Organizations that register for
tax-exempt status as a 501(c)
(3)will be classified as a “private
foundation” unless they meet the
requirements for a “public charity.” The
distinction is that a public charity receives
income from multiple sources and uses it
to pursue its exempt purpose by operating
charitable programs, while a private foundation
generally has one primary source of income
or funding and typically gives grants to more
than one cause. Regardless of an organization’s
classification, both private foundations and
public charities need to be mindful of “private
inurement” and “private benefit.”
Private inurement
In order to qualify and remain qualified, as
a tax-exempt 501(c)(3) public charitable
organization, the entity must comply with two
main rules: it must be organized and operated
exclusively for an exempt purpose as outlined
in code section 501(c)(3), and no part of the
organization’s earnings inure—that is, are
used for an insider’s private purposes—to a
private shareholder or individual. Although, on
the surface, these seem straightforward and
obvious rules for nonprofits to live by, the rules
and regulations surrounding them are often
misunderstood and misapplied.
The rule against private inurement was
originally put into place to differentiate
between for-profit and not-for-profit entities
as they are defined within the code. For-profit
entities inure earnings to private shareholders
and individuals, typically through dividends
and other distributions, whereas not-forprofit entities do not. Over time, and with the
help of court cases, the intent of the Internal
Revenue Service has become more evident:
private inurement as it applies to tax-exempt
organizations is much broader than those
typical direct payments of earnings to
individuals and shareholders paid in for-profit
entities. Although over the years, the Service
has brought cases against not-for-profit
entities that have blatantly engaged in private
inurement, inurement can also result from
transactions that appear above-board.
Private inurement can only result from
transactions with private shareholders and
individuals, who are considered to have the
authority to control the use of income and
resources of an organization for their own
personal, private benefit. Examples include
members of the board of directors, senior
executives, management, and organization
employees.
One common transaction with the potential
for causing private inurement is compensation
arrangements. Charitable organizations
can provide reasonable compensation to
their employees for the work performed
for the organization without jeopardizing
their tax-exempt status. However, how that
compensation is determined is important. It
must be negotiated at arms-length, reasonable
for the services performed, and not structured
as a mechanism for distributing profits.
Organizations often satisfy these requirements
by having a dedicated compensation
committee composed of directors who are not
also officers. Industry data and salary surveys
can and should be considered, whether there
is a compensation committee or not, to ensure
wages paid to employees in positions with
similar job duties are comparable. The process
for determining reasonable compensation
for officers and key employees must be
disclosed on Form 990, as is the amount
of compensation paid to those individuals.
Depending on the level of compensation
paid to employees, further disclosure may be
required on Schedule J of Form 990.
Other examples of arrangements that will result
in the inurement of earnings are:
• Loans or extensions of credit at belowmarket rates or with no interest
• Sales or leases of property to (or by) an
organization at prices in excess of (or below)
fair market value
• Use of an organization’s property
for personal use without adequate
compensation or without a compensatory
purpose
• The intermingling of personal and exempt
organization assets
• Outright distributions of assets to individuals
without adequate consideration and not in
furtherance of an exempt purpose
The prohibition of private inurement shouldn’t
be interpreted to mean that no transactions
should occur between a tax-exempt
organization and a private shareholder
or individual. As long as these types of
transactions are structured so that neither the
organization nor the individual is receiving
undue benefits and are entered into and carried
out in a prudent business-like manner, then the
likelihood of the transaction being considered
private inurement is greatly reduced or
eliminated.
With the exception of compensation paid
to employees, transactions between an
organization and its private shareholders and
individuals are required to be disclosed on
Schedule L of Form 990.
If the IRS finds occurrences of private
inurement, it has the right to revoke an
organization’s tax-exempt status and/or impose
a hefty tax on the excess benefits received.
Private benefit
Private benefit encompasses private inurement
and includes any individual or entity that
receives a substantial benefit from an
organization. It occurs when an organization
serves a private interest rather than one that is
public. Private benefit is broader than private
inurement and is not limited to individuals
with considerable authority and influence at
the organization. Private benefit can include
anyone or any other organization that receives
an unfair advantage from an organization’s
services. Unlike private inurement, the private
benefit is not completely barred.
An organization can lose its exempt status
if a small number of beneficiaries, which
could be people or organizations outside the
organization, benefit from their charitable
programs. Organizations are formed to operate
a charitable program that furthers its exempt
purpose and helps members of a charitable
class. If a charitable organization inadvertently
is not helping the charitable class it was
formed to help; it can lose its tax-exempt
status due to a private benefit being received
by a small number of beneficiaries. As such,
the ways in which an organization determines
what members will benefit from its charitable
programs is essential to determine whether a
private versus public benefit is being served.
If any individual or other organization obtains
an advantage that reaps the benefit of an
organization’s exempt purpose, the IRS could
deem that a private benefit.
A private benefit can occur even when
an organization is helping a member of a
charitable class. For example, an organization
is formed to help children with a specific type
of cancer. Private inurement would occur if
parents of a child with that specific type of
cancer set up an organization to specifically
help their child with this cancer. In contrast, a
private benefit would occur if that organization
decided to help only a few children with that
specific type of cancer and chose not to help
more children with that cancer if they were
able to. Additionally, even if the cancer patient
and family are not related to any members
of the organization in any way and have no
significant influence or control over the way
the organization operates, the preferential
treatment of one member of a charitable
class over all the others could be considered a
private benefit in facts and circumstances, as
the organization would be helping a “group” of
beneficiaries that is too small.
How does an organization avoid private
benefits? By pursuing its charitable mission in
ways that are as unbiased as possible. Even
though people are inherently biased, there are
actionable items nonprofits can follow to make
sure they are in check with regard to private
benefit. The IRS looks at both qualitative and
quantitative factors when trying to determine
if a private benefit has occurred. A qualitative
determination is concluded when the IRS
decides that the organization did not confer a
private benefit upon a beneficiary if the benefit
is a product of the organization pursuing its
exempt mission for the good of the public. A
quantitative determination is decided when
the IRS determines the private benefit is less
than the public benefit. These are not definitive
rules or thresholds to determine when a private
benefit explicitly occurs, only general guidelines
on how the IRS concludes whether or not a
beneficiary has received a private benefit.
The following are some additional items to
consider to avoid private benefit:
• An organization should not be formed
to help one beneficiary but to pursue
an exempt purpose regardless of who
specifically is benefitting, as long as that
beneficiary fits into the charitable class
defined by the organization.
• The class of recipients the organization
works to benefit should be as inclusive
and well-defined as possible .
• The organization should go above and
beyond to avoid conflicts of interest.
If a conflict of interest does occur, the
organization should have a well-defined,
transparent conflict-of-interest policy
in place.
• Suppose an exempt organization decides
it wants to allow the sale of goods or
services to benefit specific individuals.
In that case, the organization must
ensure the activity is insignificant to
the whole mission, and the sale and
any subsequent financial benefits are
inconsequential.
Becoming familiar with the guidance that
surrounds publicly supported tax-exempt
organizations and their business dealings is
key to navigating the business aspect of not for-profit entities without compromising their
tax-exempt status.
If you have questions, please reach out to a
member of HBK Nonprofit Solutions.
Read the full Summer issue of HBK Nonprofit Solutions quarterly newsletter.
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