[Federal Register Volume 70, Number 174 (Friday, September 9, 2005)]
[Proposed Rules]
[Pages 53599-53604]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-17858]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 53

[REG-111257-05]
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: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed 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.

DATES: Written comments and requests for a public hearing must be 
received by December 8, 2005.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-111257-05), room 
5203, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-
111257-05), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC. Alternatively, taxpayers may submit 
comments electronically via the IRS Internet site at http://www.irs.gov/regs or the Federal

[[Page 53600]]

eRulemaking Portal at http://www.regulations.gov (IRS-REG-111257-05). A 
public hearing may be scheduled if requested.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Galina 
Kolomietz, (202) 622-4441; Concerning submission of comments and 
requests for a public hearing, Richard Hurst, (202) 622-7180 (not toll-
free numbers).

SUPPLEMENTARY INFORMATION:

Background

A. Section 501(c)(3) and the Regulations Thereunder

    To be described in section 501(c)(3), an organization must be 
organized and operated exclusively for religious, charitable, 
scientific, or educational purposes. In addition, no part of the net 
earnings of the organization may inure to the benefit of any private 
shareholder or individual, no substantial part of the organization's 
activities may include attempts to influence legislation, and the 
organization may not intervene in political campaigns.
    Existing regulations under section 501(c)(3) were adopted in 
substantially their present form in 1959. In explaining and clarifying 
the statutory requirements, these regulations provide that, to be 
described in section 501(c)(3), an organization must be both organized 
and operated for exempt purposes. An organization is not operated 
exclusively for exempt purposes and, thus, is not described in section 
501(c)(3), if any of its net earnings inure to the benefit of a private 
shareholder or individual. Sec.  1.501(c)(3)-1(c)(2). The regulations 
define private shareholder or individual as referring to persons having 
a personal and private interest in the activities of the organization. 
Sec.  1.501(a)-1(c).
    In addition, an organization is not organized or operated for one 
or more of the exempt purposes enumerated in Sec.  1.501(c)(3)-
1(d)(1)(i) and, thus, is not described in section 501(c)(3), if it is 
organized or operated for the benefit of private interests such as 
designated individuals, the creator or his family, shareholders of the 
organization, or persons controlled, directly or indirectly, by such 
interests. Sec.  1.501(c)(3)-1(d)(1)(ii).
    These proposed regulations amend the regulations under section 
501(c)(3), adding 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 examples illustrate that prohibited 
private benefits may involve non-economic benefits as well as economic 
benefits. In addition, prohibited private benefit may arise regardless 
of whether payments made to private interests are reasonable or 
excessive. The examples reflect current law.

B. Section 4958 and the Regulations Thereunder

    Section 4958 was added to the Code by the Taxpayer Bill of Rights 
2, Public Law 104-168 (110 Stat. 1452, July 30, 1996). Section 4958 
imposes certain excise taxes on transactions that provide excess 
economic benefits to disqualified persons with respect to public 
charities and social welfare organizations described in sections 
501(c)(3) and 501(c)(4), respectively. These organizations are 
collectively referred to as applicable tax-exempt organizations. 
Section 4958(e). An excess benefit is the amount by which the value of 
an economic benefit provided by an applicable tax-exempt organization 
directly or indirectly to or for the use of a disqualified person 
exceeds the value of the consideration (including the performance of 
services) received for providing such benefit. Sec.  53.4958-1(b). A 
disqualified person is defined as a person who is in a position to 
exercise substantial influence over the affairs of an applicable tax-
exempt organization. Section 4958(f)(1). Section 4958(a) imposes the 
liability for excise taxes on disqualified persons who receive an 
excess benefit from, and on certain organization managers who knowingly 
participate in, an excess benefit transaction. Section 4958 imposes no 
corresponding sanctions on exempt organizations. The section 4958 
excise taxes generally apply to excess benefit transactions occurring 
on or after September 14, 1995.
    On August 4, 1998, a notice of proposed rulemaking (REG-246256-96) 
clarifying certain definitions and rules contained in section 4958 was 
published in the Federal Register (63 FR 41486). Those 1998 proposed 
regulations were revised in response to written and oral comments and 
replaced by temporary and proposed regulations on January 10, 2001 (TD 
8920, 66 FR 2144, and REG-246256-96, 66 FR 2173). Final regulations 
under section 4958 were published on January 23, 2002 (TD 8978, 67 FR 
3076).

