Changes in Intermediate Sanctions for Supporting Organizations (Types I, II and III)

Effective Dates

The expansion of the definition of disqualified persons is effective for transactions after the Pension Protection Act of 2006 (PPA)’s date of enactment (August 17, 2006). The provisions for new automatic excess benefit transactions are effective retroactively, applying to transactions after July 25, 2006. However, the IRS has provided some transition relief for such excess benefit transactions. The Council Summary of IRS Interim Guidance on Supporting Organizations and Donor-Advised Funds provides a summary of the transition relief. The change in maximum tax imposed on a foundation manager is effective for taxable years beginning after enactment.

Does the PPA expand the definition of disqualified persons under the intermediate sanction rules?

Yes. The PPA expands the class of disqualified persons in several ways. Most relevant to all supporting organizations is the provision that treats disqualified persons of a supporting organization as disqualified persons of the organization(s) it supports.

For example, a board member of a supporting organization that supports a community foundation is also a disqualified person of the community foundation even if the board member has no other relationship with the community foundation. The community foundation cannot enter any transaction with the board member that provides the board member—a disqualified person—with an excess benefit.

Note that when the payment is made by the community foundation for services provided to the community foundation, penalties apply only if the amount paid is excessive. A stricter rule applies to payments by the supporting organization to its substantial contributor and related parties. This stricter rule may also apply to payments by the community foundation to a supporting organization’s substantial contributor and related parties if the payment is for services provided to the supporting organization and is charged back to the supporting organization.

Does the PPA expand the types of excess benefit transactions?

Yes. The PPA creates several new categories of automatic excess benefit transactions. Two of these new categories are directly applicable to all supporting organizations:

Grants, loans, payments of compensation, and similar payments to substantial contributors.

The entire amount of any grant, loan, payment of compensation, or similar payment to a substantial contributor, family member of a substantial contributor, or business controlled by a substantial contributor is an automatic excess benefit transaction.

A “similar payment” includes expense reimbursement. However, payments for the sale or lease of property, for example, would not be treated as an automatic excess benefit transaction because they are not “similar” payments.

Examples of prohibited transactions:

A child of a substantial contributor to a supporting organization may not receive compensation as an executive director of the supporting organization.

A substantial contributor to a supporting organization may not receive compensation or expense reimbursement for her service as a board member of the supporting organization.

Loans to disqualified persons.

Loans to any disqualified person of a supporting organization are an automatic excess benefit transaction. Disqualified persons are persons who are in a position to exercise substantial influence over the supporting organization. Disqualified persons include, but are not limited to, people who have served the supporting organization in the role of board member, chief executive officer, or chief financial officer within the past five years.

Example of an automatic excess benefit transaction:

In an effort to retain an effective executive director, the board of a supporting organization makes a loan to the executive director to assist with the purchase of a home. Such a loan is prohibited.

Other examples of excess benefit transactions:

A salary advance to a supporting organization’s executive director

A loan to a board member of a supporting organization

Loans to public charities that are not supporting organizations are permissible even if the public charity has previously provided substantial contributions to the supporting organization. For example, a supporting organization may make a loan to a community foundation that it supports to assist with operating costs.

Who are substantial contributors, family members and controlled entities?

Substantial contributors are defined as persons who contributed or bequeathed an aggregate amount which is more than $5,000 and more than 2 percent of the total contributions and bequests received by the supporting organization before the close of the organization’s taxable year in which the contribution or bequest is received by the organization from that person.

Example: A supporting organization received $5 million in contributions during its existence. If a new contributor made a contribution of $1 million in 2006, the new contributor would be considered a substantial contributor. The $1 million contribution is both more than $5,000 and more than 2 percent of the total contributions received by the supporting organization.

The new legislation states that rules similar to those used for identifying a substantial contributor to a private foundation should be used in the context of these new rules for supporting organizations. The private foundations rules provide that a contribution or bequest is valued at fair market value on the date of receipt. Further, in determining whether an individual is a substantial contributor, one should take into account all contributions and/or bequests by his/her spouse.

If the supporting organization is a trust, the term “substantial contributor” also includes the creator of the trust.

Grants, loans, compensation, or similar payments to persons related to substantial contributors are also considered automatic excess benefit transactions. The affected family members are a substantial contributor’s spouse, ancestors, children, grandchildren, great grandchildren, brothers, sisters, and the spouses of children, grandchildren, great grandchildren, brothers, and sisters. Other related parties are 35-percent-controlled entities. A 35-percent-controlled entity is an entity in which a substantial contributor and family members described above own the following:

• More that 35 percent of the total combined voting power if the entity is a corporation
• More than 35 percent of the profits interest if the entity is a partnership
• More than 35 percent of the beneficial interest if the entity is a trust or estate

The term “substantial contributor” does not include other public charities that are not supporting organizations.

Example: A community foundation established a supporting organization to hold real estate. Even if the community foundation transferred a large piece of real estate to the supporting organization, the community foundation would not be considered a substantial contributor. The supporting organization would be permitted to make grants to the community foundation without penalty.

Private non-operating foundations may be substantial contributors.

Once designated a substantial contributor, is a person always a substantial contributor?

Relying on the rules set forth for private foundations, once a person is a substantial contributor to a supporting organization the person generally remains a substantial contributor. However, a person can cease to be treated as a substantial contributor at the close of any taxable year if all of the following are true:

• The person and all related persons have not made any contribution to the supporting organization during the ten-year period ending at the close of the year.
• The person and all related persons did not serve as a foundation manager during the 10-year period ending at the close of the year.
• The aggregate contributions made by the person (and all related persons) are determined by the secretary to be insignificant when compared to the aggregated amount of contributions to the foundation by one other person.

Have the penalties for entering into an excess benefit transaction changed?

Yes. Tax is imposed on the disqualified person who enters into an excess benefit transaction as well as on organization managers who knowingly participate in the transaction.

Tax Imposed on Disqualified Person

The tax rate for penalties imposed on disqualified persons did not change. The initial tax remains 25 percent of the excess benefit amount. Typically, this tax is imposed on the amount of the excess benefit received by the disqualified person. For example, if a disqualified person received $5,000 for services for which the fair market value was $4,000, the 25 percent tax would be imposed on $1,000 (i.e. the difference between the benefit received and the fair market value of the services). Uncorrected transactions are subject to a tax of 200 percent of the excess benefit.

However, under the new legislation, if the transaction is considered an automatic excess benefit transaction because the supporting organization provided a loan to a disqualified person or a grant, loan, compensation, or other similar payment to a substantial contributor, the tax is applied to the entire amount of the transaction. For example, if a substantial contributor received an expense reimbursement of $5,000, the 25 percent tax would be imposed on the entire $5,000. Similarly, payments that were not corrected would be subject to 200 percent of the entire payment.

Tax Imposed on Organization Managers

Organization managers that participate in a transaction knowing it is an excess benefit transaction are also subject to tax. The PPA increases the maximum tax imposed on organization managers from $10,000 to $20,000. This change is applicable to all public charities, not just supporting organizations.

The Council also has background on Intermediate Sanctions.

Review our Intermediate Sanctions Checklist.

Disclaimer

The information provided in this document is based on our continuing analysis of the bill. Every effort has been made to ensure accuracy of these documents. Please understand, however, that due to the complexity of the bill and the fact that many of these provisions introduce issues that are new to the Internal Revenue Code, this information is subject to change. The information is not a substitute for expert legal, tax or other professional advice and we strongly encourage grantmakers and donors to work with their counsel to determine the impact of this legislation on their particular situations. This information may not be relied upon for the purposes of avoiding any penalties that may be imposed under the Internal Revenue Code.