On March 28, 2008, the Internal Revenue Service (IRS) promulgated final regulations that describe the broad scope of the prohibition against tax-exempt organizations serving private interests. The final rules also provide specific guidance as to how the IRS decides whether to revoke the tax-exempt status of an organization that engages in excess benefit transactions. The new rules are effective immediately.

Hospitals, health systems and other tax-exempt health care organizations are advised to take careful note of the new regulations. These new rules demonstrate that in certain situations tax-exempt organizations may face severe penalties for engaging in excess benefit transactions. They also highlight the importance of establishing and maintaining processes to prevent private benefit and excess benefit transactions and of taking corrective measures if such events do occur.

Clarification of the Prohibition Against Serving Private Interests
A not-for-profit health care provider is eligible for exemption from federal income tax as an organization that is organized and operated exclusively for charitable purposes, as described in Section 501(c)(3) of the Internal Revenue Code (Code). The entity must primarily engage in activities that accomplish its exempt purpose of promoting health and must primarily serve public rather than private interests. That is, any private interests served must be incidental to the accomplishment of the organization’s charitable purpose and must not represent a substantial non-exempt purpose. Private benefits must be both qualitatively and quantitatively incidental.

The final regulations include three examples intended to illustrate the broad scope of prohibited private benefits, which can involve economic and non-economic benefits and can arise even though a transaction involves payments to private interests at the fair market value. The first example describes an educational organization that studies the genealogy of only one family so that family members may become acquainted. This organization primarily serves private interests and is therefore ineligible for tax exemption, demonstrating that private benefits can be non-economic as well as economic in nature.

The second example describes an organization that exhibits the work of unknown artists, sells the art on a consignment basis, and pays 90 percent of the proceeds to the artists. This activity primarily benefits the artists, rendering the organization ineligible for tax exemption because the benefit to the artists is more than merely incidental to the organization’s exempt purpose.

The third example describes an organization that pays a royalty for permission to train people in a program developed by the for-profit company. Even if the royalty payment is reasonable and fair market value, the activity primarily benefits the for-profit company, so the organization is not eligible for tax-exemption.

Factors for Revocation of Tax-exempt Status for Engaging in Excess Benefit Transactions
Under Section 4958 of the Code, the IRS may impose excise taxes on a transaction between a tax-exempt social welfare organization or public charity, such as a hospital or other health care provider, and a person who is in a position to exert substantial control over the organization, if the transaction results in an excess benefit to the person. An applicable tax-exempt organization pays an excess benefit when the value it pays to a disqualified person exceeds the value of goods or services it receives in return. A disqualified person is an individual in a position to exercise substantial influence over the affairs of the organization, a family member of such an individual, or an entity in which such an individual owns more than a 35 percent interest. The excise taxes are imposed on the disqualified person who benefited from the transaction and any organization managers who participated in the transaction knowing it was improper. The disqualified person is subject to an initial tax equal to 25 percent of the excess benefit and the organization managers who participated in the transaction knowing it was prohibited are subject to a tax equal to 10 percent of the excess benefit up to $20,000. If there is no correction of the excess benefit within a certain period of time, the disqualified person is subject to an additional tax equal to 200 percent of the excess benefit.

The final regulations clarify that the substantive requirements for tax-exemption under Section 502(c)(3) of the Code still apply to tax-exempt public charities and social welfare organizations whose disqualified persons or organization managers are subject to excise taxes. Thus, an organization may lose its tax-exempt status if, due to the excess benefit transaction, it is no longer organized and operated primarily to serve an exempt purpose. The regulations set forth five factors that the IRS considers, in addition to all relevant facts and circumstances, in determining whether to revoke an organization’s tax-exempt status:

1. the size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after the excess benefit transaction occurred;
2. the size and scope of the excess benefit transaction 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 multiple excess benefit transactions with one or more persons;
4. whether the organization has implemented safeguards that are reasonably calculated to prevent excess benefit transactions; and
5. whether the excess benefit transaction has been corrected or the organization has made good faith efforts to seek correction from the disqualified person who benefited from the excess benefit transaction.

The last two factors weigh more heavily in favor of continued recognition of tax-exemption if the organization takes action before the IRS discovers the excess benefit transaction. However, simply correcting the excess benefit transaction after the IRS has discovered it is by itself never a sufficient basis for maintaining tax exemption. The IRS provides in the regulations six examples that demonstrate how the factors apply to certain situations. The regulations do not provide any “best practices” to improve governance and prevent prohibited transactions.

Tax-exempt health care providers are encouraged take steps to reduce the risk of the revocation of their tax-exempt status, which these regulations make clear is possible for serious violations of the private benefit and excess benefit rules. If you have questions about these new regulations or other tax-exemption matters, please contact Michael Davidson at 815-490-4940 or your regular Hinshaw attorney.

This alert has been prepared by Hinshaw & Culbertson LLP to provide information on recent legal developments of interest to our readers. It is not intended to provide legal advice for a specific situation or to create an attorney-client relationship.