Private Benefit, Private Inurement, and Self-Dealing
Private benefit, private inurement, and self-dealing are defined by the Internal Revenue Service as unacceptable practices for nonprofit tax-exempt organizations. The IRS expects nonprofits to exist for the public good and not to be created or operated for the benefit, financial or otherwise, of a private individual. Violation of these doctrines can result in heavy taxation and/or loss of nonprofit status.
Private benefit is a broad concept that applies whenever any individual, whether associated with the organization or not, reaps a benefit that is not within keeping of the exempt purpose of the organization. Private benefit does not have to be financial. The IRS does not see private benefit in absolute terms. It is allowable when it is insubstantial or incidental to the main service being provided. It is not acceptable when a service or a financial transaction is purposefully aimed to benefit an individual or a narrowly defined group rather than the public.
Examples of unacceptable private benefit
- Keep Our City Beautiful, a membership organization, plants a city alley with elaborate flowering bushes. The alley is not heavily traveled but the decorations increase the attractiveness of the city’s main restaurant whose owner is a member of the organization.
- A nonprofit sets up a scholarship fund that supports only staff members’ children.
- A hospital offers joint venture incentives to physicians to entice them to join the medical staff in order to bring more patients to the facility.
Private inurement is an important part of private benefit and it happens when an insider — an individual who has significant influence over the organization — enters into an arrangement with the nonprofit and receives benefits greater than she or he provides in return. The most common example is excessive compensation, which the IRS condemns through Intermediate Sanctions, significant excise taxes. Insiders — referred to in IRS parlance as “disqualified persons” — can be high-level managers, board members, founders, major donors, highest paid employees, family members of the above, and a business where the listed persons own more than 35 percent of an interest.
Private inurement is an absolute term. There is no de minimis restriction. If a nonprofit is organized to benefit an individual — even while fulfilling its tax-exempt purpose — it cannot be a tax-exempt organization. Under the state law, an organization may lose its nonprofit status.
Examples of private inurement
- A nonprofit’s chief executive is paid a reasonable and comparable salary with health benefits. In addition, the organization pays the chief executive a lavish living allowance that brings total compensation to an amount not in line with comparable for-profit and nonprofit positions of the same nature.
- Five individuals, who are also board members, lease property to a school. The school funds or finances major improvements that greatly increase the property value beyond the life of the lease.
- A nonprofit art gallery exhibits artwork created by its members for a fee but grants board members the same service without cost.
In the context of private benefit transactions for nonprofits, self-dealing is a term that applies to private foundations. It describes a situation where a foundation insider is engaged in a financial transaction as the provider and receiver of the benefit. The Tax Reform Act of 1969 played a key role in defining private foundation purpose and accountability by addressing concerns that foundations were being used for personal gain. The act also attempts to alleviate the IRS’s difficulty in determining whether transactions are passing an arms-length rule, ensuring that objective and unbiased decisions are made by foundation insiders.
Self-dealing is absolutely forbidden in a private foundation. It is not illegal in other nonprofits. No matter how small the benefit (even $1), and even if the overall transaction is for the good of the foundation, it is not acceptable. If it has occurred, the transaction must be reversed without adversely affecting the financial situation of the foundation and penalties must be paid by the self-dealers and those who approved the decision. Ultimately, if the situation is not corrected and the penalties are not paid, the foundation will lose its tax-exempt status.
Examples of unacceptable self-dealing
- A founder uses the foundation assets to collateralize personal loans.
- A foundation lends money to the brother of a board member.
- A foundation manager sells real or personal property to the foundation.
How to avoid penalties
- Structure your organization so that it serves its tax-exempt purpose and not the needs and wants of any individuals.
- Make informed and prudent decisions.
- Create and update policies and procedures including vendor bidding process, financial practices, personnel practices, conflict of interest, board member compensation, and expense reimbursement.
- Remind staff and board members regularly of conflict-of- interest obligations and the need to fully disclose whenever they identify a potential conflict.
- Use valid data to set chief executive and other senior staff compensation and benefits package. Use data that relates to comparable positions (comparable may mean nonprofit and for-profit) obtained from objective and uninterested sources such as surveys, information from other organizations. Retain objective consulting on the issue whenever possible. Or, have the board or an authorized committee of the board review the data and agree on the compensation. Be familiar with Intermediate Sanctions regulations and avoid excess benefit transactions.
- Seek professional advice when there are questions. Don’t try to figure it out alone.
101 Resource | Last updated: June 8, 2016