds available for programmatic activities.
Further, the proposed regulations would impose the requirement on nonprofits that their governing bodies (or committees) conduct comparability studies for any fundraising contract that does not result in revenue-sharing transactions (fundraising contracts which result in revenue-sharing transactions would evidently become per se excess benefit transactions). Such governing bodies apparently would be required to obtain "compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions" &emdash; in other words, copies of the fundraising contracts of other, similarly situated for-profits and nonprofits &emdash; and determine "the availability of similar services in the geographic area of the applicable tax-exempt organization" (e.g., survey all fundraisers in the geographic area), or "independent compensation surveys compiled by independent firms" (more workfare for consultant firms).
Alternatively, those governing bodies would need to obtain "actual written offers from similar institutions competing for the services of the disqualified person" &emdash; in other words, copies of the fundraising contracts from prospective fundraising vendors.
The unreasonableness of this position is especially evident in proposed §53.4958-5(d), example 2. We are told that the structure of the compensation which fundraiser H receives for its services does not provide H with an appropriate incentive to maximize benefits and minimize costs to nonprofit L. Therefore, the entire amount paid to H under this arrangement automatically constitutes an excess benefit under the rules of this section. Surely, such a conclusion should not necessarily follow. The arrangement in question should be analyzed under the standard excess benefit test: does the economic benefit provided to the disqualified person exceed the fair market value of the consideration provided in return? Has H abused its contractual authority?
Instead, under the proposed regulations, that standard would not even be germane to identifying the existence of an excess benefit transaction. Under the proposed regulations, all payments pursuant to a contract that does not provide "an appropriate incentive" to the fundraiser would be excess benefit transactions. No matter if, in reality, the fundraiser subsidized the fundraising activity, understating its costs and claiming a below-industry standard percentage of the net proceeds (as might be expected from a new entry into the fundraising industry). Every penny paid under this contract would be subject to excise taxes of at least 25 percent, if not an additional 200 percent. This is an unreasonable and unjustified result.
Nor does the language of the example simplify or clarify the logic behind this standard. According to example 2:
All of the gross revenues generated by the charitable gaming operation belong to L. The arrangement between H and L allows a portion of those [gross] revenues to inure to H. Therefore, this arrangement results in the inurement of L's net earnings to the benefit of H, and the entire amount paid to H under this arrangement constitutes an excess benefit under the rules of this section.
The IRS lacks the authority to define net earnings as gross revenues. Unless there is no remuneration in a fundraising contract, there will always be inurement of gross revenues. To call these "gross revenues" "net earnings" is to remove any content from the concepts "gross" or "net." And to take the next step of treating all those receiving a percentage of gross receipts as disqualified persons or insiders takes all independent meaning from those terms.
Equally unreasonable is the IRS assertion that, notwithstanding the contract presented in the example, all of the gross revenues generated by the charitable gaming operation would belong to L. In essence, the IRS is stating that the contract gives the fundraiser H no rights to these proceeds. We would submit, however, that the IRS has no authority to issue regulations defining the contractual rights of other parties. The gross revenues in the above example may have the nonprofit's name on them, pending determination of the contractual costs and subsequent revenue sharing, but they have not been earned by the nonprofit until the terms of the contract have been met. (Besides, if the gross fundraising revenues are actually net earnings in example 2, is it not equally true that the gross royalties in example 3 are also net earnings? What justification exists for determining that the professor in example 3 would avoid inurement of the nonprofit's net earnings to his personal benefit?)
This proposed regulatory language would be less unreasonable if the IRS relied upon the statutory definition of disqualified person at IRC section 4946. However, where the IRS asserts (as it did in the recent United Cancer Council case) that outside contractors, performing in accordance with an arm's-length contract, become disqualified persons because they exert control over the performance of their contractual duties, it stretches the concepts of disqualified person and excess benefit transaction to unreasonable limits.
Those section 501(c)(3) and (4) organizations which lack the resources (or a sufficiently broad focus) to compete successfully for large foundation and government grants often depend on outside fundraisers for their continued existence. Such outside fundraisers often are hired when the nonprofit lacks sufficient funds or in-house expertise at fundraising. Under this division of labor, the outside fundraisers utilize their expertise by administering, or controlling in some sense, the day-to-day aspects of discrete fundraising projects. But the proposed regulations could drive these fundraisers out of business.
For example, expertise in the operation of bingo games is a marketable commodity. Yet, as explained in §53.4958-3(f), example 3, bingo operator "B," in a revenue-sharing transaction whose "compensation is based on revenues from an activity B controls" and who "has full managerial authority over [the nonprofit's] principal source of income," is subject to a 25 percent excise tax on all earnings received pursuant to its contract with the nonprofit (with at least the threat of an additional 200 percent tax on all compensation earned under the contract) &emdash; "regardless of whether the economic benefit provided to the disqualified person exceeds the fair market value of the consideration provided in return" &emdash; because the bingo operator dares to meet its contractual obligations and utilizes its expertise in the operation of bingo games.
