Tax law requires 501(c)(3) organizations to be organized and operated exclusively for one or more exempt purposes, “no part of the net earnings of which inures to the benefit of any private shareholder or individual.” Treasury Regulations elaborate by clarifying that an organization is not organized and operated exclusively for exempt purposes unless it serves a public rather than a private interest. These concepts create the prohibitions on private inurement and private benefit applicable to all 501(c)(3)s. The prohibitions exist to ensure that charitable assets are preserved for the public’s benefit and are not diverted for private use.
What is Private Inurement?
Private inurement occurs when a 501(c)(3)’s income or assets unduly benefits a person or entity closely related to the 501(c)(3), such as its directors, officers, key employees, and others who have substantial influence over the organization. The private inurement rule requires 501(c)(3)s to use a standard or reasonableness when evaluating transactions with insiders so that they do not take advantage of the 501(c)(3)’s tax exemption for private gain.
Common examples of private inurement include:
- Excessive compensation for insiders
- Loaning money to insiders at below-market rates
- Buying goods or services from insiders at inflated rates
Importantly, the prohibition on private inurement is absolute. Meaning, even minimal or incidental private inurement is a violation.
What is Private Benefit?
Private benefits are nonincidental benefits conferred on disinterested persons that serve private interests. In other words, private benefit occurs where a 501(c)(3)’s programs or activities benefits (monetarily or otherwise) any private individual. Private benefit is much broader than private inurement because it involves any third party, not just the 501(c)(3)’s insiders.
Common examples of private benefit include:
- Entering into a contract that disproportionately benefits a business partner over the nonprofit
- Running a program that exclusively helps a small, select group of people rather than the community as a whole
In contrast with private inurement, incidental private benefit is acceptable. Generally, private benefit is incidental where the benefit is insubstantial and secondary to the public good that will flow from the transaction. This is typically determined by both a qualitive and quantitative analysis of the facts.
What are the Consequences for Non-Compliance?
If the IRS determines that a nonprofit has engaged in private inurement or excessive private benefit, the consequences can be severe. The IRS may impose intermediate sanctions in the form of an excise tax on the 501(c)(3) and its insiders. If an excess benefit transaction is not corrected, the IRS may impose additional excise taxes.
In egregious cases, the IRS may revoke the organization’s 501(c)(3) status. This means the nonprofit would lose its ability to receive tax-deductible donations, and its income would become subject to federal corporate income tax.
Best Practices for Avoiding Private Benefit & Inurement
Establish a Conflict of Interest Policy. 501(c)(3)s should adopt a written Conflict of Interest Policy that requires board members, officers, and key employees to disclose any financial or business interests in transactions involving the organization. The board should be responsible for evaluating these disclosures and ensuring that no insider benefits unfairly.
Utilize Independent Compensation Review. When setting executive or key employee compensation, 501(c)(3)s should base their decisions on comparable salary data from similar organizations and industries. The process should be well-documented and approved by independent, non-conflicted board members to ensure that compensation is reasonable.
Document Transactions with Insiders. If a 501(c)(3) enters into any financial or business transaction with an insider, such as a lease, loan, or contract for services, the terms should be fair and reasonable. The board should document the process of approving these transactions, including any research or comparison shopping to ensure that the nonprofit is receiving a fair deal.
Maintain Public Focus. 501(c)(3)s should continuously assess their activities to ensure they align with the organization’s public-serving mission. Programs should benefit the broader community, and any private benefit should be incidental and secondary to the organization’s exempt purposes.
Board Training and Education. Boards of directors should be trained on the legal requirements concerning private inurement and private benefit. An informed board can help steer the organization away from potential IRS red flags.
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Kyler Mejia is an associate (bar admission pending) with Caritas Law Group, P.C. Kyler counsels nonprofit and socially responsible businesses on corporate, trademark, tax, and fundraising matters nationwide and advises donors concerning major gifts. To schedule a consultation, call 602-456-0071 or email us through our contact form.
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