C. History of the Relationship Between Section 4958 Taxes and Tax-
Exempt Status

    Section 501(c)(3) and the longstanding regulations thereunder 
establish certain tests that an organization must meet to qualify for 
tax-exempt status. Sec.  1.501(c)(3)-1(a)(1). Section 4958, by its 
terms, does not address the tax-exempt status of applicable tax-exempt 
organizations, but instead imposes excise tax liability on disqualified 
persons and certain organization managers.
    In the 1996 House Report on section 4958, Congress briefly 
addressed the relationship between section 4958 and tax-exempt status. 
Specifically, the Report stated that these ``intermediate sanctions for 
excess benefit transactions may be imposed by the IRS in lieu of (or in 
addition to) revocation of the organization's tax-exempt status.'' H. 
Rep. No. 104-506, 104th Cong., 2d Sess., at 59 (1996) (emphasis added). 
The Report also stated, in a footnote, that, in general, revocation of 
tax-exempt status, with or without the imposition of excise taxes, 
would occur only if an organization no longer operates as a charitable 
organization. H. Rep. No. 104-506, 104th Cong., 2d Sess., at 59, note 
15.
    In keeping with the differences between section 501(c)(3) and 
section 4958, the Treasury Department and the IRS consistently have 
taken the position that the imposition of excise taxes under section 
4958 does not foreclose revocation of tax-exempt status in appropriate 
cases. The 1998 proposed regulations under section 4958 stated that 
``[t]he excise taxes imposed by section 4958 do not affect the 
substantive statutory standards for tax exemption under section 
501(c)(3) or (4).'' Proposed Sec.  53.4958-7(a), (63 FR 41,505). Both 
the 2001 temporary and the 2002 final regulations stated that--

    Section 4958 does not affect the substantive standards for tax 
exemption under section 501(c)(3) or (4), including the requirements 
that the organization be organized and operated exclusively for 
exempt purposes, and that no part of its net earnings inure to the 
benefit of any private shareholder or individual. Thus, regardless 
of whether a particular transaction is subject to excise taxes under 
section 4958, existing principles and rules may be implicated, such 
as the limitation on private benefit. (26 CFR 53.4958-8(a)).

    The preamble to the 1998 proposed regulations under section 4958 
stated that the IRS will exercise its administrative discretion in 
enforcing the requirements of sections 4958, 501(c)(3), and 501(c)(4). 
The preamble to the 1998 proposed regulations listed the following four 
factors the IRS will consider in determining whether an applicable tax-
exempt organization described in section 501(c)(3) continues to be 
described in section 501(c)(3) in cases in which section 4958 excise 
taxes are also imposed: (1) Whether the organization has been involved 
in repeated excess benefit transactions; (2) the size and the scope of 
the excess

[[Page 53601]]

benefit transactions; (3) whether, after concluding that it has been 
party to an excess benefit transaction, the organization has 
implemented safeguards to prevent future recurrences; and (4) whether 
there was compliance with other applicable laws. (63 FR 41,488 through 
41,489).
    The preamble to the 2001 temporary regulations stated that the IRS 
intends to publish guidance regarding the factors it will consider as 
it gains more experience in administering section 4958. The preamble to 
the 2002 final regulations stated that, until such guidance is 
published, the IRS will consider all relevant facts and circumstances 
in the administration of section 4958 cases. These proposed regulations 
amend the regulations under section 501(c)(3) to provide 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).

D. Section 4958 and Application for Recognition of Tax-Exempt Status 
Under Section 501(c)(3)

    Section 4958 and the regulations thereunder do not apply to 
organizations that are not applicable tax-exempt organizations as 
defined therein. These proposed regulations amend the regulations under 
section 4958 to clarify that the IRS has discretion to refuse to issue 
a ruling recognizing exemption under section 501(c)(3) to any applicant 
whose purpose or activities violate any provision of section 501(c)(3), 
including the inurement prohibition and the limitation on private 
benefit, even though such violation could serve as grounds for imposing 
section 4958 excise taxes if the applicant's tax-exempt status were 
recognized.

E. Proposed Effective Date

    These regulations are proposed to be applicable on the date of 
publication in the Federal Register of a Treasury Decision adopting 
them as final regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking 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 notice of proposed 
rulemaking, and because this notice of proposed rulemaking 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, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on business.

Comments and Requests for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any comments (a signed original and 
eight (8) copies) that are submitted timely to the IRS. The IRS and the 
Treasury Department specifically request comments on the clarity of the 
proposed rule and how it may be made easier to understand. All comments 
will be available for public inspection and copying.
    A public hearing may be scheduled if requested in writing by a 
person who timely submits written comments. If a public hearing is 
scheduled, notice of the date, time, and place will be published in the 
Federal Register.

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.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 53 are proposed to be amended as 
follows:

PART 1--INCOME TAXES

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

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

    Par. 2. In Sec.  1.501(c)(3)-1, paragraph (d)(1)(iii) is 
redesignated as paragraph (d)(1)(iv).
    Par. 3. In Sec.  1.501(c)(3)-1, paragraphs (d)(1)(iii) and (g) are 
added to 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. 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 
Sec.  1.501(c)(3)-1(d)(1)(ii). 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 sole activity is 
exhibiting art created by a group of unknown but promising local 
artists. 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 Sec.  1.501(c)(3)-1(d)(1)(ii). 
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. 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 use a reference

