When a nonprofit runs amok by diverting funds to certain individuals, the organization can face two problems. The IRS can revoke the tax-exempt status of the organization. If the conduct is less egregious, the IRS may impose “intermediate sanctions” against the organization and certain interested parties.
The first part of this article discusses recent developments in nonprofit law in private inurement and private benefits. The second part will discuss excess benefit transactions, for which the IRS may impose a tax, but will refrain from the more stringent penalty of revocation of the organization’s tax-exempt status.
Private inurement and benefits can put you in hot water.
An organization is entitled to tax-exempt status under IRC Section 501(c)(3) if it is “organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes,” provided, however, that no part of the net earnings of the organization may inure “to the benefit of any private shareholder or individual.”
The first part of this formulation relates to the organization’s purpose; the second part, known as private inurement, implicates concerns that an organization insider gets rich off of the operations of the organization.
Even a little private inurement is not tolerated.
Let’s discuss private inurement first. A tax-exempt organization may receive an exemption only to the extent that there are no gains to any private shareholder or individual.
Even though the statute refers to individuals, courts have interpreted this term narrowly to mean only insiders. Insiders means the nonprofit’s managers and others in a position analogous to owners of a for-profit organization such as officers and directors. The primary interest of the government is to “prevent the siphoning of charitable receipts to insiders of the charity”—but “not to empower the IRS to monitor the terms of arm’s length contracts.”
Private inurement issues typically arise in connection with an IRS proceeding seeking to revoke the tax-exempt status of the organization. The IRS will not tolerate even a little private inurement.
The classic example most subject to scrutiny by the IRS is an agreement with an officer or director of the organization. Nonprofits are constrained in paying unreasonable compensation to its officers or directors. And officers and directors can’t get no-interest loans from a nonprofit for which they work unless they are willing to jeopardize the tax-exempt status of the organization.
In short, insiders may not unjustly enrich themselves at the organization’s expense.
IRS will scrutinize excess private benefits.
The other side of the tax-exempt requirement is in the purpose of the organization. Under the private benefit doctrine, an organization is not operated for an exempt purpose unless it serves a public rather than private interest. The IRS recognizes that private benefits to third parties may incidentally arise from the nonprofit’s activities consistent with its proper purpose. Any transaction will result in some benefit to a third party, but what the IRS is concerned about is excessive private benefits.
The private benefit doctrine typically arises when there is a pervasive pattern of benefiting a narrow class of individuals. In most judicial opinions regarding the private benefit doctrine, the purpose to benefit a narrow class is too obvious to ignore. Two recent tax cases highlight this approach to private benefits.
In New World Infrastructure Organization v. Commissioner, the tax court was faced with an attempt to hijack the nonprofit law to confer a benefit on a private class of individuals. The organization conceded that it was a “successor to a for-profit business that never made any profit.” The predecessor organization had endeavored to raise outside capital to produce and sell pipes at market rates for construction projects. It didn’t succeed, so it tried to get the taxpayers through a nonprofit organization to subsidize its research and development (R&D) effort.
The organization argued that the development of the prototype machinery would further a “scientific” purpose and ultimately “result in encouraging economic development throughout the United States.” The IRS was unimpressed and sought to revoke the organization’s tax-exempt status, contending that the organization had not demonstrated that it operated exclusively for scientific or other exempt purposes.
The tax court pointed out that scientific research as contemplated in 501(c)(3) does not include activities of a type ordinarily carried on as an incident to commercial or industrial operations as, for example, the ordinary testing or inspection of materials or products or the designing or construction of equipment.
The tax court invoked what is known as the operational test, under which the purpose toward which an organization’s activities are directed—and not the nature of the activities themselves—is dispositive of the organization’s right to be classified as a tax-exempt organization. The court noted that even in a commercial, profit-motivated context, such activities may be wholesome and commendable. But they will not support tax-exempt status unless they are undertaken to further an exempt purpose.
The tax court concluded that the nonprofit organization “appears to be a facade for” the predecessor for-profit organization. The owners of the for-profit set up the nonprofit only after they were unable to secure the funding for their for-profit business. The nonprofit had substantially the same business purpose of developing machinery capable of producing large corrugated metal pipe for sale in infrastructure projects. The owners of the for-profit were the officers and directors and paid employees of the nonprofit.
