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.”
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 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.