Texas
charter schools are no strangers to regulation. In addition to the myriad of rules and
requirements that must be followed to maintain their charter agreement with the
State of Texas, the charter holder of a Texas open enrollment charter school is
a 501(c)(3) public charity and must maintain 501(c)(3) exempt status as a
condition to keeping the open enrollment charter. Thus, it is necessary for charter leaders to
be as informed about IRS regulations as much as any other area of charter
regulation.
One
area of particular concern and continued focus by the IRS are the intermediate sanctions rules under Section
4958 of the Internal Revenue Code regarding excess benefit transactions. What
might at first sound like total bafflegab, the intermediate sanction rules on
excess benefit transactions actually set forth the basic rules and roadmap on how
the board of directors of a charter school, or any public charity, should
handle a transaction with an interested party, and provides a simple roadmap of
compliance not only for IRS purposes, but also conflict of interest rules generally.
Simply
put, an interested party may not be overpaid or enriched at the expense of the
organization. A prohibited excess benefit transaction occurs when a public
charity (or a 501(c)(4) organization) provides an economic benefit to a “disqualified
person” and that benefit exceeds the fair
value of the consideration received by the charity. If an organization engages in an excess
benefit transaction with a disqualified person, the regulations impose a
penalty tax on the disqualified person
– not the public charity – and any manager (board members included) who knowingly participated in the improper
excess benefit. A disqualified person must correct the excess benefit transaction by
making a payment in cash or cash equivalents equal to the correction amount to the
charity (plus interest) and paying a tax equal to 25% of the excess benefit
amount. A manager who “knowingly” participated in the transaction would be
liable for a penalty equal to 10% of the amount of the excess benefit amount. A
board member participating in the affirmative vote of the transaction by the
board satisfies the “knowingly
participated” standard.
The
penalty tax on the disqualified person gives rise to the name of the rules as
“intermediate sanctions” as it is an “intermediate” sanction imposed by the IRS
whereas previously, the only sanction available or a violation of private
inurement was revocation of the organization’s tax-exempt status. However, it
should be noted that while the excess benefit regulations are the current enforcement mechanism by the IRS for these
types of transactions, the IRS retains the right to revoke an exempt
organization’s status for violations of private inurement.
A
“disqualified person” is defined broadly and includes any person who is in a
position (including a five year look back period from the date of the
transaction) to exert substantial
influence over the affairs of the organization. The definition also includes
family members of those that exert substantial influence over the organization,
and an entity owned (at least 35% or more) by such person. For charter holders,
this includes board members, officers, superintendents and other highly
compensated managers, major contributors, and founders.
Nearly
any transaction with a disqualified
person qualifies as a transaction subject to the excess benefit transaction
regulations. The most common form, and those often the subject of IRS scrutiny,
include compensation and benefits to executives, real property transfers, and the payment of
personal expenses of executive employees. The standard of determining whether
or not an excess benefit has occurred is one of reasonableness and fair market
value. The regulations do not set forth any specific criteria for determining
the reasonableness of compensation or the fair market value of
property, and thus, an organization must rely on pre-existing tax law
standards, particularly concerning fair market value determinations.
Instead,
the regulations offer compliance procedures known as the “safe harbor rebuttable
presumption procedures”. If an
organization follows these procedures, the compensation to a disqualified person is presumed
to be fair and reasonable and the burden shifts to the IRS to prove otherwise:
(i)
The
Board approves the transaction in advance without the participation of the disqualified
person;
(ii)
The
Board obtains and relies upon appropriate comparability data; and
(iii)
The decision
is appropriately and contemporaneously documented.
Appropriate
comparability data in the case of compensation means obtaining data on similarly situated
organizations for functionally comparable positions, including current
compensation surveys compiled by independent firms and actual written offers
from similar institutions competing for the services of the disqualified
person. For example, in determining the
compensation of a school superintendent, the charter school would want to look
at comparable salaries of other superintendents in Texas and the same city and county. Ideally, data would be drawn from charter
schools of a similar size and budget, but can also include data from private
and public schools. While the regulations do not specify the amount of comparability
data an organization should rely upon, it is clear that an organization with
gross receipts over $1 million should, at a minimum, obtain more than 3 sources
of comparability data.
In the case of property, appropriate
comparability data includes current (at the time of transfer) independent
appraisals, market reports, and offers received as part of an open and
competitive bidding process.
Putting the rebuttable
presumption procedures into practice is not difficult and will safeguard not
only against excess benefit transactions, but conflicts of interest generally. Organizations
seeking to comply with the safe harbor rebuttable presumption procedures often
make the mistake of not gathering appropriate comparability data sufficiently
in advance of the board decision regarding the transaction, and do not
“adequately and contemporaneously” document, in the minutes of the board, the
procedures taken by the board (including documenting the comparability data
relied upon) to ensure that the organization receives the benefit of the
presumption of reasonableness. The minutes of a board decision will be the only evidence demonstrating whether or
not a board has complied with the safe harbor procedures, and thus, charter
school leaders should ensure that board minutes are properly and adequately
recorded. It is also advisable that the safe harbor procedures be incorporated
into a written conflict of interest policy that is easy to follow so that
identifying and addressing conflicts through proper procedures becomes routine
practice for the board of directors.
Lindsey B. Jones
Of Counsel
Schulman, Lopez & Hoffer, LLP
