[Federal Register Volume 73, Number 61 (Friday, March 28, 2008)]
[Rules and Regulations]
[Pages 16519-16525]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-6305]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 53

[TD 9390]
RIN 1545-BE37


Standards for Recognition of Tax-Exempt Status if Private Benefit 
Exists or if an Applicable Tax-Exempt Organization Has Engaged in 
Excess Benefit Transaction(s)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations that clarify the 
substantive requirements for tax exemption under section 501(c)(3) of 
the Internal Revenue Code (Code). This document also contains 
provisions that clarify the relationship between the substantive 
requirements for tax exemption under section 501(c)(3) and the 
imposition of section 4958 excise taxes on excess benefit transactions. 
These regulations affect organizations described in section 501(c)(3) 
of the Code and organizations applying for exemption as organizations 
described in section 501(c)(3) of the Code.

DATES: Effective Date: These regulations are effective March 28, 2008.

FOR FURTHER INFORMATION CONTACT: Galina Kolomietz, (202) 622-7971 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION: 

Background

    On September 9, 2005, a notice of proposed rulemaking (REG-111257-
05, 2005-42 CB 759) clarifying the substantive requirements for tax 
exemption under section 501(c)(3) of the Code, and the relationship 
between the substantive requirements for tax exemption under section 
501(c)(3) and the imposition of section 4958 excise taxes was published 
in the Federal Register (70 FR 53599). The IRS received several written 
comments responding to this notice. After consideration of all comments 
received, the proposed regulations under sections 501(c)(3) and 4958 
are revised and published in final form. The major areas of comments 
and revisions are discussed in the following preamble. (See Sec.  
601.601(d)(2)(ii)(b)).

Explanation and Summary of Comments

Private Benefit

    The proposed regulations added several examples to illustrate the 
requirement in Sec.  1.501(c)(3)-1(d)(1)(ii) that an organization serve 
a public rather than a private interest. The purpose of the examples is 
to illustrate that prohibited private benefit may involve non-economic 
benefits as well as economic benefits and that prohibited private 
benefit may arise regardless of whether payments made to private 
interests are reasonable or excessive.
    One comment suggested that, rather than add three isolated examples 
on private benefit to the regulations, the IRS consider a broader 
revision of the regulations under section 501(c)(3) to provide a more 
detailed discussion of the underlying principles of the private benefit 
doctrine. In particular, this comment suggested that the regulations 
address the relative quantity of private benefit that could preclude 
exemption. The IRS and the Treasury Department are not revising the 
existing regulations under section 501(c)(3) at this time. The new 
examples in the proposed regulations clarify the principles of the 
private benefit doctrine under current law. In Sec.  1.501(c)(3)-
1(d)(1)(iii), Example 1 illustrates that private benefit may involve 
non-economic benefits. Example 2 illustrates that private benefit is 
inconsistent with tax-exempt status under section 501(c)(3) if it is 
substantial and not merely incidental to the accomplishment of the 
organization's exempt purposes. Example 3 illustrates that private 
benefit may exist even though the transaction is at fair market value. 
Moreover, these examples are intended to illustrate the principle that 
private benefit remains an independent basis for revocation even if it 
does not involve economic benefit or raise fair market value issues. 
Accordingly, these examples are adopted in final form without revision.

Revocation Standards

    The proposed regulations provided guidance on certain factors that 
the IRS will consider in determining whether an applicable tax-exempt 
organization described in section 501(c)(3) that engages in one or more 
excess benefit transactions continues to be described in section 
501(c)(3). The comments received in response to the proposed 
regulations are discussed below. Overall, the commentators reacted 
favorably to the factors set forth in the proposed regulations. The 
factors described in the proposed regulations are finalized without 
major revisions. The application of the factors is refined by the 
addition of a new example to the final regulations.

[[Page 16520]]

