The recent enactment of the Tax Cuts and Jobs Act has drawn attention from all corners of the intercollegiate athletics industry. Its imposition of an excise tax, assessed against tax-exempt organizations on their compensation arrangements with certain highly-paid employees, in particular, has been a topic of significant debate recently. The enactment of such a tax makes clear that tax-exempt organizations are in Congress’ crosshairs; this assumption is further supported by the fact that Congress allowed for transition rules with respect to for-profit compensation arrangements in effect on November 2, 2017, but made no such exception with regard to the excise tax.
While the most recent excise tax certainly warrants the attention it is receiving, it’s important to recognize that it is imposed on the tax-exempt employer (e.g., colleges and universities). Conversely, the intermediate sanctions tax was enacted more than two decades ago and imposes an additional tax directly on employees (e.g., athletics directors and potentially coaches) of tax-exempt organizations. The intermediate sanctions tax is the subject of this article.
Below, we (I) provide a background of the Intermediate Sanctions tax regime and prior efforts of the IRS to measure college and university compliance therewith, (II) define the transactions that could give rise to the tax, (III) identify the consequences of engaging in those transactions, (IV) describe the safe harbor provided by the IRS to avoid the tax liability, and (V) recommend certain practices to promote compliance with that safe harbor.
“Intermediate sanctions” (i.e., sanctions short of revocation of tax exempt status) on account of unreasonable compensation arrangements were made available as an enforcement tool of the IRS with the enactment of Internal Revenue Code (“Code”) § 4958 in July, 1996. More than a decade after § 4958 was enacted, the IRS further demonstrated this heightened level of scrutiny on nonprofit compensation practices by the release of a significantly revised Form 990 (a return of an organization exempt from tax). The revisions to Form 990 included additional disclosures of the amounts and form of compensation paid to certain highly-paid administrators as well as a Schedule J, which required disclosure of the manner in which compensation decisions were made by the reporting entity. In that same year, the IRS launched the “Colleges and Universities Compliance Project” and issued to 400 randomly-selected colleges and universities detailed questionnaires, focusing, in part, on compensation amounts and design practices. The executive compensation component of the examinations focused mainly on compliance with § 4958. The Compliance Project resulted in the issuance of an interim report, in May of 2010, followed by a final report on May 2, 2013, which presented a summary of the questionnaire responses and the results of certain examinations that were conducted following the findings of the interim report (the “IRS Compliance Report”).
The IRS Compliance Report determined that “to a large extent, [the subject institutions] followed practices in setting compensation that are consistent with meeting the rebuttable presumption of reasonableness” for the purpose of avoiding intermediate sanctions. However, when the practices were scrutinized, the following weaknesses were identified:
• Only “about half” of colleges and universities used an outside compensation consultant to assist with setting compensation levels.
• About 20 percent of the private colleges and universities included institutions in their data set that were not similarly situated.
• Compensation studies provided by the colleges and universities often did not document the selection criteria for the schools in the surveys provided and did not offer an explanation as to why those schools were deemed comparable to the school relying on the study and under examination.
• Many colleges and universities relied on a compensation survey compiled by an independent firm in which their compensation data was included. However, the survey itself was not limited to schools that were sufficiently similar to all be comparable to each other. Some used the survey results without any adjustment; others removed schools that they determined were not sufficiently comparable.
• Compensation surveys relied on for comparability data often did not specify whether amounts reported included only salary or included other types of compensation to equal total compensation, as required by § 4958.
• Organizations are permitted to use amounts paid by taxable organizations as comparable data. The colleges and universities examined, however, did not rely on compensation paid by taxable organizations to set compensation.
Since the 2010 interim report, the average compensation for head football coaches in the Autonomy Five conferences has increased by 74.3%, and the compensation arrangements for those coaches have become significantly more complex. The potent combination of increased congressional scrutiny accelerated salary inflation and varied forms of compensation give rise to a renewed focus on the manner in which compensation decisions are made.
II. TRANSACTIONS SUBJECT TO INTERMEDIATE SANCTIONS
Code § 4958 established a tax on (A) “excess benefits transactions” between (B) “applicable tax-exempt organizations” and (C) “disqualified persons.”
(A) Excess Benefit Transaction
An excess benefit transaction is defined as “any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit.” The economic benefit provided by the organization includes all compensation includible in gross income and all compensatory benefits, whether or not included in gross income for income tax purposes.
There is an important “first contract” exception to the definition of “excess benefit transaction.” § 4958 does not apply to any fixed payments made by an organization to a disqualified person pursuant to an initial contract. An initial contract is a binding written contract between an applicable tax-exempt organization and a person who was not a disqualified person immediately before entering into the contract. § 4958 does, however, apply to a material change (which includes an extension or renewal of the contract, or a more than incidental change to the amount payable under the contract) to the initial contract.
