It takes a lot of planning, thoughtfulness, and attention to technical detail to become a 501(c)(3) public charity[1]. These organizations have applied for and received tax-exempt status under Section 501(c)(3) of the Internal Revenue Code (the “I.R.C.”) which means they are eligible for exemption from paying federal corporate income tax and are typically also eligible for exemption from the equivalent taxes on the state and local level (here, each tax-exempt organization is a “Nonprofit”). In addition to these financial motivators, tax-exempt status is a prerequisite for many funding opportunities from foundations and government agencies. Many individual donors also donate exclusively to tax-exempt organizations because those donations become tax-deductible to the donor.
Whatever the reasons to pursue tax-exempt status, once a Nonprofit has gone to the trouble to become tax-exempt as a public charity under 501(c)(3), it must put in place a compliance program to ensure it keeps up with its various obligations and doesn’t risk losing that tax-exempt status or incurring other costs. Let’s dive into a few of the bigger areas on which to focus your Nonprofit’s compliance efforts.
Private Benefit: The Nonprofit can’t create too much private benefit.
An organization may be tax-exempt only if it is “organized and operated exclusively for religious, charitable, scientific” or other specified purposes, exhibited by being primarily engaged only in activities which accomplish one or more of these exempt purposes.[2] An organization will only be regarded as primarily engaged in activities to accomplish one of the exempt purposes if it “serves a public rather than private interest”[3].
Private benefits are those flowing to people outside the Nonprofit’s intended charitable class. Not all private benefits are disallowed – it would be hard for many Nonprofits to advance their exempt purpose without anyone beyond the intended charitable class benefiting in some way. The key is to ensure that any private benefit is incidental compared to the public benefit being achieved. Allowable private benefit must be (1) quantitatively incidental, meaning it is insubstantial when compared to the public benefit achieved, and (2) qualitatively incidental, meaning it is a mere byproduct of the public benefit being served.
For example,[4] one Nonprofit considered by the Internal Revenue Service (“IRS”) was formed to maintain and improve a lake as a public recreational facility. There was some private ownership of lake-front property, but the public used the lake extensively for recreation and it had public beaches and launch sites on its shores. Even though the work of the Nonprofit to improve the lake benefited those owning lake-front property, the IRS found that benefit was incidental when weighed against the public benefit being achieved. In this instance, the Nonprofit could not have accomplished its objectives for the public without those private landowners receiving some benefit.
Private Inurement: The Nonprofit’s income and assets can’t create disproportionate benefits for Insiders
Tax-exempt Nonprofits cannot allow their income or assets to directly or indirectly benefit people who have a personal or private interest in the Nonprofit’s activities.[6] The rules against private inurement are a subset of the rules regarding private benefit, with a focus on people who hold power over a Nonprofit and what it does. The goal is to avoid unjust enrichment. Unlike the broader private benefit rules where the private benefit is weighed against the public benefit, any amount of private inurement is an issue and can result in loss of tax-exempt status.
However, not all benefits flowing to Insiders are prohibited. There is a safe harbor where certain Insiders[7] may receive benefits so long as they are part of a reasonable compensation plan. To fit within the safe harbor, the terms of the compensation arrangement must be approved in advance by disinterested members of the relevant authorized body and their approval must rely on appropriate comparability data. If the arrangement with the Insider fits within the safe harbor, a rebuttable presumption of reasonability is established.
Practical Steps To Protect Your Nonprofit
The consequences for a Nonprofit that creates too much private benefit or any private inurement that doesn’t fit within the safe harbor discussed above can include loss of tax-exempt status and fines and fees for those receiving or approving the benefits. There are, however, some simple steps you can take to protect a Nonprofit from these consequences.
- Revisit the Nonprofit’s exempt purpose often (consider yearly) and analyze how current programs support it.
- Put in place a robust Conflicts of Interest Policy, which includes annual conflicts disclosure practices and details a process to examine and approve (or disapprove) of conflicted transactions.
- Put in place a robust Whistleblower Policy, which specifies procedures to report suspected private benefit or private inurement (including anonymously, since private benefit involves folks with a degree of control over the Nonprofit which can prove a disincentive for others to report).
- Examine practices around compensation for executives and others with significant power. How are compensation packages being negotiated? Are you looking at comparability data in the field?
- Examine the decision-making procedures of the Nonprofit’s board. Are detailed minutes and attendance logs being kept? Are approvals being documented, including those for which the votes on disinterested directors are required?
For further food for thought on tax-exempt organization compliance, check out the IRS’ Compliance Guide for 501(c)(3) Public Charities.[8] If you find yourself thinking of any of your Nonprofit’s activities as you read the above descriptions of private benefit and private inurement or if you would like help implementing any of the practical steps detailed above, you should speak with counsel.
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[1] Note that the content of this blog is limited to public charities and does not address private foundations. If your organization is a private foundation and you would like to discuss any of these topics, please reach out directly.
[2] 26 CFR 1.501(c)(3)-1(d)(1)(i); 26 CFR 1.501(c)(3)-1(c)(1)
[3] 26 CFR 1.501(c)(3)-1(d)(1)(ii).
[4] Rev. Rule. 70-186, 1970-1 C.B. 210.
[5] “Insiders” are people who could make use of the Nonprofit’s income or assets for personal gain.
[6] Private Benefit under IRC 501(c)(3), IRS (2001).
[7] A “disqualified person” is any person who was in a position to exercise substantial influence over the affairs of the non-profit at any time during a five-year lookback period, ending on the date of the transaction. 26 CFR 53.4958-3(a).
[8] https://www.irs.gov/pub/irs-pdf/p4221pc.pdf.