[[Page 53602]]

to the program in O's name and the right to teach the program, 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 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 Sec.  1.501(c)(3)-1(d)(1)(ii), 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).
* * * * *
    (g) 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 this 
section'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 of this chapter.
    (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 
of this chapter) described in section 501(c)(3) whose disqualified 
persons or organization managers are subject to excise taxes under 
section 4958. Accordingly, an organization may no longer meet the 
requirements for tax-exempt status under section 501(c)(3) because the 
organization fails to satisfy the requirements of paragraph (b), (c) or 
(d) of this section. See Sec.  53.4958-8(a) of this chapter.
    (ii) Determining 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 of this chapter) 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 of this chapter) that violate the 
prohibition on inurement under this section, 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 repeated excess 
benefit transactions;
    (D) Whether the organization has implemented safeguards that are 
reasonably calculated to prevent future violations; and
    (E) Whether the excess benefit transaction has been corrected 
(within the meaning of section 4958(f)(6) and Sec.  53.4958-7 of this 
chapter), or the organization has made good faith efforts to seek 
correction from the disqualified persons 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 (g)(2)(ii)(D) and (E) of this section will 
weigh more strongly 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 (g)(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 (g)(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 of this chapter) described in 
section 501(c)(3) for all relevant periods. The examples are 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 almost all 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's trustees 
would be selling art to O.
    (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 
appropriate 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 Sec.  1.501(c)(3)-1(c)(2).
    (iii) The application of the factors in Sec.  1.501(c)(3)-
1(g)(2)(ii) to these facts is as follows. Beginning in Year 3, O 
does not engage in any regular and ongoing activities that further 
exempt purposes because almost all of O's activities consist of 
purchasing art from its trustees and exhibiting and offering for 
sale all of the art it purchases. 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 repeated 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 
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 
guidelines, hires legal counsel to recover the excess amounts O had 
paid its former trustees, and implements a new program of 
educational activities.
    (ii) O's purchases of art from its former trustees at more than 
fair market value constitute excess benefit transactions

[[Page 53603]]

between an applicable tax-exempt organization and disqualified 
persons under section 4958. Therefore, these transactions are 
subject to the appropriate 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 Sec.  1.501(c)(3)-1(c)(2).
    (iii) The application of the factors in Sec.  1.501(c)(3)-
1(g)(2)(ii) to these facts is as follows. In Year 3, O does not 
engage in any 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 
educational programs and implements a new program of educational 
activities. 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 are established and 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 
that began in Year 4 and continued thereafter. O was involved in 
repeated 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 
constituted excess benefit transactions between an applicable tax-
exempt organization and a disqualified person under section 4958. 
Therefore, these transactions are subject to the appropriate excise 
taxes provided in that section. In addition, these transactions 
violate the proscription against inurement under section 501(c)(3) 
and Sec.  1.501(c)(3)-1(c)(2).
    (iii) The application of the factors in Sec.  1.501(c)(3)-
1(g)(2)(ii) 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 repeated 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 employs C as its Chief Executive Officer. C, on behalf 
of O, entered into a contract with Company K to construct an 
addition to O's existing building. The addition to O's building is a 
significant undertaking in relation to O's other activities. C owns 
all of the voting stock of Company K. Under the contract, O paid 
Company K an amount that substantially exceeded the fair market 
value of the services Company K provided. When O's board of trustees 
approved the contract with Company K, the board did not perform due 
diligence that could have made it aware that the contract price for 
Company K's services was excessive. Subsequently, but before the IRS 
commences an examination of O, O's board of trustees determines that 
the contract price was excessive. Thus, O concludes that an excess 
benefit transaction has 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 payments to Company K. In addition, O promptly adopts a 
conflicts of interest policy and significant new contract review 
procedures designed to prevent future recurrences of this problem.
    (ii) The purchase of services by O from Company K at more than 
fair market value constitutes an excess benefit transaction between 
an applicable tax-exempt organization and disqualified persons under 
section 4958. Therefore, this transaction is subject to the 
appropriate excise taxes provided in that section. In addition, this 
transaction violates the proscription against inurement under 
section 501(c)(3) and Sec.  1.501(c)(3)-1(c)(2).
    (iii) The application of the factors in Sec.  1.501(c)(3)-
1(g)(2)(ii) 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 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 
under an accountable plan under Sec.  53.4958-4(a)(4) of this 
chapter. 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 under section 4958 as nontaxable 
fringe benefits and none consisted of fixed payments under an 
initial contract under Sec.  53.4958-4(a)(3) of this chapter. 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 appropriate excise 
taxes provided in that section. In addition, this transaction 
violates the proscription against inurement in section 501(c)(3) and 
Sec.  1.501(c)(3)-1(c)(2).
    (iii) The application of the factors in Sec.  1.501(c)(3)-
1(g)(2)(ii) 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 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).

    (3) Effective date. The rules in paragraph (g) of this section will 
apply with respect to excess benefit

[[Page 53604]]

transactions occurring after the date of publication in the Federal 
Register of a Treasury Decision adopting these rules as final 
regulations.

PART 53--FOUNDATION AND SIMILAR EXCISE TAXES

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

    Authority: 26 U.S.C. 7805.

    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 value of the property. 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(g), 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 Sec.  53.4958-
2(a)(1) and Sec.  53.4958-3(a)(1) of this chapter, for a period of 
five years 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 appropriate excise taxes provided in section 4958.
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 05-17858 Filed 9-8-05; 8:45 am]
BILLING CODE 4830-01-P