Private Inurement & Private Benefit: Understanding the Greatest Sin for Directors

TFew directors probably contemplate personal risk when they accept an invitation to serve as a volunteer board member; yet, if the organization compensates any employee or pays for any good or service, the directors could have personal liability for a payment that “unduly benefits” someone.  This potential liability stems from the IRS’ “Private Inurement Doctrine” – no assets or income of a nonprofit organization may unduly benefit, directly or indirectly, an individual or a person with a close relationship to the organization.  The IRS penalties can include an excise tax against the directors personally and revocation of a nonprofit’s tax-exempt status.

Two separate concepts have evolved from the doctrine:  private inurement and private benefit.  “Private Inurement” applies to situations where an insider of the organization uses her influence to acquire assets for her personal benefit.  Because the potential for abuse is so much higher, the IRS has a zero-tolerance policy by providing no exceptions for de minimus amounts.  “Private Benefit” applies to situations where a non-insider receives a financial benefit that is excessive.  The IRS is more lenient in these scenarios and will not find a violation for de minimus amounts overpaid.

Preventing the Most Common Private Inurement Violations

1.  Executive Compensation - Paying an executive too much is the most common violation.  Boards should take advantage of the IRS safe harbor for executive compensation known as the “Rebuttable Presumption of Reasonableness.”  Any board that follows its 3 step process is within the safe harbor:  (a) an “authorized body” (i.e., the board or a committee) must approve compensation, (b) using data from comparable organizations, and © document the analysis and process in writing (i.e., the minutes).  The board is well-advised to adopt this process as a policy.  Neither the executive receiving the compensation, nor anyone related to her or reporting to her, may be involved in the analysis and decision.  For instance, an executive director’s son, who sits on the board, must recuse himself from the compensation decision.  For comparable data, larger organizations should analyze data from at least 3 comparable organizations and/or hire a qualified compensation consultant every few years.

2.  Loans to Officers, Directors or Executives - Most state laws prohibit such loans, and some provide limited exceptions.  A nonprofit is well-advised to adopt such prohibitions in its by-laws and strictly enforce them.

3.  Goods or Services from Insiders - A very common scenario is when a director, or a close relative thereof, offers to lease property to the nonprofit or provide some other good or service.  This is not prohibited outright, but any rent or payment must be reasonable based upon comparable data.  The board should strictly follow its conflict of interest policy to analyze, discuss and approve the transaction.  Most importantly, any interested insider should not be present for the discussions or approval, nor be allowed to influence the decision in any other way.

Preventing the Most Common Private Benefit Violation

1.  Paying for Goods or Services – A board cannot delegate its duty to protect the assets of the organization.  Therefore, its by-laws should require that transactions of certain amounts receive board approval. For such transactions, the board should analyze transactions based on competitive or comparable data.  The organization should also have a general policy of receiving competitive quotes or bids for goods and services so that the staff do not overpay. 

Preventing private inurement or benefit seems fairly straight-forward, but it can be difficult to spot.  Consider this hypothetical:

A 501©(3) public charity requires some kitchen space each weekday morning to fulfill its mission.  A director’s son has a catering business and offers to sublease some of his unused space at fair market value for the remaining 3 years of his lease.  The space would fit the organization’s needs, but it will need some HVAC and electrical improvements costing $8,000.  The son also requests that he be able to use the space when the charity does not occupy it.  The father/director sits in on the discussions, but does not speak and abstains from the vote. The board approves the transaction. 

Are there any problems?

Because the director’s son has a close relationship with the organization, he is an insider; therefore, a private inurement analysis is required.  Would he be “unduly  benefited” by the sublease?  The answer could be "yes."  Even though the father did not contribute to the discussion, his presence during discussions and the vote was inappropriate and improper.  The board should have required him to recuse himself - i.e., not be present for the discussions or the vote.  Regarding the benefit, the IRS could find that the son’s reducing his total rent via the sublet and still getting to use the improved space unduly benefits him, constituting private inurement. 

The issue of private benefit comes into play in a subtler way.  In this scenario, the sublease will only be for 3 years, but the board has approved $8,000 worth of improvements that will enhance the value of the building. This enhancement provides a significant financial benefit to the landlord.  Even though the landlord is not an insider, the IRS could find that receiving improvements to his building - particularly in light of the short time remaining on the lease - unduly benefits him.  In order for it not to be, there better be a compelling analysis in the board’s minutes reflecting the reasons that paying for the improvements is a sound business decision.