The private inurement rule and private benefit rules exist to ensure that charitable assets are preserved for the benefit of the public and not diverted to private use. This is a fundamental concept that distinguishes tax-exempt organizations from for-profits.
The rules originate in the language of Code Section 501(c)(3). Code Section 501(c)(3) contains the specific requirement that:
[N]o part of the net earnings of [the exempt organization] inures to the benefit of any private shareholder or individual . . . .
In addition, under the regulations, an organization is not treated as organized and operated for exclusively exempt purposes “unless it serves a public rather than a private interest,” Based on this provision, tax exempt status is not available to any organization if its net earnings inure to the benefit of private individuals “in whole or in part.”
In practice, the law distinguishes between different degrees of inurement depending upon who is being benefitted. The two types of inurement are referred to as “private inurement” and “public benefit.”
The prohibition against private inurement is designed to inhibit what the IRS has called a “disproportionate share of the benefits of the exchange” flowing to an insider when an insider enters into a transaction with an exempt organization.
Under the private inurement rule, none of an exempt organization’s income or assets may unduly benefit a person or company that is closely related to the organization, particularly one who exercises a significant degree of influence over it. The private inurement rule requires exempt organizations to use a standard of reasonableness to evaluate transactions with insiders (for example, how similar organizations, acting prudently, transact their affairs in similar circumstances) to ensure they are not unduly benefiting the insider in transactions between the insider and the organization.
The most important thing to remember about the private inurement rule is that it lacks any de minimis concept. Organizations that are found to have violated the private inurement rule face the ultimate penalty of revocation of tax-exempt status.
While the private inurement and private benefit rules are based on the same Code provision and policy of preserving charitable assets for the public rather than private parties, they have some important differences. In contrast to the private inurement rule, the private benefit rule is not limited to circumstances where the benefits accrue to an organization’s insiders. That is, this prohibition includes benefits conferred on “disinterested” persons and entities, or “outsiders”.
Also unlike the private inurement rule, a “de minimis” amount of private benefit is permissible. In contrast to the absolute prohibition against inurement, the IRS has traditionally treated the flow of some private benefits to private parties who are “outsiders” as not jeopardizing the organization’s tax exempt status so long as the private benefit is purely “incidental” to the organization’s tax-exempt purposes. The IRS employs a two-part test for determining whether a private benefit is incidental to an exempt organization’s exempt purpose:
A private benefit is considered incidental only if it is incidental in both a qualitative and a quantitative sense. In order to be incidental in a qualitative sense, the benefit must be a necessary circumstance of the activity that benefits to the public at large, i.e., the activity can be accomplished only by benefiting certain private individuals. To be incidental in a quantitative sense, the private benefit must not be substantial after considering the overall public benefit conferred by the activity.
Like private inurement, the penalty for violating the private benefit rule is revocation of tax-exempt status, a penalty which is often fatal for a tax-exempt organization.