Nonprofit Accounting Basics

Private Inurement: Don’t Lose Your Tax Exempt Status

For a nonprofit organization, losing tax exempt status is one of the more devastating things that can happen. There is a particular problem—private inurement—that can create a beeline to losing exempt status. In short, private inurement (also called an excess benefit transaction) is one of those activities about which the management team of nonprofits should be acutely aware: both aware of what it is and aware of how to safeguard against it.

A Deeper Look at Inurement

Look up the definitions of “inure” and “inurement” and you’ll find explanations such as “to become of advantage, or benefit,” “to habituate to something undesirable,” and “to gravitate toward, flow to or through, or transfer to something.” Private inurement can occur when a disqualified person provides a good or service to a nonprofit and receives more than the value of that good or service in return. The IRS understandably has rules against private persons benefiting from nonprofits, i.e., private inurement. You may wonder, who is “disqualified”? To be considered disqualified, the person must be in a position to exercise substantial influence. Normally officers, directors, and key employees are considered disqualified.

The IRS means business when it comes to inurement. For 501(c)(3) and (c)(4) organizations, inurement may lead to hefty sanctions. Although the IRS states that any amount of inurement could lead to the loss of exemption or sanctions, it does weigh certain facts and circumstances when determining if inurement has occurred.

The IRS considers the following:

  • the size and scope of the charity’s regular and ongoing activities before and after the excess benefit transaction occurred and its relation to regular and ongoing exempt activities
  • if there have been multiple excess benefit transactions with one or more persons
  • if there are controls in place to prevent private inurement
  • whether the excess benefit transaction has been corrected

IRS Sanctions for 501(c)(3) and (c)(4) Organizations

There are IRS sanctions on charities that enter into excess benefit transactions with disqualified persons. If the excess benefit is reported and resolved in the period it occurred, then a 25 percent tax may be assessed to the disqualified person. If not resolved in the same period as the offense, then the tax could be as high as 200 percent.

The excise tax is not just applicable to the disqualified person; organization managers may be subject to excise taxes as well. If an organization manger knowingly and willingly participated in the excess benefit transaction with the disqualified person, the manager may be subject to a 10 percent tax on the excess benefit, up to $20,000. All managers involved are jointly and severally liable.

One common area where excess benefit transactions occur is with compensation. There are many other types of excess benefit transactions, but compensation seems to garner most of the IRS’s attention. So what is unreasonable compensation? First, we should define what the IRS considers compensation. Compensation includes all economic benefits received by the disqualified person from the charity including salary, bonuses, severance payments, deferred compensation, premiums paid on insurance contracts, and so on.

Now that we know what compensation is, when does it become unreasonable? The guidance is not definitive on this subject, yet there are things your organization could do as a defensive measure. They include the following:

  • The compensation should be approved in advance by the governing body composed of persons who do not have a conflict of interest with respect to the compensation arrangement.
  • The governing body should use comparable data when approving the compensation.
  • The governing body should document contemporaneously its actions.

While being hit with a tax is neither good nor fun, losing your organization’s exemption altogether could be, putting it mildly, tragic.

A True Story

I recently read about an organization that had lost its exemption because of private inurement. The essence of the story is that this particular organization had only one staff member, who was also the president. The governing board consisted of the president; his wife, who served as secretary/treasurer; and the president’s father, who served as vice president. The organization did not have a conflict of interest policy, and the president did not have an employment contract.

The president took loans from the organization for private purposes that the board approved after the fact. The organization paid travel and auto expenses for the president under a non-accountable plan, and the president consistently used the organization’s bank and credit cards for personal use with inadequate records to support his activities.

The IRS determined the organization’s president was privately benefiting from the nonprofit and therefore revoked its 501(c)(3) status. The organization’s accounting infrastructure and, dare I say, the lack of integrity of the president, led to this occurring.

Safeguarding Against Inurement?

While this situation of inurement and their resulting nonprofit status revocation is rather blatant, the “moral of the story,” so to speak, is about what you can do to prevent something like this from happening in your organization. Here are some safeguards your organization can take:

  • Make sure your board is comprised of independent individuals, and have them sign annually a conflict of interest policy requiring disclosure of any potential conflicts of interest.
  • Get it in writing! Have an employment contract for officers and senior employees.
  • Make sure you have an accountable plan and ensure reimbursable expenses have a business connection.
  • If you loan money to officers, is it at “arm’s length”? Make sure to have loan agreements on record (and make sure they pay the principal and interest back)! An even better policy is to never loan money to officers.
  • Keep adequate records!

Your organization may have some or all of these protective measures in place. It’s a good practice to take a step back and evaluate periodically your organization’s safeguards against inurement.

If your organization were ever to be “a true story” someone talks about, let it be one of model safeguards and practices, rather than tragedy and woe.