The IRS recently revised its Exempt Organizations Technical Guide: Disqualifying and Non-Exempt Activities, Inurement and Private Benefit – IRC Section 501(c)(3).

Organizations exempt under Section 501(c)(3) of the Internal Revenue Code (Code) must avoid engaging in impermissible conduct. Such conduct includes providing private benefit and inurement. An otherwise qualifying organization will be disqualified for exemption if it benefits private interests, either through inurement of its net earnings to certain “insiders,” or by primarily benefiting the interests of persons who, though not “insiders,” do not comprise a charitable class.

The following are some excerpts from the Technical Guide:

Inurement

Simply put, inurement is the use of an exempt organization’s net earnings to benefit an insider. As a result, the organization does not exclusively serve the public.

Treas. Reg. 1.501(c)(3)-1(c)(2) states that an organization is not exclusively operated for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals.

The “net earnings” reference goes beyond a narrow accounting definition of net income to encompass almost any use, other than an arm’s-length transaction or payment of reasonable compensation, of an organization’s assets by an insider.

Treas. Reg. 1.501(a)-1(c) defines private shareholder or individual as “persons having a personal and private interest in the activities of the organization.” It places the focus of the inurement prohibition on those who, by virtue of a special relationship with the organization in question, are able to influence the use of its funds or assets.

Inurement may exist in many forms. Some examples are:

• Unreasonable compensation – One factor to consider is whether comparable services would cost as much if obtained from an outside source in an arm’s-length transaction.
• Payment of excessive rent
• Detained or retained interests – A trust which provides for the reversion of principal on termination to the creator does not qualify for exemption under Section 501(c)(3).
• Receipt of less than fair market values in sales or exchange property
• Unsecured or inadequately secured loans
• Prohibitive benefit from funds
• Exempt organizations providing capital improvements to property owned by its insiders
• Copyrights and royalties benefiting insiders
• Interest free and/or unsecured loans to insiders
• Dividends

Excess Benefit Transactions

Excess benefit transactions are any transactions where an economic benefit is provided by an applicable tax-exempt organization (ATEO) [including 501(c)(3) public charities and 501(c)(4) organizations] directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit. 

A disqualified person, as defined in Section 4958(f)(1), includes:

1. Any person who was, at any time during the 5-year period ending on the date of the transaction, in a position to exercise substantial influence over the affairs of the organization
2. A member of the family of a disqualified person[, defined in Section 4958(f)(4)]
3. A 35% controlled entity, defined in Section 4958(f)(3)
4. A person described in a, b, or c above of a related Section 509(a)(3) supporting organization to the ATEO
5. A donor/donor advisor described in Section 4958(f)(7) involved in a transaction with a donor advised fund (DAF)
6. An investment advisor defined in Section 4958(f)(8) with respect to a sponsoring organization of a DAF

Section 4958(a)(1) imposes a tax equal to 25% of the excess benefit on each excess benefit transaction between an ATEO and a disqualified person. The initial tax is sometimes referred to as the “First Tier Tax.”

If the 25% initial tax is imposed on an excess benefit with a disqualified person, Section 4958(a)(2) imposes a 10% tax, limited to $20,000 per transaction, on any organization manager who knowingly participated in the excess benefit transaction. The 10% tax won’t be imposed if participation was not willful and due to reasonable cause. 

If the initial 25% tax is imposed on an excess benefit transaction between an ATEO and a disqualified person, and the excess benefit transaction isn’t corrected within the taxable period, an additional excise tax equal to 200% of the excess benefit is imposed on the excess benefit transaction. The additional tax is sometimes referred to as the “Second Tier Tax.”

Private Benefit

To be exempt from federal income tax under Section 501(c)(3) an organization must serve a public rather than a private interest. The organization must demonstrate that it is not organized or operated for the benefit of private interests.

The private benefit doctrine is derived from the requirement in Section 501(c)(3) that an organization be organized and operated exclusively for exempt purposes.

As discussed previously, inurement is one type of private benefit, but private benefit includes more than just inurement. Private benefit results when an individual benefits from the activities of a Section 501(c)(3) organization, regardless of the individual’s insider status.

Although even a minimal amount of inurement results in the disqualification of an exempt organization, private benefit will not jeopardize tax-exempt status if it is incidental to the accomplishment of exempt purposes ….

[FOR LAWYERS] Note: The regulations use the term “substantial,” rather than “incidental.” The Code references “organized and operated exclusively,” while the regulations interpret this as requiring no more than an insubstantial non-exempt purpose. Only in non-precedential guidance has the IRS interpreted incidental private benefit as being insubstantial.

Further, private interests must be benefited only to the extent necessary to accomplish exempt purposes. It is a facts and circumstances test in that the public benefit from the organization’s activities must outweigh any individual benefit. The key to understanding the concept of private benefit is understanding what “incidental” means in both a qualitative and a quantitative sense.

To be qualitatively incidental, private benefit must be a necessary by-product of the activity that benefits the public at large and accomplishes exempt purposes. In other words, the benefit to the public cannot be achieved without necessarily benefitting certain private individuals.

To be quantitatively incidental, private benefit must not be substantial relative to the public benefit. This is a facts and circumstances test that requires the public benefit from the organization’s activities to outweigh any individual benefit.

Examination Techniques

The last section of the Technical Guide reveals tips and techniques for IRS examiners to identify inurement and private benefit while reviewing exemption applications and returns filed by exempt organizations.

[Re: salaries paid to those controlling the organization and to other key employees -]

To determine if they are reasonable, consider factors such as:

1. Duties performed
2. Amount and type of responsibility
3. Time devoted to duties
4. Special knowledge and experience
5. Individual ability
6. Previous training
7. Compensation paid in prior years
8. Prevailing economic conditions
9. Living conditions of the particular locality
10. The type of activities carried out by the organization and its size

[Re: private benefits provided to others -]

To determine when a private individual’s benefit outweighs the benefit to the general public, consider asking the following questions during your interview and review of the books and records:

1. What is the organization’s primary purpose and activities?
2. What is the nature of the benefit?
3. Who receives it?
4. What is the amount of the benefit?
5. How large is the class of individuals receiving the benefit?
6. Does an individual’s private benefit result in significant public benefit?
7. Does the private individual’s benefit outweigh society’s benefit?