A frequently misunderstood concept is the prohibition against nonprofit private inurement. While its true that the IRS rules prohibit inurement of an organization’s net earnings to an organization’s “insiders,” such as substantial contributors, directors, officers, trustees, and their businesses and family members, that does not mean that insiders cannot ever benefit from their association with the nonprofit.
IRS regulations state that “an organization is not operated exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private individuals.” The “net earnings” language has not been interpreted strictly in an accounting sense, but has been defined by courts to include monetary compensation or other benefits.
The main potential problem areas for nonprofits regarding private inurement are: 1) Compensation agreements for executive employees or trustees; 2) Business relationships with entities in which an organization insider or insider’s family member has an interest; and 3) Benefits paid to an insider or a member of the insider’s family as a member of the charitable class the organization serves. Fortunately, there are steps that non-profits can take to ensure these improper benefits do not occur.
Non-profits can ensure compensation of executive employees and trustees does not result in private inurement by:
- Establishing an independent executive and/or trustee compensation committee to perform due diligence in deciding upon compensation;
- Recording in committee or trustee minutes data relied upon that indicates the proposed executive or trustee compensation is reasonable according to industry standards for similarly situated non-profit corporations;
- If compensation includes bonuses or non-salaried benefits, insuring that there is an upper limit to compensation, and that compensation in addition to salary is clearly tied to performance.
(For a more detailed discussion of executive compensation, see our post Setting Non-Profit Executive Compensation)
Business Relationships with Insiders
Contrary to much popular opinion, not all non-profit business with individuals closely tied to the organization are prohibited by the IRS. However, proper governance is key in such instances to avoid public relations and regulatory issues. For example, a non-profit may have a trustee who is an experienced and effective consultant in non-profit accounting. If proper procedures are followed, the non-profit can contract with such a trustee to help it upgrade its accounting procedures. To ensure business with insiders (and their family members) does not constitute “unjust enrichment” the organization should manage the conflict by:
- Adopting a conflict of interest policy;
- Making sure that trustees and advisory board members review the conflict of interest policy and sign a form disclosing conflicts at least yearly;
- As part of the conflict of interest policy, requiring that a trustee or advisory board member reveal any financial interest they or a family member has (including serving as an employee) in any organization that is receiving, or is being considered to receive, organization funds;
- As part of the conflict of interest policy, requiring potentially interested insiders to leave the room during any discussion of potential business transactions with the trustee, their business or family members, and not vote on the matter;
- Providing a record of at least three competing quotes (more for larger organizations/transactions) or other indication, such as an expert’s opinion, that the business relationship will not provide compensation above fair market value; and
- Record all of the above in contemporaneous minutes.
Benefits Received as Part of a Charitable Class
It is possible for an insider to benefit from a nonprofit as part of a large and indefinite charitable class. The IRS outlines how to distinguish between public interest and private inurement as follows:
“The distinction between an individual as a private person and the individual as a member of the general public incorporates the following two concepts which are basic to unraveling inurement problems: (1) An individual is not entitled to unjustly enrich himself at the organization’s expense. (2) Benefits directed to an individual as a member of a charitable class do not constitute unjust enrichment.”
Even so, if there is a conflict of interest and it is not managed properly, an insider receiving benefits as part of a charitable class can still result in IRS violations. For example, if a director’s child receives a scholarship from the organization, and the director served on the committee that reviewed the applications and selected the scholarship recipients, that could result in an unfair selection process and amount to private inurement. To avoid this result, the conflicted director should recuse him or herself from the committee and let the disinterested directors make the decision without any influence from the conflicted director.
To be successful, non-profits must be able to pay employees competitively, enter into the most advantageous business relationships, and retain broad latitude to pursue their missions. With careful planning and responsible governance, as outlined above, non-profits can remain in legal compliance while providing adequate compensation and forming business relationships with insiders and even permitting them to benefit as members of the charitable class served by the nonprofit where it is in the nonprofit’s best interest to do so.
Ellis Carter is a nonprofit lawyer with Caritas Law Group, PC. To contact Ellis, call 602-456-0071 or email us at firstname.lastname@example.org.