By Aaron M. Fox, CPA - Senior Tax Manager at Raffa, P.C.
Even one instance of private benefit can jeopardize the exemption of a not-for-profit organization. Because they apply to most tax-exempt organizations and are broad in scope, it pays to understand how these rules work and avoid the risk.
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 is the private benefit doctrine. Private benefit rules are broad in scope and apply to most tax-exempt organizations such as business leagues, social clubs, labor unions and charities. The Tax Court in American Campaign Academy v. Commissioner defined them 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 circumstances where the benefits accrue to an organization's insiders; that is, the court held that this prohibition is not limited to persons having a personal and private interest in the activities of the organization and embraces benefits to what the court labeled "disinterested persons." Such benefits can be monetary or non-monetary benefit.
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. Therefore, even one instance of private benefit can jeopardize the exemption of the organization, unless it can be argued as incidental.
To better understand these ideas we can examine real world examples of this in action. One need look no further than a food bank, which are usually organized as Section 501(c)(3) organizations. Food banks are charitable organizations that distribute food to those who have difficulty feeding themselves. Despite the fact they are giving out goods to individuals, impermissible private benefit is not occurring as these 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 impermissible private benefit.
Another example was the nonprofit 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 that nonprofit's principal officer controlled, and made all its travel arrangements through the agency. The court found that a substantial purpose of the nonprofit was benefiting the for-profit travel agency (read: private benefit) and, therefore, the nonprofit was not described in Section 501(c)(3).
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 about nonprofits being denied exempt status because of a related business benefiting from their activities.
A Recent Ruling on the Matter
Such an example is discussed in a recent private letter ruling which was made available to the public in late 2013. In this ruling, the nonprofit was organized to manage an online community for other nonprofits, for-profits and individuals to come together and engage supporters and fundraising as well as help for-profit organizations market their businesses and products while supporting charities. This nonprofit would have earned a share of the proceeds from any customers it referred to business partners in the community. The website required participating nonprofits to register with the organization which would enable them to receive contributions made by customers at point of purchase. Only registered charities would be eligible for these contributions. Ultimately a customer would be able to shop on the website and direct a portion of their proceeds to whichever charity they deemed worthy, and the nonprofit would keep a portion of the proceeds. 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 with this and with the fact the nonprofit engaged two organizations to help run the website. Organization A would provide hardware and software to facilitate the operation of the donation service and Organization B would provide IT support. Both organizations were closely related 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 deemed the primary function of the nonprofit which included administering, fundraising and networking related to the online community was not an exempt purpose in the code section, and more akin to operation of a commercial website.
Also, it was ruled that the nonprofit was not organized or operated exclusively for one or more tax-exempt purposes because it served a private interest rather than a public. The website only secondarily benefited the public compared to more direct benefit of generating business being provided to Organization A and B, the websites owners. The nonprofit was attracting charities to use the website, increasing web traffic, and providing 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 remind anyone that Letter Rulings are directed only by the taxpayer who requested it and should not be used as precedent. And while this true, this letter ruling does provide recent insights into how the IRS treats situations of private benefit.
Instances of private benefit occurring are very serious and should be avoided to prevent any risk of the exempt status being revoked for your organization. The organization may also face actions by the state, as they could charge the organization's directors for breaching their fiduciary duty to oversee their charitable assets.
Preventing private benefit transactions is just one of the many tax considerations that should happen in the planning phase of any major undertaking, whether it you are creating a new entity to house taxable activity as a subsidiary to your nonprofit, or perhaps contracting with a third-party that will engage in commercial co-venturing opportunities.
Nonprofits should consider the following items to mitigate risk in this area:
- Has the organization enacted or enforced a robust conflict of interest policy that makes known 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 the vendor by researching competitors and alternatives?
- Are any of the terms of the contract or transaction unfavorable to the organization?
For more information on the private benefit doctrine contact Raffa Tax Partner, Frank Smith, at 202-955-6735 or email@example.com
Article contributed by Aaron M. Fox, CPA - Senior Tax Manager at Raffa, P.C. He may be reached at 202-955-6701 or firstname.lastname@example.org