Intermediate sanctions legislation enacted.

IRS modifies its "20% Rule" in physician board membership.


August 15, 1996


Allied Association Executives


Fredric J. Entin

Several significant developments have occurred that will affect the IRS' enforcement of the obligations of tax-exempt health care organizations. The long awaited intermediate sanctions legislation has become law, and the hoped for change in IRS' 20% cap on physician membership on governing boards has occurred. Both will affect the integration efforts of hospitals and physicians and each sends a strong message about the importance of community-based and actively engaged boards of trustees for tax-exempt health care organizations.

Intermediate Sanctions

Congress has provided IRS the additional enforcement tool it has long sought. Instead of being limited to revocation of exemption, a measure IRS regarded as extreme and unsuited to violations that did not call into question the overall exempt purpose of the organization, IRS will now have the power to penalize individuals involved in abusive transactions with exempt organizations. The legislation applies to transactions occurring on or after September 14, 1995.

The intermediate sanctions are designed to operate in circumstances where, through asset purchases, compensation for services, or other arrangements, the assets of the exempt organization are used for the benefit of private interests rather than public. The two prerequisites for use of the intermediate sanctions are improper financial benefit and receipt of such benefit by an individual with substantial influence over the affairs of the organization. When both are present a money penalty may be imposed on the individual who improperly benefitted and on an organization manager who approved the arrangement knowing it to be improper. The amount of the penalty is 25% of the excess benefit (10% for organization managers).

The House Ways and Means Committee Report accompanying the legislation gives direction to the IRS on how to interpret many of the provisions, two of which will be of particular importance for boards pursuing integration strategies. It is intended that the parties to a transaction will have the benefit of a rebuttable presumption on the reasonableness of compensation and fair market value if the transaction is approved by an independent board, is justified by appraisals, surveys or other evidence, and is documented in the organization's records. It is also intended that physicians are not presumed to be in a position of substantial influence, explicit direction for a change in the operating practice of IRS.

Physician Participation in Governance

Through a combination of formal and informal communications, IRS has announced that it will no longer apply a 20% cap on the number of physicians that may serve on the board of a tax-exempt health care organization. In general, a majority of the board must be community-based and independent, although even that requirement may be met by alternative means in limited circumstances. Instead of controlling board composition, IRS will rely on the development and implementation of significant conflict-of-interest policies within exempt health care organizations to assure that an organization is operated to serve public rather than private interests.

IRS is reportedly characterizing its position on physician participation as evolving. In speeches reported on over the past several months it appeared that the conflict of interest approach would be used when organizations seeking exemption intended to have physicians fill greater than 20% of the board positions. In a draft copy of a new section in the upcoming annual revision of the IRS' internal continuing professional education training manual, the conflict of interest policy requirement has been extended to all exempt health care organizations. It also appears that IRS is prepared to permit physicians to occupy more than a minority of board positions in very limited circumstances. Several private letter rulings have allowed this where the newly formed organization was a subsidiary of an organization that met the test of a community-based independent board, and the parent exercised significant controls over decision making by the subsidiary.

The overall concern of IRS is that an organization awarded tax exemption be operated to serve public not private interests. The conflict of interest approach is an alternative to an arbitrary board composition standard to assure that adequate safeguards are in place to protect against decisions being made by those who have a financial interest in their outcome. The elements of an acceptable conflict of interest policy are being circulated by IRS in draft form. They emphasize disclosure, procedures to determine if a conflict is present and to address actual conflicts, and adequate documentation of the implementation of the policy. As an extension of this self policing approach, the organization is also encouraged to conduct periodic reviews of its operations to evaluate whether its exempt obligations are being met, with particular emphasis on compensation arrangements, acquisition of physician practices, joint ventures and partnerships.

Governing boards that incorporate significant conflict of interest policies into their routine and operate within the rebuttable presumption guidelines should find a level of comfort in the new enforcement policies. In combination, the intermediate sanctions legislation and the conflict of interest policy requirement should enhance the ability of tax-exempt health care organizations to pursue appropriate integration strategies.

