In order for a nonprofit to be eligible for tax exempt status under section 501(c)(3) of the Internal Revenue Tax Code, the organization has to prove that it "serves a public rather than a private interest." No organization whose donations or assets directly or indirectly benefit an individual or for-profit entity is eligible for tax exempt status.
Public vs. Private Interest
It’s helpful to think of what we know about businesses in the United States — the private sector. Simply put, businesses operate for the purpose of making money for their owners, investors and shareholders. These people, and the businesses themselves, are operating for private interest. And as we all know, businesses and individuals are required to pay income taxes by the IRS.
501(c)(3) organizations have an exemption from paying income taxes because they are charitable in nature — they are not-for-profit. These organizations operate for the benefit of the public interest by striving to fulfill a charitable mission as defined by the IRS. It’s pretty cool that nonprofits get to use more of their resources to do good, right? We think so too!
So, to make sure that all 501(c)(3) charities are actually organized and operating that way, the IRS has created private benefit and inurement rules. At GVNG, we want to do everything we can to help nonprofits on our platform succeed, so it is imperative that you understand and comply with these rules. Private benefit and inurement can be a bit tricky, so we’ve run through some common scenarios that could get you into trouble — and how to avoid them — as your nonprofit gets on its feet.
The Rules on Private Benefit
The private benefit rule is pretty much exactly what it sounds like. Charities are not allowed to use their tax-exempt status, charitable funds, programs, etc. to benefit private parties that do not fall within a charitable class. The problem with this rule is that it’s deceptively simple. It is a lot easier to break than you’d think. We’ll go through some examples in the flowchart below so you don’t have to learn the hard way.
Note: The purchase of goods and services for your nonprofit will inherently benefit a private individual or company— and the IRS gets that. For example, you may need to pay a catering company for serving food at a fundraising event. Totally understandable. This does not break private benefit rules so long as you’re paying the vendor at or below fair market value, the expense is truly necessary to further your nonprofit’s charitable mission and you’re able to prove it.
The Rules on Private Inurement
The insider rule. It is illegal for a charitable organization’s income or assets to disproportionately benefit a private entity that has "significant influence over the organization" or is otherwise "closely related" to it. Basically, no one should be profiting simply because of their connection to a nonprofit. Makes sense, right?
Let’s Break it Down...
- Paying Employees
- Nonprofit employees can (and should) be fairly compensated for their work with an appropriate, competitive salary. The key takeaway related to paying employees is to avoid excesses. You need happy, well-paid employees to facilitate the delivery of your charitable mission. But your employees don’t need a first class plane ticket for their business trip. The difference is pretty clear, right?
- Selecting Vendors & Paying Expenses
- The key to understanding private benefit as related to vendors and expenses lies in the concept of fair market value. Your nonprofit will likely need to pay for expenses in order to host a fundraising event or run your charitable programming, and this is totally acceptable. The only caveat is that you must spend your charitable funds responsibly, ensuring that you are paying at or below fair market value for any expense. How do you ensure you’re making a purchase at fair market value? The best practice is to get at least three quotes (in writing) from different vendors to confirm that you’re getting the best deal. This is often called getting an RFP (request for proposal).
- Relationships With Other Individuals and Businesses
- The concept here is that because every 501(c)(3) is a public charity (that serves the public’s benefit) 501(c)(3)s can’t endorse, promote, or generate revenue for a private gain. Even though these activities may seem harmless (like linking to a vendor page selling products) this rule ensures that nonprofits are focused on the greater good rather than supporting or endorsing specific individuals or businesses.
- When any of the aforementioned examples involve people or businesses related to your nonprofit, take extra caution. For example, you are using a friend or family member’s catering company for your fundraiser. Actions that do not constitute private benefit with unaffiliated parties may constitute private inurement with an affiliated party.
- Although nuanced and specific, private benefit and inurement rules truly boil down to ensuring that all of your organization's operations and expenses are being allocated toward your charitable purpose. If you are questioning whether an activity may constitute private benefit, ask yourself, "Is the activity is in the best interest of my nonprofit’s charitable mission and class? Will it maximize our impact? Is it truly benefiting the public?"
- Err on the side of caution. If you are questioning whether something is private benefit or private inurement, it is best to investigate further... or avoid the activity all together.
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