IRS Announces Heightened Scrutiny for Tax-Exempt Entities
The IRS division tasked with ensuring tax-exempt entities comply with relevant tax laws has announced that beginning in fiscal year 2018, it will focus on examining charitable organizations that show indicators of “private benefit or inurement.” Consequently, non-profit entities will want to review their business operations, hiring practices, and compensation packages to ascertain whether indicators exist and take steps to address any problematic characteristics apparent in such transactions or practices.
Private Benefit or Inurement = Loss of Tax-Exempt Status
Code § 501(c)(3) corporations and entities, operated exclusively for charitable purposes, are exempt from federal taxation under Code § 501(a) if no part of the net earnings of the corporation 1) inures to a private shareholder or individual who is in a position to control the charitable entity or 2) benefits a private individual or class of individuals. The private benefit and inurement prohibitions preclude employees and officers of an organization, as well as private individuals or entities, from unfairly or unreasonably benefiting from a charity’s benefits, income, or assets.
A finding of private benefit or inurement — no matter how small — jeopardizes the tax-exempt status of a charitable organization. In addition, the IRS imposes significant financial penalties upon those who approve and/or benefit from a prohibited inurement. The following examples illustrate the types of transactions that have proven fatal to an organization’s exempt status:
• Excessively large salaries to officers or employees. While salary may have been reasonable, other payments in the form of loans, disguised distributions, and benefits from net earnings made to the individual and his family disqualified the organization for tax-exempt status. 823 F.2d 1310 (9th Cir. 1987)
• The provision of facilities or office space to private corporations at less than fair market value. IRS Private Letter Ruling 201017078
• Charitable hospital corporation’s payment of administrative, service, medical, and professional expenses of physician medical practice. Tax Court Memo 1974-273
• Interest-free, unsecured loans and payment of personal expenses on behalf of family in control of school. 228 Ct. Cl. 902 (1981)
• Federal income tax advantages and property tax reductions that indirectly benefited non-exempt partners with charitable organization providing affordable housing for low income and disabled individuals because the non-exempt partners were relieved of maintaining rents at a level sufficient to cover operating expenses that would otherwise have to be paid out of partnership capital. 58 F.3d 401 (9th Cir. 1995)
• Two-thirds of retired teachers’ legal defense fund membership were not low-income or disabled persons. 78 Tax Court 280 (1982)
• Charitable hospital restricting the use of its facilities exclusively to one physician group. Revenue Ruling 56-185
Ensuring Compliance for Maintaining Tax-Exempt Status
The most common type of inurement is the payment of excessive compensation to an employee or an officer. The inurement prohibition requires that the total compensation paid to an employee or officer be fair and reasonable. “Reasonable compensation” as defined by the IRS is “the value that would ordinarily be paid for like services by like enterprises under like circumstances.” Compensation items taken into account by the IRS when determining reasonableness include:
• All forms of cash and noncash compensation, including salary, fees, bonuses, severance payments, and deferred and noncash compensation;
• Payment of liability insurance premiums;
• All other compensatory benefits, whether or not included in gross income for income tax purposes;
• Taxable and certain nontaxable fringe benefits; and
• Foregone interest on loans.
The IRS will presume a compensation arrangement is reasonable if the compensation arrangement is:
1. Approved by an independent, authorized body of the organization;
2. Based upon appropriate comparability data on compensation paid by comparable organizations — exempt and taxable — for equivalent positions in the same or similar communities for similar services; and,
3. Adequately documented throughout the process — see Form 990 Instructions for detailed requirements.
As noted above, the IRS’s radar is currently programmed to find indicators of inurement and private benefit in the non-profit sector. Tax-exempt entities should carefully evaluate the potential implications that inurement and private benefit issues have on their operations. Internal evaluations into the fairness and reasonableness of compensation paid to the organization’s key employees and officers should encompass detailed documentation requirements set forth by the IRS. In addition, charitable organizations should examine any transaction with private individuals or with entities that involve the rental, sale, purchase, or use of the organization’s assets or facilities.