This article first appeared in Bloomberg Tax on June 23, 2022. Reproduced with permission from Copyright 2022 The Bureau of National Affairs, Inc.

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When a nonprofit runs amok by diverting funds to certain individuals, the organization can face two problems. The IRS can revoke the tax-exempt status of the organization. If the conduct is less egregious, the IRS may impose “intermediate sanctions” against the organization and certain interested parties.

The first part of this article discusses recent developments in nonprofit law in private inurement and private benefits. The second part will discuss excess benefit transactions, for which the IRS may impose a tax, but will refrain from the more stringent penalty of revocation of the organization’s tax-exempt status.

Private inurement and benefits can put you in hot water.

An organization is entitled to tax-exempt status under IRC Section 501(c)(3) if it is “organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes,” provided, however, that no part of the net earnings of the organization may inure “to the benefit of any private shareholder or individual.”

The first part of this formulation relates to the organization’s purpose; the second part, known as private inurement, implicates concerns that an organization insider gets rich off of the operations of the organization.

Even a little private inurement is not tolerated.

Let’s discuss private inurement first. A tax-exempt organization may receive an exemption only to the extent that there are no gains to any private shareholder or individual.

Even though the statute refers to individuals, courts have interpreted this term narrowly to mean only insiders. Insiders means the nonprofit’s managers and others in a position analogous to owners of a for-profit organization such as officers and directors. The primary interest of the government is to “prevent the siphoning of charitable receipts to insiders of the charity”—but “not to empower the IRS to monitor the terms of arm’s length contracts.”

Private inurement issues typically arise in connection with an IRS proceeding seeking to revoke the tax-exempt status of the organization. The IRS will not tolerate even a little private inurement.

Related article: Nonprofit Management: Legal Challenges Galore

The classic example most subject to scrutiny by the IRS is an agreement with an officer or director of the organization. Nonprofits are constrained in paying unreasonable compensation to its officers or directors. And officers and directors can’t get no-interest loans from a nonprofit for which they work unless they are willing to jeopardize the tax-exempt status of the organization.

In short, insiders may not unjustly enrich themselves at the organization’s expense.

IRS will scrutinize excess private benefits.

The other side of the tax-exempt requirement is in the purpose of the organization. Under the private benefit doctrine, an organization is not operated for an exempt purpose unless it serves a public rather than private interest. The IRS recognizes that private benefits to third parties may incidentally arise from the nonprofit’s activities consistent with its proper purpose. Any transaction will result in some benefit to a third party, but what the IRS is concerned about is excessive private benefits.

The private benefit doctrine typically arises when there is a pervasive pattern of benefiting a narrow class of individuals. In most judicial opinions regarding the private benefit doctrine, the purpose to benefit a narrow class is too obvious to ignore. Two recent tax cases highlight this approach to private benefits.

In New World Infrastructure Organization v. Commissioner (T.C. Memo. 2021-91), the tax court was faced with an attempt to hijack the nonprofit law to confer a benefit on a private class of individuals. The organization conceded that it was a “successor to a for-profit business that never made any profit.” The predecessor organization had endeavored to raise outside capital to produce and sell pipes at market rates for construction projects. It didn’t succeed, so it tried to get the taxpayers through a nonprofit organization to subsidize its research and development (R&D) effort.

The organization argued that the development of the prototype machinery would further a “scientific” purpose and ultimately “result in encouraging economic development throughout the United States.” The IRS was unimpressed and sought to revoke the organization’s tax-exempt status, contending that the organization had not demonstrated that it operated exclusively for scientific or other exempt purposes.

The tax court pointed out that scientific research as contemplated in 501(c)(3) does not include activities of a type ordinarily carried on as an incident to commercial or industrial operations as, for example, the ordinary testing or inspection of materials or products or the designing or construction of equipment.

The tax court invoked what is known as the operational test, under which the purpose toward which an organization’s activities are directed—and not the nature of the activities themselves—is dispositive of the organization’s right to be classified as a tax-exempt organization. The court noted that even in a commercial, profit-motivated context, such activities may be wholesome and commendable. But they will not support tax-exempt status unless they are undertaken to further an exempt purpose.

The tax court concluded that the nonprofit organization “appears to be a facade for” the predecessor for-profit organization. The owners of the for-profit set up the nonprofit only after they were unable to secure the funding for their for-profit business. The nonprofit had substantially the same business purpose of developing machinery capable of producing large corrugated metal pipe for sale in infrastructure projects. The owners of the for-profit were the officers and directors and paid employees of the nonprofit.

The tax court held that an organization is not operated exclusively for one or more exempt purposes if more than an insubstantial part of its activities does not further an exempt purpose. An organization is not operated exclusively for exempt purposes unless it benefits the public rather than a private interest. The organization was unable to establish that it was not organized or operated for the benefit of private interests. Consequently, the nonprofit did not qualify for tax-exempt status.

In Korean-American Senior Mutual Association Inc. v. Commissioner (T.C. Memo. 2020-129), the private benefit to a narrow class of individuals was too obvious for the IRS to ignore. The nonprofit’s members received certain “benefits” in exchange for their payment of dues. These benefits included a burial benefit to the surviving family. The nonprofit encouraged other members to attend the funeral services; members received a discount on funeral expenses and received information on burial plots and funeral arrangements.

The IRS sought to revoke its tax-exempt status under section 501(c)(3) because the organization was not operated exclusively for one or more tax-exempt purposes. The IRS argued that the primary activity of the nonprofit was to provide funds to defray or pay for the funeral costs of its members. The nonprofit argued that it served the recognized charitable class of the elderly.

The tax court easily disposed of the nonprofit’s arguments. It operated a fee-for-service. Its primary activity was not directed toward meeting the special needs of the charitable class, the elderly, by relieving distress or providing a community benefit. It provided burial benefits only to its members who paid dues, not to non-dues-paying seniors in the community. If a member failed to pay the required membership dues, their membership could be terminated, and the organization would have no obligation to pay burial benefits.

The nonprofit operated in a commercial manner by providing burial benefits to its members, not to all elderly. The tax court concluded that it did not operate exclusively for one or more exempt purposes within the meaning of section 501(c)(3), upholding the decision to revoke the tax-exempt status of the organization.

These cases show that the IRS seems to act most aggressively in those matters in which the private benefit is too obvious to ignore.

Related article: Nonprofit Law Developments in Excess Benefit Transactions