a. Interaction With Determination of Existence of Excess Benefit 
Transaction
    Two comments suggested that the final regulations clarify the 
interaction between the determination of the organization's tax-exempt 
status and the determination of the existence of an excess benefit 
transaction. One of these comments specifically requested that the 
final regulations state that the IRS will not take any action to remove 
an organization's tax exemption on excess benefit transaction grounds 
while the IRS's determination of the existence of an excess benefit 
transaction is itself being contested in court. The final regulations 
do not adopt this comment. The determination of an organization's tax-
exempt status and the determination of the existence of an excess 
benefit transaction are separate determinations, involving distinct 
parties, different legal elements, and separate processes, even though 
they may relate to the same facts.
b. Clarification of Terms
    Two comments voiced the need to clarify the terms ``significant'' 
and ``de minimis'' as they are used in the proposed regulations. One of 
these comments suggested adding an example of a safe harbor based on 
specific amounts the IRS would consider clearly insignificant, perhaps 
as a percentage of overall expenditures. Because the determination of 
whether an activity or an amount is ``significant'' or ``de minimis'' 
depends on the facts and circumstances, the final regulations do not 
adopt this comment.
    One comment suggested adding examples combining potential de 
minimis values with other abating or negative factors and/or examples 
containing values that are not de miminis. The final regulations 
contain a new example that illustrates the application of the 
revocation factors to an excess benefit transaction that is neither 
significant in comparison to the size and scope of the organization's 
exempt activities nor de minimis.
    One comment requested clarification of the term ``repeated'' as 
used in Example 3 of Sec.  1.501(c)(3)-1(g) of the proposed 
regulations. The term was used in that example to correspond to the 
third factor in the proposed regulations, which looked to ``whether the 
organization has been involved in repeated excess benefit 
transactions.'' In response to this comment, the third factor of the 
proposed regulations is revised to substitute the term ``multiple'' for 
the word ``repeated.'' The term ``multiple'' refers to both (1) 
repeated instances of the same (or substantially similar) excess 
benefit transaction, regardless of whether the transaction involves the 
same or different persons; and (2) the presence of more than one excess 
benefit transaction, regardless of whether the transactions are the 
same or substantially similar and regardless of whether they involve 
the same or different persons.
    Another comment requested guidance regarding when the IRS would 
consider the presence of a single excess benefit transaction to 
jeopardize an organization's tax-exempt status. Because such a 
determination would depend on the facts and circumstances, the final 
regulations do not adopt the comment.
c. Due Diligence and Safeguards
    One comment requested that evidence that an organization's board of 
directors conducted appropriate due diligence or followed certain 
safeguards in connection with the excess benefit transaction be treated 
as a factor weighing in favor of continuing to recognize exemption. The 
IRS and the Treasury Department agree that the organization's reliance 
on objectively reasonable internal controls and procedures, such as the 
procedures for establishing a rebuttable presumption of reasonableness, 
in approving a transaction that is later determined to be an excess 
benefit transaction, should be treated as a factor weighing in favor of 
continuing to recognize exemption. Accordingly, the fourth factor under 
the proposed regulations is revised to make clear that implementation 
by an organization of safeguards that are reasonably calculated to 
prevent excess benefit transactions will be treated as a factor 
weighing in favor of continuing to recognize exemption regardless of 
whether such safeguards are implemented in direct response to the 
excess benefit transaction(s) at issue or as a general matter of 
corporate governance or fiscal management. Thus, an organization may be 
treated as having implemented safeguards reasonably calculated to 
prevent excess benefit transactions even though the organization is 
contesting the existence of the excess benefit transaction(s) at issue. 
An example is added to illustrate how implementation of safeguards, 
including preexisting safeguards, will be taken into account in 
determining whether to continue to recognize an organization's tax-
exempt status.
    One comment suggested that an organization's good faith attempt to 
establish a rebuttable presumption of reasonableness within the meaning 
of Sec.  53.4958-6 be treated as a factor weighing in favor of 
continuing to recognize exemption. Another comment suggested that a 
good faith attempt by an organization's board of directors to determine 
fair market value be treated as a factor precluding revocation even if 
the IRS disagrees with the board's fair market value analysis. The 
fourth factor, as revised in these final regulations, takes into 
account whether the organization has implemented safeguards that are 
reasonably calculated to prevent excess benefit transactions. This 
factor takes safeguards into account, regardless of whether they were 
implemented before or after an excess benefit transaction occurred. The 
comments raise the question of how this factor will apply where steps 
have been taken to avoid an excess benefit transaction, but nonetheless 
have failed to prevent the excess benefit transaction. The weight 
afforded to this particular circumstance will depend upon the specific 
facts and circumstances.
d. Requests for Additional Examples
    Two comments suggested adding to the proposed regulations an 
example specifically addressing reasonable compensation. In response to 
these comments, the new example added by these final regulations 
addresses reasonable compensation.
    One comment suggested that the regulations include examples 
involving health care organizations. The IRS and the Treasury 
Department note that the application of sections 501(c)(3) and 4958 to 
health care organizations is not unique. The examples in these 
regulations, although not specifically involving health care 
organizations, apply to health care organizations in the same manner as 
they apply to other organizations described in section 501(c)(3).
    One comment criticized the examples in the proposed regulations as 
too ``black-and-white'' and suggested that the regulations be 
supplemented with examples that discuss less clear facts. Specifically, 
this comment requested guidance on situations involving more than de 
minimis amounts in which an applicable tax-exempt organization does not 
seek correction from the disqualified person involved. The new example 
added by these final regulations illustrates that, in some situations, 
even in the absence of correction of non-de minimis excess benefit 
transactions, an organization may retain its tax-exempt status if the 
other factors, in combination, warrant continued exemption. Under the 
fifth factor, the IRS will take into account the organization's good 
faith with respect to

