Excess Benefit Transactions and Intermediate Sanctions: Determining Reasonable Compensation

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

Recent EEOC Guidance on Using Criminal History in Employment Decisions

The EEOC recently issued updated guidance on the use of criminal history record information in employment decisions. While the EEOC had previously warned against the use of arrest records in employment decisions, since arrests alone do not establish that criminal conduct occurred, this new guidance stakes out a more extreme position.  Now, the EEOC suggests that even the use of criminal convictions as an absolute bar to employment can have a disparate impact based on race and national origin, thus exposing employers to potential Title VII claims.

For a potential plaintiff to make a claim for discrimination based on the employer’s use of a criminal conviction record, the plaintiff first has to establish that the policy creates a disparate impact.  The burden then shifts to the employer to demonstrate “that the challenged practice is job related for the position in question and consistent with business necessity.”  See Griggs v. Duke Power Co., 401 U.S. 424, 431 (1971).  To meet this rebuttal burden, the employer must show that the policy or practice is one that “bears a demonstrable relationship to successful performance of the jobs for which it was used” and “measures the person for the job and not the person in the abstract.”  See id. 

The new EEOC guidance includes in its recommended “Employer Best Practices” that employers eliminate policies that exclude people from employment based on any criminal record.  In its place, the EEOC suggests that an employer develop a “narrowly tailored written policy and procedure for screening applicants and employees for criminal conduct.”  The EEOC suggests that this policy should identify the essential job requirements and determine the specific offenses that might demonstrate unfitness for performing such jobs.  We believe that conforming to these recommended “best practices” would be somewhat prohibitive for an employer like a charter school, which is going to have so many different types of positions to fill.  While these are the recommended best practices, based on the legal authority on which the EEOC builds its disparate impact argument against using criminal conviction background in employment decisions, there may be other less-burdensome policy options.  Any such policy will have to be closely aligned with requirements of this new guidance, which is essentially using criminal conviction history as an employment “screen” and providing an opportunity for individual review of the policy’s application based on the position sought.

There are two potential circumstances in which the EEOC believes employers will consistently meet the “job related and consistent with business necessity” defense to a disparate impact claim.  They are as follows:

·      The employer validates the criminal conduct exclusion for the position in question in light of the Uniform Guidelines on Employee Selection Procedures (if there is data or analysis about criminal conduct as related to subsequent work performance or behaviors); or

·      The employer develops a targeted screen considering three factors: (i) the nature of the crime; (ii) the time elapsed; and (iii) the nature of the job.  See Green v. Missouri Pacific Railroad, 549 F.2d 1158 (8th Cir. 1977). The employer’s policy then provides an opportunity for an individualized assessment of the screened applicant’s to determine if the policy as applied (barring employment) is job related and consistent with business necessity.

Although Title VII does not require individualized assessment in all circumstances, the EEOC believes that the use of a screen that does not include an individualized assessment is more likely to violate Title VII.  Thus, the EEOC’s guidance confirms that if en employer develops a screening policy that meets these established criteria, then it will satisfy this defense.  However, if an employer’s targeted criminal records screen is sufficiently narrowly tailored to identify criminal conduct with a demonstrably tight nexus to the position in question, the individualized assessment process may not even be required.

To establish that a criminal conduct exclusion that has a disparate impact is job related and consistent with business necessity under Title VII, the employer needs to show that the policy operates to effectively link specific criminal conduct, and its dangers, with the risks inherent in the duties of a particular position.  Policy should therefore include a factor that is job related, but it is possible that this might also be accomplished broadly, such as “any job that involves contact with students or gives access to students.”  This could be applied to cover almost all positions at a public school.  An additional suggestion might be to establish a criminal record review committee process within the school’s employment screening process where the purpose of the committee is to give an opportunity for an individual assessment to “determine if the policy as applied is job related and consistent with business necessity.” 

Please consult your legal counsel for specific guidance relating to the above EEOC Guidance.

Joe Hoffer

Independent Auditor Findings and TEA Action

All public schools are required to have an annual audit conducted by a certified public accountant and to file an annual audit report with the Texas Education Agency (TEA). Although most audits do not result in the disclosure of audit findings, some schools face the prospect of having to address findings of noncompliance and weaknesses in internal control. In some instances, these issues are labeled as material or significant and include questioned costs. While most school boards will not question the independent auditor and approve the annual audit report, a more prudent course of action is for the board and school administrators to question the substance and veracity of the independent auditor's finding(s) to ensure that the resulting TEA action is well founded. However, in the event that the board approves the annual audit report, this does not mean that the school does not have any other course of action but to accept the TEA's action. In truth, the board should disapprove the annual audit report if it disagress with the independent auditor's finding and include a written statement with the certificate of board citing its disagreement with the finding as the reason for its disapproval of the annual audit report.

Pursuant to §___.405, Management decision, of Office of Management and Budget Circular No. A-133, Audits of States, Local Governments, and Non-Profit Organizations, the TEA is required to render a management decision concerning findings pertaining to federal awards. In its management decision, the TEA is required to:

• Clearly state whether or not the audit finding is sustained,

• The reasons for the decision,

• The expected action to repay disallowed costs, make financial adjustments, or take other action, and

• A description of any appeal process available to the school.

Additionally, if the school has not completed corrective action, the TEA should provide a timetable for follow-up.

Prior to issuing its management decision, the TEA may request additional information or documentation from the school, including a request for auditor assurance related to the documentation, as a way of mitigating disallowed costs. This latter authority is important for public schools to know in the event that they disagree with an independent auditor's finding and wish to have their disagreement heard and considered by the TEA prior to its rendering a management decision.

In the event that the TEA does not request additional information, the school should be aware that the TEA may require a refund of the amount questioned by the independent auditor pursuant to Section 74.62(a)(2) or 80.43(a)(2) of Title 34 of the Code of Federal Regulations (34 CFR 74.62(a)(2)/80.43(a)(2)). However, pursuant to 34 CFR 74.62(b) or 80.43(b) and 76.783(a)(1), the school may have an opportunity for a hearing or an appeal of an enforcement action ordering the repayment of misspent or misapplied Federal funds in accordance with a final TEA audit resolution determination.

As always, every school should make a good faith effort to address auditor requests for information in a timely manner. This includes maintaining an honest and open dialogue with the independent auditor so that concerns and potential issues can be appropriately addressed and misunderstandings may be avoided. However, in the event that the school and its independent auditor simply cannot agree on the basis or substance of a finding, the school should be aware that it has a legal avenue that it may pursue to address its concerns.

Schulman, Lopez & Hoffer, LLP
By Ramon Medina