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Tax Exemption is a Privilege and Not a Right – Part Three

By: Shawn P. Williams, CPA, Audit Senior Manager

Note: This article concludes a three-part series discussing issues that may jeopardize an organization’s tax exempt status. Part one provided an overall discussion of the issues while part two discussed detailed issues regarding political and lobbying activities. This article will address the consequences of private inurement and private benefit.

Even though this is simply stated, the actions and activities of certain tax-exempt, not-for-profit entities must be much more progressive to maintain their tax-exempt status. Recently there has been increased discussion and communication to NFP entities concerning private inurement and private benefit, such elements that can affect the tax exempt status of a questioned company. Both instances of inurement and benefit could lead to further tax penalties, known as intermediate sanctions, in the amount of 25% of the excess benefit conveyed as well as a 10% tax to others who knowingly and willfully participated in the transaction. The oversight reporting requirements and imposed penalty taxes on transactions that are deemed excessive are nothing new.

The Taxpayer Bill of Rights 2, signed in 1996 by President Bill Clinton with provisions retroactive to 1995, established the framework for increased reporting standards. As well, Internal Revenue Code Section 4958 initially imposed intermediate sanctions between disqualified persons and a tax-exempt organization. These measures were in response to a growing number of NFPs filings. Just to outline the magnitude of growth in NFPs from the reporting years 1998-1999 to 2007-2008, the 501(c)(3) organizations increased from 211,000 informational returns accounting for $750B in revenues to 315,180 Form 990 and 990-EZ returns with total revenues of $1.4T (per IRS Statistics of Income).

We’ve previously discussed private inurement and private benefit in prior NFP Updates, so as a recap:

  • Inurement – Under the private inurement rule, none of an exempt organization’s income or assets may disproportionately benefit a person or company that is closely related to the organization, particularly one who exercises a significant degree of influence over it. Private inurement can arise from unreasonable compensation; unreasonable fringe benefits; personal expenses paid by the entity, other than arm’s length transactions; or low-interest or unsecured loans. Most importantly, private inurement lacks any de minimis concept.
  • Benefit – In contrast to the private inurement rule, the private benefit rule is not limited to circumstances where the benefits accrue to an organization’s insiders. This prohibition includes benefits to “disinterested” persons or entities or outsiders. However, while private inurement lacks any de minimis concept, the IRS has traditionally allowed some private benefits to inure to outsiders so long as the private benefit is purely incidental to the organization’s tax-exempt purposes. A private benefit is considered incidental only if it is incidental in both a qualitative and quantitative sense. To be incidental in a qualitative sense, the activity giving rise to the benefit can be accomplished only by benefiting certain private individuals. To be incidental in a quantitative sense, the private benefit must not be substantial after considering the overall public benefit.

As recent as 2011, these rules for private inurement and private benefit have stretched from 501(c)(3) entities to those registered as 501(c)(4)-(6). The following discussion concentrates on the differences between inurement and benefit as well as examples, traps, and best practices of both doctrines followed by possible penalties that could ensue.

Private Inurement

IRS General Counsel Memorandum 38459 discusses when private inurement likely arises, but you don’t have to be a rocket scientist to know when certain rules are infringed. If an organization’s financial resources are transferred to an individual based upon their relationship with that organization without regard to accomplishing the organization’s exempt purposes this can give rise to private inurement. These individuals in question are considered insiders, however, not all transactions between the organization and insiders are prohibited. The whole purpose behind the rule is to ensure that the organization is serving exempt interests and not private interests involving the aforementioned insiders. As long as the transactions succeed when tested against the standard of reasonableness and at an arm’s length basis, private inurement may be avoided. Conversely, relative insignificance of the private benefit conveyed does not serve as an adequate defense. Any violation of these private inurement rules could lead to revocation or denial of tax-exempt status.

Examples of Private Inurement are as follows:

  • Sale or exchange, or leasing, of property between an organization and a private individual
  • Lending of money or other extension of credit between an organization and a private individual
  • Furnishing of goods, services, or facilities between an organization and a private individual
  • Payment of compensation (or payment or reimbursement of expenses) by an organization to a private individual
  • Transfer to, or use by or for the benefit of, a private individual of the income or assets of an organization

Keep in mind that in healthcare, the private individual definition reaches to officers, directors, and physicians who all may, or at least in part, are in positions of control and influence.

A common practice most NFPs should follow, concerning compensation and the other examples above, is the use of the IRS rebuttable presumption checklist. This checklist comprises three elements requiring approval of an independent board or governing body:

  • was composed entirely of individuals unrelated to and not subject to the control of the disqualified person(s) involved in the arrangement.
  • obtained and relied on data analyzing the comparability of the compensation arrangement with those offered by similar taxable and tax-exempt organizations.
    1. appropriate data such as compensation levels paid by similarly situated organizations
    2. geographic location of the organization
    3. nationally recognized, independent compensation surveys
    4. actual written offers competing for the services of the individual
  • adequately documented the basis for its determination.

Private Benefit

The ground rules for private benefit transactions are very similar to private inurement transactions yet in a much broader sense. These rules disperse from the insider approach and extend beyond those individuals to a new group called “disinterested persons” as we defined above and in prior newsletters. Thus the incidental nature of purported benefits must be proved both qualitatively and quantitatively.

Examples of Private Benefit are as follows:

  • Partnerships and Joint Venture cases (mainly involving at least one not-for-profit and for-profit party)
    1. The main concentration is whether the tax-exempt organization involved in the joint venture has ceded effective control over its assets and interests to for-profit interests.

Intermediate Sanctions

As discussed in the introductory paragraph, intermediate sanctions are the penalties assessed to those outside the tax-exempt organization. IRC § 501(c)(3) prohibits the net income of a tax exempt organization from inuring to the benefit of a private shareholder or individual (referred to as disqualified individual). This requires an organization to establish that it is not organized or operated for the benefit of private interest such as individuals with the ability to either directly or indirectly control the organization. If this type of benefit is conveyed to an insider, it is considered an excess benefit transaction.

Regardless, if the excess benefit transaction is direct or indirect, it can result exposure to intermediate sanctions. Intermediate sanctions are a two tiered penalty excise tax that, under IRC § 4958, is imposed on the amount of the excess benefit when a tax exempt organization engages in an excess benefit transaction. This penalty is imposed on both the individual receiving the excess benefit (initially taxed at 25%) as well as the organization managers (taxed at 10%) who participated in the transaction with the knowledge that it was improper. The individual receiving the excess benefit is also required to reimburse the organization for the amount of the excess benefit within the tax year of occurrence. If the excess benefit is not corrected by the disqualified individual within the tax year, the excise tax will increase to 200% of the excess benefit.

To conclude, if the doctrines of private benefit and private inurement have existed for more than 20 years, why is there increased scrutiny? With the increased national debt and taxing concerns, coupled with increased formations of tax-exempt companies and fraud within not-for-profits, there’s probably a reason why the 2012 IRS budget calls for approximately 1,300 in additional FTEs. Keep in mind, you just read a tax article written by an auditor.

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