Over the years, the Internal Revenue Service (IRS) has paid close attention to enforcing the private benefit, private inurement, and excess benefit transaction doctrines against tax-exempt organizations. A doctrine is a specific set of guidelines regarding a specific issue.
Each set of guidelines has its own specific features, but in general, these are enforced to ensure that charitable organizations are operating and entering into transactions to advance the organization’s charitable mission and serve the public interest, and not to benefit individuals in their private capacity.
As the IRS has significantly increased its enforcement efforts in these areas recently and has assessed millions of dollars in penalties for these types of violations, nonprofits that fail to follow the basic steps suggested by the IRS and described below are acting irresponsibly and risk suffering penalties itself.
What constitutes a private benefit?
The private benefit doctrine is an extension of the requirement that nonprofits are organized and operated exclusively for the benefit of the public. Specifically, it states that many tax-exempt organizations (though not all of them) are prohibited from benefiting a private interest to a degree that is more than just incidental, either qualitatively or quantitatively, to its otherwise permissible activities.
To be quantitatively incidental, the private benefit must be insubstantial when measured in the context of the overall exempt benefit conferred by the activity. And to be qualitatively incidental, private benefit must be a necessary concomitant of the exempt activity, in that the exempt objectives of the organization cannot be achieved without necessarily benefitting certain individuals privately.
Private benefit, then, can even be significant so long as it also meets these requirements. For example, a tax-exempt organization that provides housing, food, job training, etc. to the homeless is clearly providing benefit to private individuals. However, such benefit is incidental to the overall benefit to society and is a necessary by-product of the organization’s purposes of providing support to the poor.
The private inurement doctrine
The private inurement doctrine falls under the umbrella of the private benefit doctrine but is more specific and involves only those individuals defined as “disqualified persons.” Under these rules, a “disqualified person” is defined, in relevant part, as a founder, director, officer, key employee, family members of these individuals, or business entities controlled by them. The important relationship between the organization and the “disqualified person” is that by way of their position within the organization, they can exercise control and influence over the organization.
The most common example of private inurement is excessive compensation. However, the IRS does not expect employees of public charities to donate their services. Therefore, if the board of directors of the organization determines that the compensation is reasonable, based on comparability data, then the organization may be able to decrease the chance that the private inurement doctrine is being violated.
What is an excess benefit transaction?
An excess benefit transaction is a transaction involving an economic benefit directly or indirectly to a disqualified person and the value of the excess benefit exceeds the value of the consideration received by the organization. Under these rules a disqualified person is:
- Any person who was, at any time during the 5-year period ending on the date of such transaction, in a position to exercise substantial influence over organizational affairs/business;
- A member of the family of an individual described above; or
- A 35% controlled entity (an entity in which the nonprofit in question has at least a 35% controlling interest).
However, the dangers of entering into a transaction with a disqualified person can be lessened if the organization follows the procedures laid out by the IRS to create a presumption that the transaction is reasonable. In order to ensure that such presumption is obtained properly, it would be best to seek an attorney or other professional to help you, rather than attempting to obtain the presumption on your own.
On the other hand, if an organization engages in an excess benefit transaction, it and the disqualified persons may face the imposition of intermediate sanctions and other penalties, which can be levied on the disqualified persons at 25% of the excess benefit, and possibly on the organization’s managers who improperly benefited from or were knowingly involved in the transaction at 10% of the excess benefit. The organization itself might be subject to revocation of its tax-exempt status if the excess benefit transaction also violates the prohibitions on private inurement, private benefit, or any other limitations on the actions of public charities.
Conclusion
In the end, private benefit, private inurement, and excess benefit transactions, can be dangerous for your tax-exempt organization as they run the risk of having your organization’s tax-exempt status revoked. The IRS has much discretion in evaluating these transactions, which has historically led to inconsistent court rulings. Therefore, before engaging in such transactions, you should do your best to ensure there is no such impermissible benefit or inurement.
Attorney Zac Kester provides generalist and strategic nonprofit legal and consulting services. He holds a Master of Laws, a post-law school advanced degree, in which he studied the unique needs of tax-exempt nonprofit organizations. His legal and consulting career has focused on nonprofit organizations.
Attorney Robert Miller is an attorney in the State of Indiana and holds a Doctorate of Jurisprudence with a certificate in Corporate and Commercial Law. He focuses his practice on representing nonprofit organizations.
Substantiation
- Hopkins 20.1, 20.2, 20.3, 20.4, 20.12, 21.4
- IRC Reg. 1.501(c)(3)-1(d)(1)(ii)
- 26 CFR § 53.4958-4(a)(1) and (2).
- 26 CFR § 53.4958(e)(2);
- Reg. § 53.4958-2(b)(1).
- American Campaign Academy v. Comm’r, 92 T.C. 1053 (1989); Variety Club Tent No. 6 Charities Inc. v. Comm’r, 74 T.C.M. 1485 (1997
- Variety Club Tent No. 6 Charities, Inc. v. Comm’r, 74 T.C.M. 1485, 1493 (1997)
- Miller & Son Drywall, Inc. v. Comm’r, 89 T.C. 1279 (2005)
- https://boardsource.org/resources/private-benefit-private-inurement-self-dealing/
- https://www.irs.gov/charities-non-profits/charitable-organizations/intermediate-sanctions-excess-benefit-transactions
- https://www.lawhelp.org/files/7C92C43F-9283-A7E0-5931-E57134E903FB/attachments/C2359DC6-464B-4B2F-8B1B-8A9CA9EAF064/excess-benefit-transactions-alert-2017-final.pdf