(B) Applicable Tax-Exempt Organizations
While there remains some debate regarding the applicability of the new excise tax (Code § 4960), the coverage of the intermediate sanctions regime (Code § 4958) is relatively certain. Generally, an “applicable tax-exempt organization” is an organization exempt from tax under Code §§ 501(c)(3) or 501(c)(4) on the day the excess benefit transaction occurred or at any time in the five-year period ending on the day the excess benefit transaction occurred. Although every university likely meets the requirements described in Code § 501(c)(3), public universities instead derive their tax-exempt status from an implied statutory immunity as “an integral part of a state” and/or Code § 115 (exemption from tax for states and their agencies which provide essential government functions). Private universities, if tax-exempt, are certain to have received a § 501(c)(3) determination letter and are unquestionably applicable tax-exempt organizations. If a public university relies on the implied immunity or Code § 115 for its tax exemption and, therefore does not file an annual return, it is exempt from § 4958, even if it has applied for and received a determination letter concluding that the entity is described in § 501(c)(3). The IRS acknowledged this position by instructing public colleges and universities not to complete the sections of the questionnaire regarding compensation determination processes and went one step further by affirmatively stating, in the IRS Compliance Report that “Section 4958 applies to private, but not public, colleges and universities…” Finally, university foundations and support organizations are likely to be applicable tax-exempt organizations for purposes of § 4958.
Compensation arrangements for coaches at private schools are not the only arrangements within the coverage of the intermediate sanctions regime. Some intercollegiate athletics programs are operated through legal entities separate and distinct from the University and others rely on the University foundation to provide some or all of the compensation to their most highly-compensated coaches. All told, over 1/3 of the Autonomy Five programs have compensation arrangements in place which are subject to the requirements of § 4958.
(C) Disqualified Persons
For those athletic departments that are subject to the requirements of § 4958, the determination of whether a coach or administrator constitutes a “disqualified person” becomes critically important. Treas. Reg. § 53.4958-3 defines a disqualified person as “any person who was in a position to exercise substantial influence over the affairs of an applicable tax-exempt organization at any time during the five-year period ending on the date of the transaction (the lookback period).” Paragraph (c) of the that regulation identifies a person holding any of the following powers, among others, as a person in a position to exercise substantial influence over the affairs of an applicable tax-exempt organization:
(i) any individual serving on the governing body of the organization who is entitled to vote on any matter over which the governing body has authority;
(ii) any person who, regardless of title, has ultimate responsibility for implementing the decisions of the governing body or for supervising the management, administration, or operation of the organization. A person who serves as president, chief executive officer, or chief operating officer has this ultimate responsibility unless the person demonstrates otherwise; or
(iii) any person who, regardless of title, has ultimate responsibility for managing the finances of the organization. A person who serves as treasurer or chief financial officer has this ultimate responsibility unless the person demonstrates otherwise.
Paragraph (e) of that Regulation provides for a “facts and circumstances” test to determine whether a person holds any of those powers. Subpart (2) then describes certain facts and circumstances which tend to show that a person has substantial influence over the affairs of an organization, and includes the following factors:
(iv) the person has or shares authority to control or determine a substantial portion of the organization’s capital expenditures, operating budget, or compensation for employees; or
(v) the person manages a discrete segment or activity of the organization that represents a substantial portion of the activities, assets, income, or expenses of the organization, as compared to the organization as a whole.
Given the relative size and influence of intercollegiate athletics departments, it’s hard to fathom that an athletics director would not be considered a disqualified person pursuant to the foregoing criteria. Whether a coach may be considered a disqualified person may again be open to interpretation. During the hearings that led to the final Treasury Regulations under Code § 4958, the IRS was specifically asked to clarify that coaches were not disqualified persons. It chose not to offer such an assurance. However, the IRS Compliance Report concluded that sports coaches should be classified as “non-Officers, Directors, Trustees and Key Employees (ODTKEs)” and “by definition, are not disqualified persons covered by § 4958.”
Perhaps to their ultimate detriment from a tax perspective, college coaches at the highest levels have contracted for far greater autonomy and authority within intercollegiate athletic departments. It has become much more common in recent years for head coaches to contract for staff salary pools, and discretion in the allocation and distribution thereof, in their own employment agreements. Coach compensation is also becoming increasingly intertwined with other departmental contractual relationships. As coaches continue to push for and receive greater influence within their respective athletic departments, they increase the likelihood that they may become a “disqualified person” within the scope of § 4958. Because those coaches with the bargaining power to gain such influence are often among the highest paid coaches in their respective sports, those arrangements will inevitably push the bounds of reasonableness and become subject to the sanctions described herein.