The tax court held that an organization is not operated exclusively for one or more exempt purposes if more than an insubstantial part of its activities does not further an exempt purpose. An organization is not operated exclusively for exempt purposes unless it benefits the public rather than a private interest. The organization was unable to establish that it was not organized or operated for the benefit of private interests. Consequently, the nonprofit did not qualify for tax-exempt status.
In Korean-American Senior Mutual Association Inc. v. Commissioner, the private benefit to a narrow class of individuals was too obvious for the IRS to ignore. The nonprofit’s members received certain “benefits” in exchange for their payment of dues. These benefits included a burial benefit to the surviving family. The nonprofit encouraged other members to attend the funeral services; members received a discount on funeral expenses and received information on burial plots and funeral arrangements.
The IRS sought to revoke its tax-exempt status under section 501(c)(3) because the organization was not operated exclusively for one or more tax-exempt purposes. The IRS argued that the primary activity of the nonprofit was to provide funds to defray or pay for the funeral costs of its members. The nonprofit argued that it served the recognized charitable class of the elderly.
The tax court easily disposed of the nonprofit’s arguments. It operated a fee-for-service. Its primary activity was not directed toward meeting the special needs of the charitable class, the elderly, by relieving distress or providing a community benefit. It provided burial benefits only to its members who paid dues, not to non-dues-paying seniors in the community. If a member failed to pay the required membership dues, their membership could be terminated, and the organization would have no obligation to pay burial benefits.
The nonprofit operated in a commercial manner by providing burial benefits to its members, not to all elderly. The tax court concluded that it did not operate exclusively for one or more exempt purposes within the meaning of section 501(c)(3), upholding the decision to revoke the tax-exempt status of the organization.
These cases show that the IRS seems to act most aggressively in those matters in which the private benefit is too obvious to ignore.
Excess benefit transactions applied to list of “insiders.”
Until 1996, the IRS had a binary choice for tax-exempt organizations that had run afoul of their charitable purpose: Try to revoke the tax-exempt status of the organization or don’t. There was no intermediate ground—until Congress passed Section 4958 of the Internal Revenue Code.
The purpose of the new statute was not to collect revenue but to “deter insiders of an organization from using their positions of influence to receive unreasonable compensation.” The target of these “intermediate sanctions” is not the tax-exempt organization, but rather insiders who may have benefited from the malfeasance.
Under Section 4958, the IRS may impose excise taxes for certain “excess benefit transactions” between a tax-exempt organization and certain insiders, known in the jargon of the statute as “disqualified persons.” The term “excess benefit transaction” means any transaction in which an economic benefit is provided by a tax-exempt organization “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.”
The IRS may impose the tax on not only on the disqualified person but also on any organization’s managers participating in the excess benefit transaction, unless the manager’s participation “is not willful and is due to reasonable cause.”
The amount of the tax on the disqualified person is 25% of the excess benefit, which is known as the first-tier tax. The law provides a significant incentive to pay up to recalcitrant insiders. If they do not correct the excess benefit and pay the first-tier tax within the taxable period, then the IRS is required to impose a 200% tax of the excess benefit on the disqualified person.
Intermediate sanctions can be imposed not only on traditional insiders such as officers and directors but also on family members, as well as a much broader category of individuals who are “in a position to exercise substantial influence over the affairs of the organization” during a five-year look-back period.
In Fumo v. Commissioner, the tax court considered whether disqualified persons included those without an official position with the organization. The court underscored that apart from those named in the law as disqualified persons who were obvious targets—such as directors and certain officers, members of their families, and certain affiliated entities—there may be others who qualify as “disqualified persons.” The question whether an individual is a disqualified person generally “depends upon all relevant facts and circumstances.” In Fumo, there were lots of facts and circumstances.
The petitioner on whom the tax for the excess benefit transaction was imposed objected that he was not a disqualified person. Yet he was intricately intertwined with the organization. Sure, he wasn’t an officer or director or employee. But according to his own testimony in his criminal trial (we’ll get to that in a moment), he “created” the tax-exempt organization, “gave it birth,” and “nursed it along.” He testified that "[i]f it weren’t for me, [the tax-exempt organization] wouldn’t exist.”