[[Page 16521]]

correction. Accordingly, the reasons behind the organization's failure 
to seek correction will be examined.
    One comment suggested adding an example that would illustrate what 
factors, in addition to post-audit correction, would be sufficient to 
avoid revocation. The example that has been added illustrates a case 
where factors other than correction support continued exemption. The 
IRS and the Treasury Department may consider publication of future 
guidance on the application of the factors based on other specific fact 
patterns that the IRS encounters in the course of tax administration.
    One comment requested adding an example discussing the effect of 
``automatic excess benefit transactions'' that are not de minimis on 
the organization's tax-exempt status. The term ``automatic excess 
benefit transaction'' refers to a transaction in which a disqualified 
person provides services to an organization and receives economic 
benefits from the organization that are not substantiated, 
contemporaneously and in writing, as compensation within the meaning of 
Sec.  53.4958-4(c). After the enactment of the Pension Protection Act 
of 2006, Public Law 109-280 (120 Stat. 780 (2006)), the term 
``automatic excess benefit transaction'' also refers to any grant, 
loan, compensation or other similar payment from a donor advised fund 
to a donor or donor advisor with respect to such fund and from a 
supporting organization to any of its disqualified persons. See section 
4958(c)(2) and (3). Although not in the context of an automatic excess 
benefit transaction, the new example in the final regulations involves 
an excess benefit transaction that is not de minimis.
e. Removal of Disqualified Person
    One comment suggested that the regulations address whether and 
under what circumstances removal of a disqualified person may be 
necessary to avoid revocation. The new example added by these final 
regulations illustrates that removal of a disqualified person is not a 
necessary condition for continued exemption. In the example, the 
organization implemented safeguards designed to prevent future excess 
benefit transactions involving the same disqualified persons.
f. Best Practices
    One comment described specific actions that boards of applicable 
tax-exempt organizations should be required to take to improve 
governance and to prevent excess benefit transactions at their 
organizations. This comment was not adopted because the purpose of 
these regulations is to set forth an analytical framework for 
determining whether to revoke tax-exempt status if an organization 
engages in one or more excess benefit transactions.

Special Analyses

    It has been determined that this regulation is not a significant 
regulatory action as defined in Executive Order 12866. Therefore, a 
regulatory assessment is not required. It also has been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
does not apply to this regulation, and because this regulation does not 
impose a collection of information on small entities, the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to 
section 7805(f) of the Code, the notice of proposed rulemaking 
preceding this regulation was submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on its impact 
on business.

Drafting Information

    The principal authors of these regulations are Galina Kolomietz and 
Phyllis Haney, Office of Division Counsel/Associate Chief Counsel (Tax 
Exempt and Government Entities). However, other personnel from the IRS 
and the Treasury Department participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 53

    Excise taxes, Foundations, Investments, Lobbying, Reporting and 
recordkeeping requirements.

Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 53 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read, in 
part, as follows:

    Authority: 26 U.S.C. 7805 * * *


0
Par. 2. Section 1.501(c)(3)-1 is revised by:
0
1. Redesignating paragraph (d)(1)(iii) as paragraph (d)(1)(iv) and 
adding a new paragraph (d)(1)(iii).
0
2. Redesignating paragraph (f) as paragraph (g) and adding a new 
paragraph (f).
    The additions read as follows:


Sec.  1.501(c)(3)-1  Organizations organized and operated for 
religious, charitable, scientific, testing for public safety, literary, 
or educational purposes, or for the prevention of cruelty to children 
or animals.

* * * * *
    (d) * * *
    (1) * * *
    (iii) Examples. The following examples illustrate the requirement 
of paragraph (d)(1)(ii) of this section that an organization serve a 
public rather than a private interest:

    Example 1. (i) O is an educational organization the purpose of 
which is to study history and immigration. O's educational 
activities include sponsoring lectures and publishing a journal. The 
focus of O's historical studies is the genealogy of one family, 
tracing the descent of its present members. O actively solicits for 
membership only individuals who are members of that one family. O's 
research is directed toward publishing a history of that family that 
will document the pedigrees of family members. A major objective of 
O's research is to identify and locate living descendants of that 
family to enable those descendants to become acquainted with each 
other.
    (ii) O's educational activities primarily serve the private 
interests of members of a single family rather than a public 
interest. Therefore, O is operated for the benefit of private 
interests in violation of the restriction on private benefit in 
paragraph (d)(1)(ii) of this section. Based on these facts and 
circumstances, O is not operated exclusively for exempt purposes 
and, therefore, is not described in section 501(c)(3).
    Example 2. (i) O is an art museum. O's principal activity is 
exhibiting art created by a group of unknown but promising local 
artists. O's activity, including organized tours of its art 
collection, promotes the arts. O is governed by a board of trustees 
unrelated to the artists whose work O exhibits. All of the art 
exhibited is offered for sale at prices set by the artist. Each 
artist whose work is exhibited has a consignment arrangement with O. 
Under this arrangement, when art is sold, the museum retains 10 
percent of the selling price to cover the costs of operating the 
museum and gives the artist 90 percent.
    (ii) The artists in this situation directly benefit from the 
exhibition and sale of their art. As a result, the sole activity of 
O serves the private interests of these artists. Because O gives 90 
percent of the proceeds from its sole activity to the individual 
artists, the direct benefits to the artists are substantial and O's 
provision of these benefits to the artists is more than incidental 
to its other purposes and activities. This arrangement causes O to 
be operated for the benefit of private interests in violation of the 
restriction on private benefit in paragraph (d)(1)(ii) of this 
section. Based on these facts and circumstances, O is not operated 
exclusively for exempt purposes and, therefore, is not described in 
section 501(c)(3).
    Example 3. (i) O is an educational organization the purpose of 
which is to train individuals in a program developed by P, O's 
president. The program is of interest to academics and 
professionals, representatives