The tax imposed on excess benefits transactions has three separate components:
(A) The first is a 25% tax, imposed on the disqualified person, on the excess benefit received by the disqualified person;
(B) The second is a 10% tax, imposed on the “organization manager” (any officer, director, or trustee of such organization), on the excess benefit received by the disqualified person, unless such participation of such organization manager is not willful and is due to reasonable cause.
An organization manager is a person who “regularly exercises general authority to make administrative or policy decisions on behalf of the organization.” The regulations under § 4958 offer a safe harbor for organization managers who rely on professional advice. An organization manager will not be subject to tax if the manager fully discloses the factual situation to an appropriate professional and then relies on the reasoned written opinion of the professional with respect to elements of the transaction within the professional’s expertise. Appropriate professionals include legal counsel, certified public accountants or accounting firms with expertise regarding the relevant tax laws, and independent valuation experts who hold themselves out to the public as appraisers or compensation consultants, perform the relevant valuations on a regular basis, are qualified to make valuations of the property or services involved, and include in the written opinion a certification that they meet these requirements; and
(C) The third is a 200% tax, imposed on the disqualified person, on the excess benefit received by the disqualified person, if the excess benefit transaction is not corrected within the taxable period.
Noteworthy in the penalty structure, relative to intercollegiate athletics, is that athletics directors may be subjected to the tax both as a disqualified person (in connection with excess benefits paid to the athletics director) and as an organization manager (if the IRS were to determine that a head coach’s responsibilities and authority warrant a determination that the head coach is a disqualified person).
IV. CREATING A REBUTTABLE PRESUMPTION
Treasury Regulation § 53.4958-6 allows an organization the opportunity to establish a rebuttable presumption that payments it made to a disqualified person under a compensation arrangement are reasonable (and therefore, not subject to the tax consequences described herein), by satisfying the following three prong test:
(1) the compensation arrangement are approved in advance by an authorized body of the applicable tax-exempt organization composed entirely of individuals who do not have a conflict of interest with respect to the compensation arrangement;
(2) the authorized body obtained and relied upon appropriate data as to comparability prior to making its determination; and
(3) the authorized body adequately documented the basis for its determination concurrently with making that determination.
Relative to item number (2), Regulation § 53.4958-6(c)(2) provides that “relevant information includes, but is not limited to, compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions; the availability of similar services in the geographic area of the applicable tax-exempt organization; current compensation surveys compiled by independent firms; and actual written offers from similar institutions competing for the services of the disqualified person.”
V. CONCLUSION AND BEST PRACTICES
Due to the increased public attention to and congressional scrutiny of athletic compensation trends, colleges, universities and athletics department entities and their supporting organizations are advised to consider the following when negotiating and documenting compensation arrangements with key administrators and coaches:
(1) Whether the applicable contract allows the administrator/coach sufficient autonomy or authority to cause the administrator/coach to be a “disqualified person”, therefore subjecting the compensation arrangement to §4958;
(2) Whether the organization has established an independent body, or committee, to evaluate and approve proposed compensation arrangements with disqualified persons;
(3) Whether the organization has an appropriately robust, current and accurate comparability data set to evaluate the amounts and varying forms of compensation and benefits payable to similarly situated employees; and
(4) Whether the organization maintains complete and contemporaneous records of the process by which compensation decisions are made and approved?
Analysis of the foregoing fundamental considerations is a worthy exercise for determining exposure to Intermediate Sanctions.
The more recent Tax Cuts and Jobs Act has potential to disrupt the collegiate sports industry. But athletics directors (whether in their capacity as the organization manager or, potentially, a disqualified person) at many institutions should remain mindful of and diligent about their individual exposure to Intermediate Sanctions.
 Code § 4958(c)(1)(A)
 Treas. Reg. § 59.4958-4(b)(ii)(B)
 Rev. Rul. 87-2, 1987-1 C.B. 18.
 Treas. Reg. § 59.4958-2(a)(2)(ii). Notably, until the final Treasury Regulations were promulgated, the IRS took the opposite position – that any organization operating with a determination letter would be subject to intermediate sanctions, regardless of other available exemption(s).
 Regulations to Implement New Intermediate Sanctions Statute: Public Hearings on Proposed Regulations Under Section 4958 Before the IRS Oversight Board (testimony of Dorothy Robinson, Vice President and Gen. Counsel, Yale Univ., on behalf of the Am. Council on Ed.).
 Treas. Reg. § 53.4958-1(d)(2)(i)(B)
 Treas. Reg. § 53.4958-1(d)(4)(iii).