Protect the Tax-Exempt Status of Your 501(c)(3) Charity: The Prohibition on Private Inurement and the Private Interest Doctrine
Allowing a nonprofit organization to be tax exempt provides an incredible advantage by leaving the organization with more resources to accomplish its mission, especially with charitable organizations. However, the tax-exempt status can be taken away if the organization breaks the rules. Thus, it is important for the directors, officers and employees of tax-exempt organizations to know about those rules and how they interact.
One such rule is known as the "prohibition on private inurement", which states that an organization is not operated exclusively for tax-exempt purposes if its net earnings inure, in whole or in part, to the benefit of private individuals. Okay, that is admittedly dry and probably raises more questions than it answers, but the prohibition is basically meant to prevent money or other assets of the organization from going to an individual that is not in one of the charitable classes the organization is meant to benefit (otherwise known as the "public beneficiaries"). The obvious examples are directors who grossly overpay themselves or divert funds for their private use. Inurement also occurs when a private individual benefits from any transaction with the organization that does not reflect fair market value and current economic conditions.
The bad news is that even a minimal amount of inurement can have a disastrous effect: the total loss of tax-exempt status. The good news is that the prohibition is typically only applied to "insiders" of the organization who have the ability to influence how the funds of an organization are spent. Usually this is limited to officers, directors or trustees, but if market conditions give a particular individual significant influence over the organization’s operations, they may be treated as an "insider" in an economic sense. Thus, the key question is whether an insider has received any benefit, including the mere lessening of an economic burden, at the expense of the organization.
In addition to the prohibition, tax-exempt organizations must also deal with the "private benefit doctrine", which requires that the organization be operated for the benefit of the public and not private interests. This sounds a lot like the prohibition; however, there are several distinct differences.
While the prohibition is generally applied only to "insiders", the doctrine applies to outsiders as well. Although application of the doctrine is complicated and fact sensitive, the key focus is whether the benefit being conveyed by the organization (whether to an insider or an outsider) falls into one or more of the tax-exempt purposes specified in Section 501(c)(3) of the Internal Revenue Code (generally religious, charitable, scientific, testing for public safety, literary or educational purposes).
However, while even a minimal amount of inurement can result in tax-exempt disqualification under the prohibition, a private benefit must be substantial to jeopardize an organization’s tax-exempt status under the doctrine. Thus, if the benefit conveyed to the private interest is unrelated to a charitable purpose but is insubstantial in nature, the risk to the organization is low. On the other hand, if the benefit is more substantial in nature, the risk of violating the doctrine increases. Unfortunately, there is no bright-line definition of "substantial" and "insubstantial" so the IRS and courts adopt a case-by-case approach.
Be sure to check back in the near future when I address "excess benefit transactions" and the resulting intermediate sanctions. While they are not likely to threaten the tax-exempt status of a nonprofit organization, they can result in significant financial penalties that hinder an organization from accomplishing its mission.