[[Page 16522]]

of whom serve on an advisory panel to O. All of the rights to the 
program are owned by Company K, a for-profit corporation owned by P. 
Prior to the existence of O, the teaching of the program was 
conducted by Company K. O licenses, from Company K, the right to 
conduct seminars and lectures on the program and to use the name of 
the program as part of O's name, in exchange for specified royalty 
payments. Under the license agreement, Company K provides O with the 
services of trainers and with course materials on the program. O may 
develop and copyright new course materials on the program but all 
such materials must be assigned to Company K without consideration 
if and when the license agreement is terminated. Company K sets the 
tuition for the seminars and lectures on the program conducted by O. 
O has agreed not to become involved in any activity resembling the 
program or its implementation for 2 years after the termination of 
O's license agreement.
    (ii) O's sole activity is conducting seminars and lectures on 
the program. This arrangement causes O to be operated for the 
benefit of P and Company K in violation of the restriction on 
private benefit in paragraph (d)(1)(ii) of this section, regardless 
of whether the royalty payments from O to Company K for the right to 
teach the program are reasonable. Based on these facts and 
circumstances, O is not operated exclusively for exempt purposes 
and, therefore, is not described in section 501(c)(3).
* * * * *
    (f) Interaction with section 4958--(1) Application process. An 
organization that applies for recognition of exemption under section 
501(a) as an organization described in section 501(c)(3) must establish 
its eligibility under this section. The Commissioner may deny an 
application for exemption for failure to establish any of section 
501(c)(3)'s requirements for exemption. Section 4958 does not apply to 
transactions with an organization that has failed to establish that it 
satisfies all of the requirements for exemption under section 
501(c)(3). See Sec.  53.4958-2.
    (2) Substantive requirements for exemption still apply to 
applicable tax-exempt organizations described in section 501(c)(3)--(i) 
In general. Regardless of whether a particular transaction is subject 
to excise taxes under section 4958, the substantive requirements for 
tax exemption under section 501(c)(3) still apply to an applicable tax-
exempt organization (as defined in section 4958(e) and Sec.  53.4958-2) 
described in section 501(c)(3) whose disqualified persons or 
organization managers are subject to excise taxes under section 4958. 
Accordingly, an organization will no longer meet the requirements for 
tax-exempt status under section 501(c)(3) if the organization fails to 
satisfy the requirements of paragraph (b), (c) or (d) of this section. 
See Sec.  53.4958-8(a).
    (ii) Determination of whether revocation of tax-exempt status is 
appropriate when section 4958 excise taxes also apply. In determining 
whether to continue to recognize the tax-exempt status of an applicable 
tax-exempt organization (as defined in section 4958(e) and Sec.  
53.4958-2) described in section 501(c)(3) that engages in one or more 
excess benefit transactions (as defined in section 4958(c) and Sec.  
53.4958-4) that violate the prohibition on inurement under section 
501(c)(3), the Commissioner will consider all relevant facts and 
circumstances, including, but not limited to, the following--
    (A) The size and scope of the organization's regular and ongoing 
activities that further exempt purposes before and after the excess 
benefit transaction or transactions occurred;
    (B) The size and scope of the excess benefit transaction or 
transactions (collectively, if more than one) in relation to the size 
and scope of the organization's regular and ongoing activities that 
further exempt purposes;
    (C) Whether the organization has been involved in multiple excess 
benefit transactions with one or more persons;
    (D) Whether the organization has implemented safeguards that are 
reasonably calculated to prevent excess benefit transactions; and
    (E) Whether the excess benefit transaction has been corrected 
(within the meaning of section 4958(f)(6) and Sec.  53.4958-7), or the 
organization has made good faith efforts to seek correction from the 
disqualified person(s) who benefited from the excess benefit 
transaction.
    (iii) All factors will be considered in combination with each 
other. Depending on the particular situation, the Commissioner may 
assign greater or lesser weight to some factors than to others. The 
factors listed in paragraphs (f)(2)(ii)(D) and (E) of this section will 
weigh more heavily in favor of continuing to recognize exemption where 
the organization discovers the excess benefit transaction or 
transactions and takes action before the Commissioner discovers the 
excess benefit transaction or transactions. Further, with respect to 
the factor listed in paragraph (f)(2)(ii)(E) of this section, 
correction after the excess benefit transaction or transactions are 
discovered by the Commissioner, by itself, is never a sufficient basis 
for continuing to recognize exemption.
    (iv) Examples. The following examples illustrate the principles of 
paragraph (f)(2)(ii) of this section. For purposes of each example, 
assume that O is an applicable tax-exempt organization (as defined in 
section 4958(e) and Sec.  53.4958-2) described in section 501(c)(3). 
The examples read as follows:

