Charity Can’t Begin Too Close to Home

A 501(c)(3) Organization Cannot Benefit Private Parties Excessively – Even If Terms are “Reasonable”

violation-complianceTwo recent IRS rulings reiterate a principle in federal tax law that is not well understood by many nonprofit leaders and the professionals who advise them – the prohibition of substantial private benefit.

In the two private rulings, the IRS held that substantial private benefit precluded exemption for the subject organizations under Section 501(c)(3).  In one ruling, the IRS revoked the 501(c)(3) status of an organization formed to promote and conduct national high school athletic competitions.  The facts in the ruling indicate that the organization utilized a related for-profit company to handle substantially all of the travel and administrative affairs of the organization and that it was compensated for doing so.  In the other ruling, the IRS denied 501(c)(3) status to an organization formed to facilitate charitable contributions to 501(c)(3) organizations by operating a website designed to direct a portion of a for-profit company’s sales to unrelated charities.  In both rulings, the IRS determined that, regardless of the charitable activities that the subject organizations may be conducting, the economic arrangements served to substantially benefit the interests of the for-profit companies.

A 501(c)(3) organization must serve a public rather than a private interest in order to establish and maintain tax-exempt status.  While nonprofit leaders and their advisors are generally aware of the “private inurement” prohibition and the prohibition of “excess benefit transactions” in federal tax law for 501(c)(3) organizations, there is less awareness and understanding of the prohibition of substantial private benefit.  There are important distinctions between the private inurement prohibition (and the related excess benefit transaction prohibition) and the substantial private benefit prohibition.  A little-known aspect of the substantial private benefit prohibition is the fact that an organization may violate the prohibition even if its transactions are at “fair value” terms or are with unrelated parties.

Private inurement and excess benefit transactions

Prior to 1996, if a nonprofit 501(c)(3) organization paid excessive compensation to its leaders or otherwise allowed its earnings to inure to the benefit of private individuals (actions referred to as “private inurement”), the IRS had only one enforcement tool available—revoking the organization’s tax-exempt status. While revocation was appropriate in the case of egregious violations, the measure was viewed as inappropriately harsh in many situations. Revocation was also often viewed as improperly penalizing the organization (and, indirectly, the people who benefit from its charitable, religious, or educational mission) rather than the individuals who received the prohibited benefits or those who approved them.

In an effort to provide the IRS with more appropriate and effective options for administration of the law in such circumstances, Congress adopted “intermediate sanctions” as part of the Taxpayer Bill of Rights in 1996. Now found in Section 4958 of the Internal Revenue Code, the intermediate sanctions law imposes excise tax penalties on the individuals who receive an excess benefit from a 501(c)(3) or 501(c)(4) organization, as well as on organizational leaders who knowingly approve excess benefits.

An “excess benefit transaction” occurs when a 501(c)(3) organization makes a payment or provides an economic benefit to an organizational leader where the payment or the value of the benefit exceeds the value of what the organization receives from the leader in exchange (including performance of services). Excessive or unreasonable compensation is an example of an excess benefit transaction. The amount by which a payment or benefit exceeds the value of what the organization receives in exchange is referred to as the “excess benefit amount.”

Under current law, if a nonprofit leader (referred to in the law as a “disqualified person”) receives an excess benefit, a two-tier penalty structure applies to that leader. First, a penalty of 25 percent of the excess benefit amount applies.  Additionally, the leader must “correct” the excess benefit (generally by returning the value of the excess benefit to the nonprofit organization) within a specified timeframe. In the event that the excess benefit is not corrected in a timely manner, a second-tier penalty, equal to 200 percent of the excess benefit amount, applies to the leader individually.

Also under current law, nonprofit officers, board members, or their equivalent (referred to in the law as “organization managers”) who knowingly approve an excess benefit transaction are individually subject to excise tax penalties as well—10 percent of the excess benefit amount, up to $20,000 for each excess benefit transaction.[i],[ii]

Key elements of the private inurement and excess benefit transaction prohibitions

In order to violate the prohibition against private inurement or excess benefit transactions, certain elements must generally be present:

  1. The transaction or arrangement must be between the organization and one of its insiders or leaders.

As a general rule, it is not possible to engage in private inurement or an excess benefit transaction with a non-leader employee or with a party who is unrelated to the organization.  In fact, Code Section 4958 specifically stipulates that one aspect of the definition of an excess benefit transaction is that a “disqualified person” is a party to the transaction.  The law and related Regulations define the term “disqualified person” in a manner that includes certain organizational leaders and parties related to them.  A party that is unrelated to the 501(c)(3) organization is not a “disqualified person” with respect to the excess benefit transaction prohibition. Case law with respect to the private inurement prohibition has generally held that a party must be an “insider” to the organization for the rule to apply.