A more detailed description of the intermediate sanctions legislation is attached to this memo. A copy of the draft IRS Community Board and Conflict of Interest Policy may be obtained from the Office of the General Counsel by calling 312/422-7777. Treasury staff have indicated that they will be soliciting input from health care organizations on the areas where further guidance is needed. AHA will be providing comments and feedback to Treasury and the IRS. If you have any comments or questions about these matters, feel free to contact Maureen D. Mudron, Assistant General Counsel, at 312/422-2790.


Intermediate Sanctions Legislation Summary 

The intermediate sanctions legislation was signed into law on July 30 as part of the Taxpayer Bill of Rights Act. The following description reflects both the statutory language and the Report of the House Ways and Committee (Committee Report) which accompanied the legislative proposal and provides guidance to Treasury and the IRS on how Congress intended the various provisions to be implemented and interpreted.

Excess benefit transaction

The triggering event for application of a money penalty (a tax) is an excess benefit transaction. That occurs when an exempt organization provides an economic benefit to a disqualified person, and the value of the benefit exceeds the value of the property or services provided by the disqualified person to the organization in exchange for the benefit. The excess benefit is the difference between the value of the benefit provided by the exempt organization and the value of the consideration received by the organization, and is the amount on which the tax is computed.

The benefit provided to the disqualified person cannot be justified as payment for services rendered unless there was a clear indication that the organization intended it as compensation. The Committee Report indicates that what is offered as evidence of intent should be contemporaneous with the occurrence of the transaction, and provides examples such as: approval in accordance with procedures applicable to compensation matters, the completion and filing of any required forms, e.g. a Form 990, a W-2 or 1099, a recipient's 1040.

The Secretary of the Treasury is authorized to treat compensation arrangements that are based on the revenue of one or more activities of the organization and which constitute inurement, as an excess benefit transaction. To exercise this grant of authority the Secretary is required to issue regulations. The Committee Report makes clear that not all revenue-based compensation arrangements are inurement and provides that any guidance on which constitute inurement would have prospective effect.

The Committee Report provides that parties to a transaction are entitled to rely on a rebuttable presumption of reasonableness with respect to a compensation arrangement or the valuation of property if it was approved by a board of directors (or a committee of the board) that:

  • was composed entirely of individuals unrelated to and not subject to the control of the disqualified person(s) involved in the arrangement;
  • obtained and relied upon appropriate data as to comparability such as compensation levels paid by similarly situated organizations for functionally comparable positions; the location of the organization, including the availability of similar specialties in the geographic area; independent compensation surveys; actual written offers, and other types of studies;
  • adequately documented the basis for the determination (e.g. the record includes an evaluation of the individual whose compensation was being established and the basis for determining that the individual's compensation was reasonable in light of the evaluation and data).

The Committee Report also provides for a transition period during which parties to a transaction which has already occurred may take steps to qualify for the presumption.

Disqualified person

A disqualified person is an individual in a position to exercise substantial influence over the affairs of the organization at the time of the transaction or at any time during a period five years prior to the transaction. The family of a disqualified person and a corporation or other business entity over which the individual or the family has greater than 35% ownership or control are also considered disqualified persons.

The Committee Report makes clear that title alone will not determine whether the individual has substantial influence. It also makes explicit that physicians are not presumed to have substantial influence, contrary to the current practice of the IRS.

Tax Liability

A disqualified person is subject to a first tier tax equal to 25% of the amount of the excess benefit. If the arrangement is not corrected, a second tier tax equal to 200% of the amount of the excess benefit is imposed. The Committee Report defines correction to mean undoing the excess benefit to the extent possible and taking any additional measure necessary to place the organization in a financial position not worse than that in which it would have been if the disqualified person were dealing under the highest fiduciary standards.

Any organization manager who participated in a transaction knowing that it provided excess benefit is subject to a tax equal to 10% of the amount of the excess benefit, unless the manager's participation was not willful and was due to reasonable cause. Liability for a manager(s) is subject to a maximum of $10,000 per transaction.

If more than one disqualified person or more than one organization manager is involved in an excess benefit transaction they are jointly and severally liable for the respective taxes.

Effective Date

The law applies to excess benefit transactions occurring on or after September 14, 1995, unless the transaction occurred pursuant to a written contract which was binding on September 13, 1995



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