    Example 1. (i) O was created as a museum for the purpose of 
exhibiting art to the general public. In Years 1 and 2, O engages in 
fundraising and in selecting, leasing, and preparing an appropriate 
facility for a museum. In Year 3, a new board of trustees is 
elected. All of the new trustees are local art dealers. Beginning in 
Year 3 and continuing to the present, O uses a substantial portion 
of its revenues to purchase art solely from its trustees at prices 
that exceed fair market value. O exhibits and offers for sale all of 
the art it purchases. O's Form 1023, ``Application for Recognition 
of Exemption,'' did not disclose the possibility that O would 
purchase art from its trustees.
    (ii) O's purchases of art from its trustees at more than fair 
market value constitute excess benefit transactions between an 
applicable tax-exempt organization and disqualified persons under 
section 4958. Therefore, these transactions are subject to the 
applicable excise taxes provided in that section. In addition, O's 
purchases of art from its trustees at more than fair market value 
violate the proscription against inurement under section 501(c)(3) 
and paragraph (c)(2) of this section.
    (iii) The application of the factors in paragraph (f)(2)(ii) of 
this section to these facts is as follows. Beginning in Year 3, O 
does not engage primarily in regular and ongoing activities that 
further exempt purposes because a substantial portion of O's 
activities consists of purchasing art from its trustees and dealing 
in such art in a manner similar to a commercial art gallery. The 
size and scope of the excess benefit transactions collectively are 
significant in relation to the size and scope of any of O's ongoing 
activities that further exempt purposes. O has been involved in 
multiple excess benefit transactions, namely, purchases of art from 
its trustees at more than fair market value. O has not implemented 
safeguards that are reasonably calculated to prevent such improper 
purchases in the future. The excess benefit transactions have not 
been corrected, nor has O made good faith efforts to seek correction 
from the disqualified persons who benefited from the excess benefit 
transactions (the trustees). The trustees continue to control O's 
Board. Based on the application of the factors to these facts, O is 
no longer described in section 501(c)(3) effective in Year 3.
    Example 2. (i) The facts are the same as in Example 1, except 
that in Year 4, O's entire board of trustees resigns, and O no 
longer offers all exhibited art for sale. The former board is 
replaced with members of the community who are not in the business 
of buying or selling art and who have skills and experience running 
charitable and educational programs and institutions. O promptly 
discontinues the practice of purchasing art from current or former 
trustees, adopts a written conflicts of interest policy, adopts 
written art valuation

[[Page 16523]]