The petitioner was a politician who had been convicted on 34 counts related to a scheme to defraud the same tax-exempt organization. He had conspired to use the organization’s funds to purchase vehicles, farm equipment, tools, and consumer goods for his own use and make other expenditures on his behalf—e.g., for foreign travel, the services of a private investigator, and cellphone service for his chauffeurs and daughter. He had already been ordered to pay the organization more than $1.1 million in restitution.
Although an officer of the organization exercised day-to-day control over the organization’s affairs, the petitioner approved most significant projects and directed many major expenditures, including, for example, an office building that housed his first district office.
The tax court exhaustively reviewed the factors relating to whether the petitioner, who had no official capacity with the organization, could be a disqualified person. The status of most other individuals is governed by the “facts and circumstances” test of paragraph (e). Under that test, an individual can be a disqualified person even though they have no formal job title or formal affiliation with the charity. The regulations provide a laundry list of factors tending to show that a person has “substantial influence” over the organization.
Numerous facts supported the finding that the petitioner was a disqualified person. But “the clearest indication” that he was in a position to exercise substantial influence over the affairs of the organization was, according to the court, that “he in fact exercised such influence, and did so repeatedly over a period of many years.”
The second recent case dealing with excess benefit transactions is a clearer example of a disqualified person. In Ononuju v. Commissioner, the petitioner’s husband was a medical doctor and president of a nonprofit established to operate a medical facility in Michigan. The clinic’s purported purpose was to provide medical examination and treatment services for individuals unable to afford such services.
The petitioner’s husband had received checks and other benefits from the organization of over $650,000 to defray the personal living expenses of his family, including the petitioner, her husband the doctor, and their eight children. The petitioner was also part of this gravy train. She received biweekly checks totaling $27,000 and monthly checks totaling $88,000.
The petitioner may have held some official position with the organization and was listed as the organization’s treasurer and secretary on an annual report filed with the state of Michigan. She was listed as its secretary and as a director on the Form 990. She had signature authority over at least three of organization’s bank accounts and regularly attended the organization’s board meetings during some of the relevant times.
She testified that her husband put her on the payroll, which is why she received the biweekly checks, but she offered no testimony or other evidence that she performed any services for the organization. She referred to the nonprofit as her husband’s “business” and as “the name of his medical practice.”
Her testimony regarding the monthly checks was no more believable. She argued that although the $88,000 of checks were made out to her, she did not personally benefit. She testified that she withdrew these funds from the organization’s account at her husband’s request, for distribution to needy people in town—e.g., to help them pay rent and utilities, to pay for children’s after-school programs, and to reward children who got good grades at school. She testified: “I was just like a messenger.”
It did not help her defense that she received compensation for services rendered to the nonprofit when she testified: “I don’t know anything about this case. I’m just a mother of eight children, and that was my job at that time.” She could supply no substantiation to show that the nonprofit intended to treat the $27,000, much less the $88,000, as compensation for her services.
The tax court was unimpressed, determining that it was “far more plausible” that the IRS’s conclusion that she used the $88,000 to defray personal living expenses of her family. As to whether she was a disqualified person, the tax court had no problem with finding that the petition was automatically deemed to be a disqualified person because she was the doctor’s spouse. The court did not reach any conclusion regarding whether she also qualified as a disqualified person because of being a director.
The tax court affirmed the finding that she was subject to a first-tier tax of $32,500 under Section 4958(a), and because the petitioner failed to correct the improper transactions during the applicable period, the IRS imposed a second-tier tax of a whopping $260,000.
The same guidance that goes for nonprofits goes for every legal entity: keep the entity separate. It may be obvious, but you should not use the nonprofit’s funds to buy groceries for the officers or directors or other insiders. You should not pay unreasonable compensation for the officers. In short, you should not use a nonprofit tax-exempt organization, which is subsidized by US taxpayers, as a personal piggybank for officers, directors, their families, or other insiders.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Keith A. Rosten is a partner in the law firm of Berliner, Corcoran & Rowe LLP in Washington, D.C. He is a business attorney serving the legal needs of for profit and nonprofit organizations and recently served as an expert witness in major litigation on issues dealing with private inurement.
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