January 20, 2022

Too Much Private Benefit? Say Goodbye to Your Tax Exemption!

By Aaron Fox, Partner, Nonprofit Tax Services

Too Much Private Benefit? Say Goodbye to Your Tax Exemption! Nonprofit Tax Services

Even one instance of private benefit can jeopardize a not-for-profit organization’s exemption. Because these rules apply to most tax-exempt organizations and are broad in scope, it pays to understand how they work so you can avoid the risk.

The private benefit doctrine is an area of tax law that should be understood properly when establishing a new nonprofit entity or engaging with other for-profit entities as a nonprofit. Private benefit rules apply to most tax-exempt organizations, such as business leagues, social clubs, labor unions, and charities. In the relevant case American Campaign Academy v. Commissioner, the Tax Court defined private benefit rules as “non-incidental benefits conferred on disinterested persons that serve private interests.” The Court noted that the prohibition against private benefit is not limited to an organization’s insiders or people who have a personal and private interest in the activities of the organization; even benefits that accrue to “disinterested persons” can violate private benefit rules. Such benefits can be monetary or non-monetary.

The origins of the law stem from Treasury regulations related to Section 501(c)(3) organizations, which state that entities are not organized and operated exclusively for one or more charitable purposes unless they serve a public rather than private interest. That’s why even one instance of private benefit can jeopardize the exemption of the organization, unless it can be argued as incidental.

Examples of Private Benefit Violations

To better understand this concept, let’s examine a couple of examples. Consider food banks, which are usually organized as Section 501(c)(3) charitable organizations. Food banks distribute food to those in need. Despite the fact they are giving out goods to individuals, they aren’t violating private benefit rules because the recipients are part of the charitable class the nonprofit is designed to be serving. However, if the organization was set up to serve just friends and family of the founder, or other specific individuals, that would constitute an impermissible private benefit.

Here’s a real-world example. A nonprofit was organized to provide continuing medical education to physicians. As part of this purpose, it took physicians on three-week tours throughout the world. The nonprofit shared offices with a for-profit travel agency controlled by the nonprofit’s principal officer, and it made all its travel arrangements through the agency. The Court found that benefiting the for-profit travel agency was a substantial purpose of the nonprofit. Therefore, it could not be described as a Section 501(c)(3) organization.

An exempt organization creates private benefit risk just by engaging in transactions with commercial businesses if there is a level of common control involved. There is much court precedence for denying nonprofits their exempt status when a related business benefits from their activities.

A Modern Ruling

Another example comes from a private letter ruling that was made available to the public in late 2013. The nonprofit in question was organized to manage an online community for other nonprofits, for-profits, and individuals to come together and engage supporters, raise funds, and help for-profit organizations market their businesses and products while supporting charities. This nonprofit earned a share of the proceeds from any customers it referred to business partners in the community. Customers could also shop on the website and direct a portion of their proceeds to whichever charity they deemed worthy. The website required nonprofits to register with the organization in order to receive these contributions at the point of purchase. Administering this feature constituted the majority of all activities performed by the nonprofit.

One might wonder how these activities would ever qualify an organization for Section 501(c)(3) status. The IRS was concerned that the organization’s purpose did not qualify under this code section, and with the fact the nonprofit engaged two organizations to help run the website. Organization A provided hardware and software to facilitate the donation service and Organization B provided IT support. Both organizations were closely related to or owned by the officers and directors of the nonprofit.

The IRS concluded that the nonprofit was not entitled to exemption from federal income tax under section 501(c)(3). It determined that the primary function of the nonprofit (including administering, fundraising, and networking related to the online community) was not an exempt purpose in the code section, and more akin to the operation of a commercial website.

Also, the IRS ruled that the nonprofit was not organized or operated exclusively for one or more tax-exempt purposes because it served a private rather than public interest. The website only secondarily benefited the public; the more direct benefit was generating business for Organizations A and B. The nonprofit was engaging charities to use the website which increased web traffic and provided opportunities for commercial businesses to market goods and services. These activities, the IRS reasoned, enhanced the utility and appeal of the website and therefore conferred non-incidental benefits serving private interests.

The Service is quick to note that letter rulings are directed only to the taxpayer that requested it and should not be used as precedent. And while this true, this letter ruling does provide recent insights into how the IRS approaches private benefit violations.

These violations are very serious and should be avoided to preserve your organization’s exempt status. In addition to the IRS, the organization may also face actions by the state, which could charge the organization’s directors for breaching their fiduciary duty to oversee their charitable assets.

How you’ll prevent private benefit transactions is just one of many tax considerations that should happen in the planning phase of any major undertaking. This is the case whether you are creating a subsidiary to your nonprofit to house taxable activity, or perhaps contracting with a third party that will engage in commercial co-venturing opportunities.

Nonprofits should consider the following questions to mitigate this risk:

  • Has the organization enacted or enforced a robust conflict of interest policy that exposes any overlapping ownership or conflicts with potential vendors?
  • Will a third party receive benefits in excess of what is necessary to achieve the organization’s mission?
  • Will any person be compensated unreasonably, and has documentation been put in place to show compensation is reasonable?
  • For Section 501(c)(3) organizations, is the charitable class that should be served in the transaction actually benefiting from the activities?
  • Is the mission of the organization being furthered?
  • Has the organization performed its due diligence when selecting a vendor by researching competitors and alternatives?
  • Are any of the terms of the contract or transaction unfavorable to the organization?