guidelines, hires legal counsel to recover the excess amounts O had 
paid its former trustees, and implements a new program of activities 
to further the public's appreciation of the arts.
    (ii) O's purchases of art from its former trustees at more than 
fair market value constitute excess benefit transactions between an 
applicable tax-exempt organization and disqualified persons under 
section 4958. Therefore, these transactions are subject to the 
applicable excise taxes provided in that section. In addition, O's 
purchases of art from its trustees at more than fair market value 
violate the proscription against inurement under section 501(c)(3) 
and paragraph (c)(2) of this section.
    (iii) The application of the factors in paragraph (f)(2)(ii) of 
this section to these facts is as follows. In Year 3, O does not 
engage primarily in regular and ongoing activities that further 
exempt purposes. However, in Year 4, O elects a new board of 
trustees comprised of individuals who have skills and experience 
running charitable and educational programs and implements a new 
program of activities to further the public's appreciation of the 
arts. As a result of these actions, beginning in Year 4, O engages 
in regular and ongoing activities that further exempt purposes. The 
size and scope of the excess benefit transactions that occurred in 
Year 3, taken collectively, are significant in relation to the size 
and scope of O's regular and ongoing exempt function activities that 
were conducted in Year 3. Beginning in Year 4, however, as O's 
exempt function activities grow, the size and scope of the excess 
benefit transactions that occurred in Year 3 become less and less 
significant as compared to the size and extent of O's regular and 
ongoing exempt function activities. O was involved in multiple 
excess benefit transactions in Year 3. However, by discontinuing its 
practice of purchasing art from its current and former trustees, by 
replacing its former board with independent members of the 
community, and by adopting a conflicts of interest policy and art 
valuation guidelines, O has implemented safeguards that are 
reasonably calculated to prevent future violations. In addition, O 
has made a good faith effort to seek correction from the 
disqualified persons who benefited from the excess benefit 
transactions (its former trustees). Based on the application of the 
factors to these facts, O continues to meet the requirements for tax 
exemption under section 501(c)(3).
    Example 3. (i) O conducts educational programs for the benefit 
of the general public. Since its formation, O has employed its 
founder, C, as its Chief Executive Officer. Beginning in Year 5 of 
O's operations and continuing to the present, C caused O to divert 
significant portions of O's funds to pay C's personal expenses. The 
diversions by C significantly reduced the funds available to conduct 
O's ongoing educational programs. The board of trustees never 
authorized C to cause O to pay C's personal expenses from O's funds. 
Certain members of the board were aware that O was paying C's 
personal expenses. However, the board did not terminate C's 
employment and did not take any action to seek repayment from C or 
to prevent C from continuing to divert O's funds to pay C's personal 
expenses. C claimed that O's payments of C's personal expenses 
represented loans from O to C. However, no contemporaneous loan 
documentation exists, and C never made any payments of principal or 
interest.
    (ii) The diversions of O's funds to pay C's personal expenses 
constitute excess benefit transactions between an applicable tax-
exempt organization and a disqualified person under section 4958. 
Therefore, these transactions are subject to the applicable excise 
taxes provided in that section. In addition, these transactions 
violate the proscription against inurement under section 501(c)(3) 
and paragraph (c)(2) of this section.
    (iii) The application of the factors in paragraph (f)(2)(ii) of 
this section to these facts is as follows. O has engaged in regular 
and ongoing activities that further exempt purposes both before and 
after the excess benefit transactions occurred. However, the size 
and scope of the excess benefit transactions engaged in by O 
beginning in Year 5, collectively, are significant in relation to 
the size and scope of O's activities that further exempt purposes. 
Moreover, O has been involved in multiple excess benefit 
transactions. O has not implemented any safeguards that are 
reasonably calculated to prevent future diversions. The excess 
benefit transactions have not been corrected, nor has O made good 
faith efforts to seek correction from C, the disqualified person who 
benefited from the excess benefit transactions. Based on the 
application of the factors to these facts, O is no longer described 
in section 501(c)(3) effective in Year 5.
    Example 4. (i) O conducts activities that further exempt 
purposes. O uses several buildings in the conduct of its exempt 
activities. In Year 1, O sold one of the buildings to Company K for 
an amount that was substantially below fair market value. The sale 
was a significant event in relation to O's other activities. C, O's 
Chief Executive Officer, owns all of the voting stock of Company K. 
When O's board of trustees approved the transaction with Company K, 
the board did not perform due diligence that could have made it 
aware that the price paid by Company K to acquire the building was 
below fair market value. Subsequently, but before the IRS commences 
an examination of O, O's board of trustees determines that Company K 
paid less than the fair market value for the building. Thus, O 
concludes that an excess benefit transaction occurred. After the 
board makes this determination, it promptly removes C as Chief 
Executive Officer, terminates C's employment with O, and hires legal 
counsel to recover the excess benefit from Company K. In addition, O 
promptly adopts a conflicts of interest policy and new contract 
review procedures designed to prevent future recurrences of this 
problem.
    (ii) The sale of the building by O to Company K at less than 
fair market value constitutes an excess benefit transaction between 
an applicable tax-exempt organization and a disqualified person 
under section 4958 in Year 1. Therefore, this transaction is subject 
to the applicable excise taxes provided in that section. In 
addition, this transaction violates the proscription against 
inurement under section 501(c)(3) and paragraph (c)(2) of this 
section.
    (iii) The application of the factors in paragraph (f)(2)(ii) of 
this section to these facts is as follows. O has engaged in regular 
and ongoing activities that further exempt purposes both before and 
after the excess benefit transaction occurred. Although the size and 
scope of the excess benefit transaction were significant in relation 
to the size and scope of O's activities that further exempt 
purposes, the transaction with Company K was a one-time occurrence. 
By adopting a conflicts of interest policy and significant new 
contract review procedures and by terminating C, O has implemented 
safeguards that are reasonably calculated to prevent future 
violations. Moreover, O took corrective actions before the IRS 
commenced an examination of O. In addition, O has made a good faith 
effort to seek correction from Company K, the disqualified person 
who benefited from the excess benefit transaction. Based on the 
application of the factors to these facts, O continues to be 
described in section 501(c)(3).
    Example 5. (i) O is a large organization with substantial assets 
and revenues. O conducts activities that further its exempt 
purposes. O employs C as its Chief Financial Officer. During Year 1, 
O pays $2,500 of C's personal expenses. O does not make these 
payments pursuant to an accountable plan, as described in Sec.  
53.4958-4(a)(4)(ii). In addition, O does not report any of these 
payments on C's Form W-2, ``Wage and Tax Statement,'' or on a Form 
1099-MISC, ``Miscellaneous Income,'' for C for Year 1, and O does 
not report these payments as compensation on its Form 990, ``Return 
of Organization Exempt From Income Tax,'' for Year 1. Moreover, none 
of these payments can be disregarded as nontaxable fringe benefits 
under Sec.  53.4958-4(c)(2) and none consisted of fixed payments 
under an initial contract under Sec.  53.4958-4(a)(3). C does not 
report the $2,500 of payments as income on his individual Federal 
income tax return for Year 1. O does not repeat this reporting 
omission in subsequent years and, instead, reports all payments of 
C's personal expenses not made under an accountable plan as income 
to C.
    (ii) O's payment in Year 1 of $2,500 of C's personal expenses 
constitutes an excess benefit transaction between an applicable tax-
exempt organization and a disqualified person under section 4958. 
Therefore, this transaction is subject to the applicable excise 
taxes provided in that section. In addition, this transaction 
violates the proscription against inurement in section 501(c)(3) and 
paragraph (c)(2) of this section.
    (iii) The application of the factors in paragraph (f)(2)(ii) of 
this section to these facts is as follows. O engages in regular and 
ongoing activities that further exempt purposes. The payment of 
$2,500 of C's personal expenses represented only a de minimis 
portion of O's assets and revenues; thus, the size and scope of the 
excess benefit transaction were not significant in relation to the 
size and scope of O's activities that further exempt purposes. The 
reporting omission that resulted in the excess benefit transaction 
in Year 1 occurred only once and

