PRIVATE INUREMENT AND PRIVATE BENEFIT ISSUES REGARDING COMPENSATION AND DISCOUNTS OFFERED EMPLOYEES

I.    PROHIBITION AGAINST PRIVATE INUREMENT.

The basic prohibition against inurement is found in the Code and is further refined in related regulations. Code §501(c)(3) grants a tax exemption only if "no part of the net earnings of [the organization] inure to the benefit of any, private shareholder or individual * * *." While nonprofit organizations do not generally have shareholders, applicable regulations explain what the code section means. A "private shareholder or individual" is defined to mean "persons who having a personal and private interest in the activities of the organization." Treas. Reg. §1.501(a) -1(e). This definition is broad enough to include anyone who, upon later examination, appears to have not had and arms-length relationship wilt the organization.

Nonprofit organizations must compete with private business to obtain talented executive personnel. The law recognizes that this means that exempt organizations must offer competitive salaries and fringe benefit packages. In an ordinary for-profit business, these financial arrangements generally pose no problem as long as they are arms-length. The Board of Directors and shareholders provide oversight and, only in extreme cases involving closely held corporations, is the IRS likely to challenge the reasonableness of salaries, bonuses and other fringe benefits. Even if found unreasonable, the penalty is not excessive. For exempt organizations, on the other hand, the possible adverse consequences of paying unreasonable compensation is a finding of prohibited private inurement to the employee, and the possible loss of the entire exemption. This impact can be devastating to the organization because of its impact on contributions and the resulting overall tax liability.

II.    PROHIBITION AGAINST PRIVATE INUREMENT FROM ACTIVITIES OF A TAX-EXEMPT ORGANIZATION NOW EXTENDS TO INUREMENT TO "NON-CONTROL" EMPLOYEES WHO HAVE PERSONAL AND PRIVATE INTEREST IN THE ORGANIZATION.

For years the IRS did not view an employee of an exempt organization who lacked control over its activities as having a "private interest" in the organization, regardless of his compensation package. See, e.g. Rev. Rul. 69-383, 1989-2 CB 113 (exempt status of a hospital is not jeopardized where, after negotiations, it entered into an agreement with a hospital-based radiologist to compensate him on the basis of a fixed percentage of departmental income).

More recently however, the IRS has become more aggressive in finding a private interest for noncontrolling employees. In a 1986 General Counsel Memorandum, for example, employees or other "individuals with a close professional working relationship" with a hospital were considered to be persons with a personal and private interest ir the hospitals activities. GCM 39498 (April 24, 1986). In a 1982 General Counsel Memorandum, the IRS found an investment advisor employed by a title holding corporation for exempt Organizations was subject to the inurement prohibition. GCM 38905 (June 11, 1982).

As a general caution, you should bear in mind that tax exempt status is not available to any organization if its net earnings inure to the benefit of private individuals "in whole or in part". Treas. Reg. §1.501(c)(3)-l(c)(2). This test lacks any de minimis concept such as the "qualitative and quantitative" standard used by the IRS to judge prohibited private benefit to an organizer of the organization, discussed below. Under the regulations, an organization is not treated as organized and operated for exclusively exempt purposes "unless it serves a public rather than a private interest", i.e., it is not organized or operated "for the benefit of private interests * * *." Treas. Reg. §l.501(c)(3)-l(d)(1)(ii). See, also, Rev. Rul. 69545, 1969-2 CB 117 (A hospital controlled by a board of trustees that restricted the number of doctors admitted to the medical staff, entered into favorable rental agreements with the doctors, and limited emergency room care and hospital admission substantially to the trustees' own patients was held to be operated for a private benefit and therefore not exempt.)

A.    PRIVATE BENEFIT.

Not all private benefits necessarily amount to prohibited inurement. In contrast to the absolute prohibition against inurement, IRS has traditionally analyzed the flow of some private benefits to the organization's control persons as not jeopardizing the tax exempt status of an organization, if such private benefit is purely "incidental" to the organization's exempt purposes. See, e.g., GCM 39598 (January 23, 1987). This same GCM stated the IRS's two-part test for determining whether a private benefit was incidental to an organization's exempt purpose:

A private benefit is considered incidental only if it is incidental in both a qualitative and a quantitative sense. In order to be incidental in a qualitative sense, the benefit must be a necessary concomitant of the activity which benefits to the public at large, i.e., the activity can be accomplished only by benefiting certain private individuals, * *. To be incidental in a quantitative sense, the private benefit must not be substantial after considering the overall public benefit conferred by the activity. GCM 39598 (January 23, 1987).

Thus, it may not be improper to organize a nonprofit organization to provide jobs or services to or for the benefit of the organizers provided this result is incidental to the exempt purposes of the organization. A doctor could organize a nonprofit clinic which, incidentally, employed him or her to work on its staff. A teacher could organize a nonprofit school which, incidentally, employed him or her to teach. A minister can organize an exempt church which, incidentally, employs the minister as its head minister. In all three cases, so long as the nonprofit organization "fulfills" its exempt function, the fact that it provides an incidental benefit to the organizer will not be fatal. In determining whether the benefit to the organizer is incidental, however, the IRS will look at whether the salary and benefits provided are reasonable in comparison to what would be provided by the same organization to someone with whom it dealt at arms-length. Truth Tabernacle, Inc. v. Commissioner of Internal Revenue, T.C. Memorandum (1989-451).

B.    PRIVATE INUREMENT DISTINGUISHED.

A salary might be "incidental" to the purpose and incidental in comparison to expenditures on the overall program and still be excessive as to an individual, thus possibly violating the private inurement prohibition. For example, an organizer of a nonprofit school can properly be employed by that school as a teacher, and the organizer's compensation might be small (incidental) compared to the overall expenditures on the nonprofit educational activity of the school, but the salary might be 4 or 5 times that paid any other teacher at the school although credentials, experience and teaching duties were generally similar. The salary, if deemed excessive, would be a form of prohibited inurement.

Often, a start-up group will not have much money and salary issues do not arise. However, if the group is successful, the issue of compensation must be carefully considered by the Board of Directors, and an accountant or attorney should review compensation programs.