Nor is it clear that this provision is limited to fundraisers. What if a nonprofit fair housing group hires a law firm (on a contingent fee basis) to sue a landlord for damages alleging discrimination? The law firm certainly can be expected, pursuant to its representation of the nonprofit, "to control the activities generating the revenues on which the compensation [would be] based." The law firm was hired for its expertise. Further, any award of damages may well prove to be a "principal source of income" for the nonprofit, at least for the tax year in which the award is received. Yet every penny of the contingent fees under such circumstances may be deemed to be an excess benefit, subject to excise tax.
Evidently the IRS is not shy about tackling difficult issues &emdash; having already undertaken, in these proposed regulations, to define a "reasoned written legal opinion" (see §53.4958-1(d)(7)). Perhaps it is also prepared to undertake the determination as to what legal fees are (or are not) proportionate to the benefits provided by a legal firm to a nonprofit. These kinds of issues, however, are not susceptible to hard and fast rules.
Why should contractors' performance pursuant to such contracts be subject to punishment? An accountant firm will utilize its expertise to control the preparation of the nonprofit's financial statements. A legal firm will utilize its expertise to control the conduct of (hourly-rate) litigation on behalf of the nonprofit. There is no point in hiring contractors with expertise, if they may not use the expertise. Further, the preparation of the financial statements or conduct of the litigation may have a significant impact on the nonprofit, yet these activities do not face excise taxes as excess benefit transactions.
What is the result of the proposed regulations? Looking back at example number 3 of §53.4958-3(f), a bingo operator would be driven out of business, and a nonprofit would lose its principal source of income. Is the IRS seeking the prerogative to drive both nonprofit and for-profit organizations out of business at its discretion? We submit the proposed regulations should be confined to promulgating standards that would be helpful to organizations in light of new IRC Section 4958. It is not the role of the Service to rewrite the law, including the law with respect to what constitutes "reasonable compensation."
As discussed above, the role of these regulations should be to clarify and explain the application of the statutory provisions. The statutory language is ambiguous as to whether all disqualified persons will receive any notice that the IRS is examining a possible excess benefit transaction before either the earlier of "the date of mailing a notice of deficiency under section 6212 with respect to the section 4958(a)(1) tax" or "the date on which the tax imposed by section 4958(a)(1) is assessed" &emdash; when the taxable period (and opportunity for correction without paying the section 4958(b) tax) ends. The regulations should clarify this ambiguity, hopefully identifying what notice and minimum time for correction will be provided to disqualified persons following the IRS' identification of a potential excess benefit transaction.
At all events, the regulations should not attempt to penalize persons who contest the imposition of proposed excess benefit taxes. Thus, when enacted, the regulations should provide expressly that the 200-percent excise tax will not be imposed during any period in which the 25-percent excise tax may be, or is being, contested.
If the excess benefit transaction consists of the payment of compensation for services under a contract that has not been completed, termination of the employment or independent contractor relationship between the organization and the disqualified person is not required in order to correct. However, the terms of any ongoing compensation arrangement may need to be modified to avoid future excess benefit transactions.
Section 53.4958-1(g)(2) of the proposed regulations states that: The section 4958 taxes do not apply to any transaction occurring pursuant to a written contract that was binding on September 13, 1995, and at all times thereafter before the transaction occurs. A written binding contract that is terminable or subject to cancellation by the applicable tax-exempt organization without the disqualified person's consent is treated as a new contract as of the date that any such termination or cancellation, if made, would be effective. If a binding written contract is materially modified (a material modification includes amending the contract to extend its term or to increase the amount of compensation payable to the disqualified person), it is treated as a new contract entered into as of the date of the material modification.
The proposed regulations are not clear as to whether "the terms of any ongoing compensation arrangement...need to be modified to avoid future excess benefit transactions" only when the arrangement "is terminable or subject to cancellation by the applicable tax-exempt organization without the disqualified person's consent." The issue of when "a written contract that was binding on September 13, 1995" does not create an excess benefit transaction needs to be clarified in the regulations.
FSC members are concerned that the IRS has misconstrued its role in promulgating these regulations, drafting them so as to make the statutory provisions as punitive as possible for nonprofits, rather than more neutrally defining and clarifying the application of the statutory provisions. For this reason, and for the other reasons set out above, FSC is very strongly opposed to the ideas and language of the proposed regulations, and respectfully requests that these regulations be reconsidered, and, where appropriate, withdrawn. If the IRS believes that revisions can be made which would eliminate the objections advanced in these Comments, we would ask for an opportunity for FSC and others to review such revisions and to provide further comments.
Mark B. Weinberg
William J. Olson