[[Page 16524]]

is not repeated in subsequent years. Based on the application of the 
factors to these facts, O continues to be described in section 
501(c)(3).
    Example 6. (i) O is a large organization with substantial assets 
and revenues. O furthers its exempt purposes by providing social 
services to the population of a specific geographic area. O has a 
sizeable workforce of employees and volunteers to conduct its work. 
In Year 1, O's board of directors adopted written procedures for 
setting executive compensation at O. O's executive compensation 
procedures were modeled on the procedures for establishing a 
rebuttable presumption of reasonableness under Sec.  53.4958-6. In 
accordance with these procedures, the board appointed a compensation 
committee to gather data on compensation levels paid by similarly 
situated organizations for functionally comparable positions. The 
members of the compensation committee were disinterested within the 
meaning of Sec.  53.4958-6(c)(1)(iii). Based on its research, the 
compensation committee recommended a range of reasonable 
compensation for several of O's existing top executives (the Top 
Executives). On the basis of the committee's recommendations, the 
board approved new compensation packages for the Top Executives and 
timely documented the basis for its decision in board minutes. The 
board members were all disinterested within the meaning of Sec.  
53.4958-6(c)(1)(iii). The Top Executives were not involved in 
setting their own compensation. In Year 1, even though payroll 
expenses represented a significant portion of O's total operating 
expenses, the total compensation paid to O's Top Executives 
represented only an insubstantial portion of O's total payroll 
expenses. During a subsequent examination, the IRS found that the 
compensation committee relied exclusively on compensation data from 
organizations that perform similar social services to O. The IRS 
concluded, however, that the organizations were not similarly 
situated because they served substantially larger geographic regions 
with more diverse populations and were larger than O in terms of 
annual revenues, total operating budget, number of employees, and 
number of beneficiaries served. Accordingly, the IRS concluded that 
the compensation committee did not rely on ``appropriate data as to 
comparability'' within the meaning of Sec.  53.4958-6(c)(2) and, 
thus, failed to establish the rebuttable presumption of 
reasonableness under Sec.  53.4958-6. Taking O's size and the nature 
of the geographic area and population it serves into account, the 
IRS concluded that the Top Executives' compensation packages for 
Year 1 were excessive. As a result of the examination, O's board 
added new members to the compensation committee who have expertise 
in compensation matters and also amended its written procedures to 
require the compensation committee to evaluate a number of specific 
factors, including size, geographic area, and population covered by 
the organization, in assessing the comparability of compensation 
data. O's board renegotiated the Top Executives' contracts in 
accordance with the recommendations of the newly constituted 
compensation committee on a going forward basis. To avoid potential 
liability for damages under state contract law, O did not seek to 
void the Top Executives' employment contracts retroactively to Year 
1 and did not seek correction of the excess benefit amounts from the 
Top Executives. O did not terminate any of the Top Executives.
    (ii) O's payments of excessive compensation to the Top 
Executives in Year 1 constituted excess benefit transactions between 
an applicable tax-exempt organization and disqualified persons under 
section 4958. Therefore, these payments are subject to the 
applicable excise taxes provided under that section, including 
second-tier taxes if there is no correction by the disqualified 
persons. In addition, these payments violate the proscription 
against inurement under section 501(c)(3) and paragraph (c)(2) of 
this section.
    (iii) The application of the factors in paragraph (f)(2)(ii) of 
this section to these facts is as follows. O has engaged in regular 
and ongoing activities that further exempt purposes both before and 
after the excess benefit transactions occurred. The size and scope 
of the excess benefit transactions, in the aggregate, were not 
significant in relation to the size and scope of O's activities that 
further exempt purposes. O engaged in multiple excess benefit 
transactions. Nevertheless, prior to entering into these excess 
benefit transactions, O had implemented written procedures for 
setting the compensation of its top management that were reasonably 
calculated to prevent the occurrence of excess benefit transactions. 
O followed these written procedures in setting the compensation of 
the Top Executives for Year 1. Despite the board's failure to rely 
on appropriate comparability data, the fact that O implemented and 
followed these written procedures in setting the compensation of the 
Top Executives for Year 1 is a factor favoring continued exemption. 
The fact that O amended its written procedures to ensure the use of 
appropriate comparability data and renegotiated the Top Executives' 
compensation packages on a going-forward basis are also factors 
favoring continued exemption, even though O did not void the Top 
Executives' existing contracts and did not seek correction from the 
Top Executives. Based on the application of the factors to these 
facts, O continues to be described in section 501(c)(3).