  1. The transaction must involve the 501(c)(3) organization transferring more value to the related party than the organization receives in exchange.

Private inurement or excess benefit transactions do not generally exist where the terms of a transaction between a 501(c)(3) organization and a related party are at fair value or better as to the organization.  For example, if an organization rents a building for use in its operations from one of its board members and pays the board member “fair rental value” for use of the property, the transaction would not ordinarily constitute an excess benefit transaction or private inurement.

Private benefit

Private inurement is a subset of private benefit but private benefit is a broader concept.  Federal tax Regulations provide that an organization is not organized or operated exclusively for exempt purposes unless it serves a public rather than a private interest. Thus, even if an organization has many activities which further exempt purposes, exemption may be precluded if it serves a private interest. Federal courts have ruled that the presence of private benefit, if substantial in nature, will destroy the exemption regardless of an organization’s other charitable purposes or activities.[iii]

Private benefit exists any time a party benefits from a transaction with a nonprofit 501(c)(3) organization.  For example, when a nonprofit organization hires an unrelated vendor at fair market value to provide maintenance services for the organization’s facilities, an element of private benefit occurs because the arrangement benefits the vendor. Payment of compensation by an organization to its employees provides some private benefit to the employees.  Accordingly, some amount of private benefit is inherent in the operations of any organization.

A 501(c)(3) crosses the line in the area of private benefit when such benefit is substantial.  As the IRS stated in its 1990 training materials for IRS agents, “In the charitable area, some private benefit may be unavoidable. The trick is to know when enough is enough.”[iv]

Another important point about substantial private benefit is that it can exist even in circumstances where there are no business transactions between the 501(c)(3) organization and related parties or where such transactions are conducted at “fair value” or better terms as to the organization.  For example, in a 1992 case, the court ruled that an organization formed to help improve the lives of and relocate indigent persons had a “true purpose” of benefitting the owners of restaurants in a particular city, who had formed the organization to create a more desirable business environment for their establishments.  The organization did not qualify for exemption even though it had a genuine activity of helping indigent persons.  (Westward Ho v. Commissioner, TCM 1992-192 (1992))

More recently, the IRS ruled that an organization formed for the purpose of producing a genuine children’s educational television show was not exempt due to the fact that a for-profit company retained the intellectual property rights to market products with the name and imagery of the characters in the show.   The facts in the ruling indicate that the for-profit company created the characters and was willing to allow the nonprofit organization to use the characters for purposes of creating and producing the show.  The IRS ruled that the production and broadcast of the children’s television show would substantially benefit the for-profit company – effectively serving to promote its intellectual property.   The IRS stated, “By using and promoting intellectual property created and owned by a for-profit in exchange for royalties, you both provide a stream of income from the property and, by giving it wide distribution, enhance its value.”  The IRS also noted that “a finding of private benefit does not require that payments for goods or services be unreasonable or exceed fair market value.”   (PLR 201129043)

Conclusion

A nonprofit organization can violate the prohibition against substantial private benefit when private parties other than charitable beneficiaries benefit significantly from the organization’s activities.  This is true regardless of whether the benefiting private party or parties are related to the organization, regardless of whether the relationship involves business transactions between the organization and the private parties that benefit, and regardless of whether such transactions (if any) are at fair value terms or better as to the organization. Violation of the substantial private benefit prohibition is a basis for loss or denial of exemption under Section 501(c)(3).

 

 

 


[i] The summary description of private inurement and excess benefit transactions is derived from the report of the Commission on Accountability and Policy for Religious Organizations, issued December 2012, available at www.religiouspolicycommission.org.

[ii] The references to 501(c)(3) organizations herein are to 501(c)(3) public charities such as churches, schools, and publicly-supported 501(c)(3) organizations.  Different rules apply to 501(c)(3) private foundations.

[iii] See IRS EO CPE Text, 2001, “Private Benefit Under IRC 501(c)(3)” by Andrew Megosh, Lary Scollick, Mary Jo Salins and Cheryl Chasin.

[iv] IRS EO CPE Text, 1990, Overview of Inurement/Private Benefit Issues in IRC 501(c)(3).

 

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