Non-profit organizations: Inurement, excess benefits, private benefits – what does it all mean?
The regulations surrounding non-profit organizations and maintaining tax exempt status can be confusing – to say the least. This article seeks to clarify a few of the finer points regarding the inurement (a fancy way of saying “benefit”) prohibition, what constitutes an excess benefit upon disqualifies persons, and the distinction between those and a private benefit.
In order to qualify for tax exempt status under either a 501(c)(3), (4), or (6) designation, a non-profit entity must not be organized for profit and no part of the net earnings of the entity may inure to the benefit of any shareholder or individual. In addition to the inurement prohibition, under Internal Revenue Code (IRC) Section 4958, if the IRS determines that a non-profit entity confers an “excess benefit” upon a “disqualified person,” both the entity and the organization could be subject to monetary penalties.
A non-profit may, however, confer a benefit to a private person so long as the benefit is incidental both in quality and quantity to the organization’s stated exempt purpose.
The Inurement Prohibition
While the standards imposed upon an organization’s not-for-profit purpose varies slightly between 503(c)(3), (4), and (6) designations, the inurement prohibition is the same for all three, which provides that no part of the earnings of such an organization may inure to the benefit of a private shareholder or individual.
The inurement restriction is absolute in that any violations will result in an organization’s loss of (or failure to qualify for) tax exempt status. Because of the severity of this penalty, the IRS has historically only enforced it in the most egregious of circumstances, and thus has adopted related rules under IRC Section 4958 as a way of imposing intermediate sanctions on organizations whose structure or transactions confer an “excess benefit” that constitutes inurement upon a “disqualified person.” The intermediate sanctions can include monetary penalties for the organization, the individual upon whom the benefit was conferred, and even organizational managers who participate in the transaction.
In the context of inurement, the term “private shareholders or individuals” means persons having a personal and private interest in the activities of the organization. IRC § 1.501(a)-1(c) and 1.501(c)(3)-1(c)(2). These persons are often referred to as “insiders.” The burden of establishing that there is no inurement is on the organization applying for exempt status. Id. § 1.501(c)(3)-1(d)(1)(2). If members of the licensing vehicle have any voting power, ability to appoint or remove directors, or other related governance functions, then it would be argued that their personal interests in receiving revenue from licensing activities could increase their loyalties to non-charitable goals over charitable ones.
In order to qualify for and maintain tax-exempt status, the burden is upon the entity to establish both (a) organizational structures that prevent inurement and (b) proof that the structures do in fact prevent inurement.
Private Benefit Prohibition
The inurement and private benefit prohibitions are often confused. The private benefit prohibition is much broader than the inurement prohibition and in fact inurement is encompassed within the meaning of “private benefit.” The Tax Court has found, however, that a private benefit will not cause the loss of tax-exempt status when the benefit is both qualitatively and quantitatively incidental to the furtherance of the organization’s stated tax-exempt purpose. To this end, the private benefit must (a) be insubstantial in comparison to the overall benefit that the activity confers and (b) be a necessary side-effect of achieving the organization’s charitable purpose. American Campaign Academy v. Commissioner, 92 T.C. 1053 (1989).
Excess Benefit and Disqualified Persons
Whether a transaction qualifies as an excess benefit depends on whether the value of the economic benefit provided by the exempt organization exceeds the value of the consideration (including performance of services) received for providing the benefit. IRC § 4958-4. Whether a transaction is an excess benefit is a rebuttable presumption. IRC § 4958-6. Reasonable compensation paid to employees of a non-profit organization is generally not considered an excess benefit.
The test to determine if there has been an excess benefit is fairly straightforward and requires three definitional inquiries: whether (1) the organization is an “applicable tax-exempt organization;” (2) the person involved is a “disqualified person;” and (3) the transaction is an “excess benefit transaction.” If the answer to all three questions is “yes,” then there has been an impermissible excess benefit.
Disqualified persons can include:
- Any person who was, at any time during the five-year period ending on the date of the transaction involved, in a position to exercise substantial influence over the affairs of the organization (whether such influence is formal or informal and includes members with voting power, members of the executive team, and others);
- A family member of an individual in the preceding category; or
- An entity in which individuals described in the preceding categories own more than a 35 percent interest. IRC § 4958-2.
Persons considered not to have “substantial influence” can include other tax-exempt organizations and employees who receive an economic benefit of less than a specified amount in a taxable year.
While blatant violations of the inurement prohibition will result in the loss of an organization’s tax-exempt status and the imposition of intermediate sanctions such as monetary penalties, less severe violations, such as those in which an organization confers an excess benefit on disqualified persons may be addressed through intermediate sanctions alone.