    (3) Applicability. The rules in paragraph (f) of this section will 
apply with respect to excess benefit transactions occurring after March 
28, 2008.
* * * * *

PART 53--FOUNDATION AND SIMILAR EXCISE TAXES

0
Par. 3. The authority citation for part 53 continues to read, in part, 
as follows:

    Authority: 26 U.S.C. 7805 * * *


0
Par. 4. In Sec.  53.4958-2, paragraph (a)(6) is added to read as 
follows:


Sec.  53.4958-2  Definition of applicable tax-exempt organization.

    (a) * * *
    (6) Examples. The following examples illustrate the principles of 
this section, which defines an applicable tax-exempt organization for 
purposes of section 4958:
    Example 1. O is a nonprofit corporation formed under state law. 
O filed its application for recognition of exemption under section 
501(c)(3) within the time prescribed under section 508(a). In its 
application, O described its plans for purchasing property from some 
of its directors at prices that would exceed fair market value. 
After reviewing the application, the IRS determined that because of 
the proposed property purchase transactions, O failed to establish 
that it met the requirements for an organization described in 
section 501(c)(3). Accordingly, the IRS denied O's application. 
While O's application was pending, O engaged in the purchase 
transactions described in its application at prices that exceeded 
the fair market values of the properties. Although these 
transactions would constitute excess benefit transactions under 
section 4958, because the IRS never recognized O as an organization 
described in section 501(c)(3), O was never an applicable tax-exempt 
organization under section 4958. Therefore, these transactions are 
not subject to the excise taxes provided in section 4958.
    Example 2. O is a nonprofit corporation formed under state law. 
O files its application for recognition of exemption under section 
501(c)(3) within the time prescribed under section 508(a). The IRS 
issues a favorable determination letter in Year 1 that recognizes O 
as an organization described in section 501(c)(3). Subsequently, in 
Year 5 of O's operations, O engages in certain transactions that 
constitute excess benefit transactions under section 4958 and 
violate the proscription against inurement under section 501(c)(3) 
and Sec.  1.501(c)(3)-1(c)(2). The IRS examines the Form 990, 
``Return of Organization Exempt From Income Tax'', that O filed for 
Year 5. After considering all the relevant facts and circumstances 
in accordance with Sec.  1.501(c)(3)-1(f), the IRS concludes that O 
is no longer described in section 501(c)(3) effective in Year 5. The 
IRS does not examine the Forms 990 that O filed for its first four 
years of operations and, accordingly, does not revoke O's exempt 
status for those years. Although O's tax-exempt status is revoked 
effective in Year 5, under the lookback rules in paragraph (a)(1) of 
this section and Sec.  53.4958-3(a)(1) of this chapter, during the 
five-year period prior to the excess benefit transactions that 
occurred in Year 5, O was an applicable tax-exempt organization and 
O's directors were disqualified persons as to O. Therefore, the 
transactions between O and its directors during Year 5 are subject 
to the

[[Page 16525]]

applicable excise taxes provided in section 4958.
* * * * *

Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
    Approved: March 19, 2008.
Eric Solomon,
Assistant Secretary of the Treasury (Tax Policy).
 [FR Doc. E8-6305 Filed 3-27-08; 8:45 am]
BILLING CODE 4830-01-P