The IRS recently updated its technical guide addressing, among other things, the concept of impermissible inurement in Section 501(c)(3) organizations. The guide offers useful reminders on how the agency identifies inurement in nonprofit audits and the potential consequences of crossing the line.

Inurement vs. private benefit

Nonprofits, of course, must be operated exclusively for one or more tax-exempt purposes. According to federal tax regulations, an organization fails this requirement if its net earnings “inure in whole or in part to the benefit of private shareholders or individuals.”

While the terms “private inurement” and “private benefit” are sometimes used interchangeably, the IRS distinguishes between them. “Inurement” refers to improper benefits received by so-called “insiders” (whether individuals or entities) who control the organization. “Private benefit” casts a wider net, applying to insiders as well as “outsiders” who don’t belong to a charitable class. In other words, all inurement is private benefit, but not all private benefit is inurement.

Additionally, inurement involves the taking of a nonprofit’s net earnings in a manner that benefits an insider. The private benefit doctrine, however, looks at the organization’s primary activities and who benefits from them.

The consequences of violating the two principles differ as well. The IRS says any degree of inurement is fatal to a nonprofit’s tax-exempt status, regardless of the quality of the organization’s charitable activities. Insubstantial private benefit may be permitted in some cases, though.

The “net earnings” umbrella

Notably, the IRS defines the term “net earnings” broadly, extending well beyond the typical accounting definition. The agency reads it as encompassing almost any use, other than an arm’s-length transaction or payment of reasonable compensation, of an organization’s assets by an insider.

According to the updated guide, examples of inurement include:

• Unreasonable compensation paid to insiders,
• Payment of excessive rent to insiders,
• Receipt by the nonprofit of less than fair market value in a sale to or exchange of property with an insider,
• Unsecured, inadequately secured or interest-free loans to insiders,
• Provision of capital improvements to property owned by insiders, and
• Copyrights and royalties benefiting insiders.

It’s irrelevant if the transaction at issue ultimately proves profitable for the organization; the test isn’t whether there’s profit or loss. Instead, the question is whether, at every stage of the transaction, those controlling the organization guarded its interests and dealt with the parties involved at arm’s length.

Evidence of inurement

According to the guidance, IRS auditors will examine a variety of areas for indicators of inurement, including:

Salary information. Auditors will evaluate the salaries paid to those who control the organization and other key employees to determine if the compensation is reasonable. They’ll reconcile the salaries the organization paid with the wages reported on Forms W-2, “Wage and Tax Statement,” and watch for any unreported payments of expenses for the benefit of an officer or employee. Auditors will also look closely at reimbursements, such as travel expenses, and determine whether the amounts paid were “ordinary and necessary.”

Sales or exchanges of property. Auditors will determine whether the organization engaged in any sales or exchanges of property involving insiders. If so, were the sales or exchanges compensated at fair market value?

The composition of the nonprofit’s assets. As noted above, “net earnings” is defined broadly for inurement purposes, so IRS auditors will analyze an organization’s assets to determine if an insider had personal use of them. For example, did an insider use a vehicle owned by the nonprofit for personal travel? If so, was the personal use included on that individual’s Form W-2?

Fundraising agreements. Any fundraising agreements involving insiders must be an arm’s-length transaction. Auditors will also consider the method of raising funds and whether the income is subject to unrelated business income tax.

Look before you leap

With your tax-exempt status on the line, you can’t afford to take inurement risks lightly. So, make sure all compensation paid to insiders is reasonable. If your organization has engaged in any transactions with insiders, or is planning to, also ensure they’ll be able to withstand IRS scrutiny. We can help.

Reduce your inurement risk

Inadvertent inurement could jeopardize your nonprofit’s tax-exempt status. Fortunately, you can take some steps to mitigate that risk, including:

Establishing and enforcing appropriate policies. If you don’t already have them, your board should implement strong policies on conflicts of interest and compensation. It’s also advisable to have a well-publicized whistleblower policy to encourage the reporting of suspected violations.

Educating employees and leaders. Make sure they understand not just the ins and outs of the relevant policies but also the reasoning behind them. Including discussions about inurement and similar risks to nonprofits in board training and employee onboarding can help foster a culture of compliance and accountability.

Documenting decisions. Make sure you properly document the rationale and decision-making processes regarding areas that could pose inurement concerns. For example, keep minutes of board or other meetings where compensation packages are considered and collect evidence that transactions are for fair market value.

Mitigating missteps. If you realize inurement has occurred, don’t delay. It’s vital that you take timely corrective measures.

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