What’s the Deal with 501(c)(3)’s? (Part 1)

Non-profit organizations, by their nature, provide great value through their missions and services. That is at least part of the reason why they typically receive tax-exempt status, including under Section 501(c)(3) of the Internal Revenue Code (IRC). However, that tax-exempt status is fragile and contingent on meeting and maintaining certain requirements, and an organization can end up losing the status without intending to do so.

One of the requirements of 501(c)(3) organizations is that “no part of the net earnings of which inures to the benefit of any private shareholder or individual.”[1] In layman’s terms, that means that the earnings of the organizations are not supposed to go to private individuals. In legal terms, the IRS refers to this as “inurement.” The IRS defines “private shareholder or individual” as anyone who has “a personal and private interest in the activities of the organization.”[2] The IRS also makes clear that an organization is not operated exclusively for an exempt purpose (one of the requirements of a 501(c)(3) organization) if inurement occurs.[3] In other words, inurement can be a basis of the IRS revoking the tax-exempt status of an organization.

A subset of inurement is an “excess benefit transaction,” which the IRC defines as: (1) a transaction (2) where a 501(c)(3) provides an economic benefit (3) to a disqualified person (4) that is in excess of what the disqualified person offers in return.[4] The definition of a “disqualified person” is kind of lengthy, but it boils down to a person that has significant influence over a 501(c)(3), as well as a family member, an entity owned by, or certain other people associated with that person.[5] The penalties are pretty severe for an excess benefit transaction. The disqualified person must pay a 25% tax on the excess benefit (and a 200% tax if they don’t pay back the excess benefit by the end of the tax year), and each person involved in the management of the 501(c)(3) that agreed to provide the excess benefit is personally liable for a 10% tax of the excess benefit.[6]

These definitions might start sounding scary to a non-profit organization. Nobody can personally benefit from the organization, and the tax-exempt status and big tax hits are on the line for any violations? Luckily, the IRS has provided some guidance on how to avoid inurement situations. In a revenue ruling, the IRS determined that a radiologist receiving a share of the revenue from a tax-exempt hospital was not inurnment because 1) the dealing was at arms’ length (both parties acted on their own without the influence of one party over the other); 2) the radiologist was not in a position of control within the hospital (officer, director, etc.); 3) the terms of the agreement were reasonable under the circumstances; 4) the amount of payment radiologist received was comparable to the amount received in similar situations.[7]

Thank you for enduring my quick survey of the rules around inurement. Tune in next week for me to highlight how organizations can structure themselves and operate in ways to avoid inurement scenarios.

[1] 26 USC § 501(c)(3)

[2] 26 CFR § 1.501(a)-1(c)

[3] 26 CFR § 1.501(c)(3)-1(c)(2)

[4] 26 USC § 4958(c)(1)

[5] 26 USC § 4958(f)(1)

[6] 26 USC § 4958(a) and (b)

[7] Rul. 69-383, 1969-2 C.B. 113

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