5.1 Private Benefit
Private benefit occurs in a transaction or exchange between a tax-exempt organization and one of its “insiders” that furthers private interest (typically the interests of the “insider”), rather than the public interest. (IRC Section 501(c)(3); IRS Treasury Regulation 1.501(c)(3)-1(c)(2)). If private benefit is found to exist in a tax-exempt organization, it can be the basis for revocation of the tax-exempt status of that organization. Any private benefit from an activity must be “incidental” in both a “qualitative” and a “quantitative” sense to the overall public benefit of the activity.
Inurement occurs when a transaction or exchange occurs whereby an individual with a personal interest in the exempt organization activities acquires economic gain through the use of funds or assets of that exempt organization. It should be noted that there is nothing wrong with “insiders” transacting with the exempt organization, as long as reasonable compensation at fair market values is exchanged.
In IRS Revenue Ruling 69-383 the IRS developed a three-part test for determining whether a compensation arrangement results in prohibited inurement.
- Is the compensation arrangement consistent with exempt purposes? The compensation arrangement must be designed to further the organization’s exempt purposes, rather than to advance the private interests of the individual being compensated.
- Is the compensation arrangement the result of arm’s length bargaining? Compensation arrangements must result either from arm’s-length negotiations between the employer and employee or be pursuant to a plan or arrangement covering a broad class of non-controlling or non-management employees. As to executives and other controlling members of an exempt organization, the organization must enforce policies and procedures designed to prevent conflict of interest and ensure independent approval.
- Does the compensation arrangement result in reasonable compensation? Whether compensation is reasonable is a question of fact to be determined in light of all the circumstances. The payments must be intended as compensation, rather than a distribution of profits. Also, the compensation must be equivalent to the value of services performed. The compensation should relate to the requirements of the job, the amount of time and effort expended in the job, and the individual’s qualifications.
The IRS indicates that there is no “de minimis” amount of permissible inurement. Findings of private inurement can also be grounds for revocation of the tax-exempt status of an organization and, as opposed to private benefit, can be the basis for assessing employment tax liabilities against the organization for unreported income.
IRS auditors review contractual relationships and compensation arrangements to determine whether there is a clear community benefit, or whether private benefit and/or inurement exists. Specific target groups of employees subject to IRS scrutiny are:
- athletic department officials;
- principal investigators on research projects where there is potential commercial viability of the results of the research;
- executive management, deans, directors, departments heads, etc.; and
- executive management of related organizations.
Auditors are being directed to review for specific types of transactions that indicate the possible existence of private benefit or inurement. Targeted transactions include:
- those relating to athletic camps conducted on university/agency property;
- payment of below market rents for space or equipment, if provided by the institution to the insider;
- payment of below market compensation for use of support services, if provided by the institution to the insider;
- payment of above market rents for space or equipment, if provided by the insider to the institution;
- payment of above market compensation for use of support services, if provided by insider to the institution;
- minimum income guarantees and inadequately secured loans; and
- technology transfer transactions involving principal investigators.