Doing the right thing
Avoid excess benefit transactions

One way to lose your nonprofit’s tax-exempt status (or for the individuals who control your organization to rack up excise tax penalties) is to ignore the private benefit and private inurement — also known as excess benefit — provisions of the Internal Revenue Code (IRC). These rules prohibit an individual inside or outside a nonprofit from reaping an excess benefit from a transaction by the organization. Excess benefits can take many forms, such as excessive compensation, favorable sales of assets, below-market property rental and lending money.

What’s at risk

The official IRS stance is that any amount of private benefit or inurement in your organization is enough to cause the loss of your tax-exempt status. Although in practice the agency doesn’t strictly enforce this position, it’s important to remember that it can do so at any time.

Even if a violation doesn’t cause a status loss, those receiving the excess benefit — and any of the organization’s managers and board members who willingly participated in the transaction — may be subject to intermediate sanctions in the form of an excise tax penalty. Penalties can range from a minimum of 10% (maximum of $20,000) of the excess benefit for managers who knowingly participate up to 200% for the person receiving the benefit.

Excess benefit transactions

The concept of private benefit is easy to understand: It’s any payment or transfer of assets made (directly or indirectly) by your nonprofit that’s beyond reasonable compensation for the services provided or the goods sold to your organization, or services or products that don’t further your tax-exempt purpose. If any of your net earnings inure to the benefit of any individual, the IRS won’t view your nonprofit as operating primarily to further its tax-exempt purpose.

The private inurement rules take the excess benefit transaction concept and extend it to “insiders” of the organization. The term “insider” or “disqualified person” generally refers to any officer, director, individual or organization that’s in a unique position to be able to exert significant influence over the nonprofit’s activities and finances. A violation happens when the approval of a transaction ultimately benefits the insider. An insider could include an insider’s family members or any organizations they control.

Of course, the rules don’t prohibit all payments, such as salaries and wages, to an insider. They simply require that a payment be reasonable in relation to the services provided or the goods received — and that it be made with the nonprofit’s tax-exempt purpose in mind.

As a result, your organization should document its practices and procedures relating to any payments being made to insiders. This is to ensure that, upon an audit or inquiry, you’d be able to show that there was a reasonable and valid exempt purpose for the transaction to have taken place.

Duty of care

Duty of care is a related concept that requires board member understanding. It refers to a board member’s responsibility to act in good faith, in the organization’s best interest, and with such care that proper inquiry, skill and diligence has been exercised in the performance of duties.

Remember, nonprofits are essentially stewards of the public’s money. So, board members carry a fiduciary responsibility to act with due care to safeguard assets until they can be spent for the organization’s tax-exempt purpose. This concept extends to all facets of the nonprofit and includes ensuring there are proper procedures in place to receive, hold and, ultimately, expend the assets for their proper purpose.

Clear consequences

It’s the duty of nonprofits and their boards to ensure that their organizations’ resources are properly spent and safeguarded. A violation of this duty is most evident when an organization enters into an excess benefit transaction with an insider or an individual or organization outside of it.

The consequences of such a transaction can be devastating to the nonprofit, which may lose its tax-exempt status, and to the individuals involved, who may be subject to significant excise tax penalties.

Because any violation of the excess benefit rules — no matter how small — can be enforced by the IRS, everyone in your organization needs to be intimately familiar with them. •