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Section 300
Private Inurement and Excess Benefit Transactions

¶310 Principles of Private Inurement

¶311 Origin and Summary of Doctrine

The concept of private inurement, while lacking precise definition, is broad and wide-ranging. The word inure means to gravitate toward, flow to or through, or transfer to something. The term private is used in this setting to mean personal benefits and other forms of nonexempt uses and purposes. Consequently, the private inurement doctrine forbids

• the flow or transfer of income or assets of a tax-exempt organization (one that is subject to the doctrine) through or away from the organization, and
• the use of this income or assets by one or more persons associated with, or
• for the benefit of one or more persons with some significant relationship to,
• the organization, for nonexempt purposes.

An IRS General Counsel Memorandum (GCM) stated that private inurement is "likely to arise where the financial benefit represents a transfer of the organization's financial resources to an individual solely by virtue of the individual's relationship with the organization, and without regard to accomplishing exempt purposes" (see GCM 38459, July 31, 1980). Another GCM stated that the inurement prohibition serves to "prevent anyone in a position to do so from siphoning off any of a charity's [or other exempt organization subject to the doctrine] income or assets for personal use" (see GCM 39862, Dec. 2, 1991).

The purpose of the private inurement rule is to ensure that the tax-exempt organization involved is serving exempt interests and not private interests. It thus becomes necessary for an organization subject to the doctrine to establish that it is not organized and operated for the benefit of private persons, such as the creators of the organization, trustees, directors, officers, members of their families, persons controlled by these individuals, or any other persons having a personal and private interest in the activities of the organization (see 26 CFR §§1.501(a)-1(c), 1.501(c)(3)-1(c)(1)(ii) (hereafter Treas. Reg. §).

In ascertaining the presence of any proscribed private inurement, the law looks to the ultimate purpose of the organization involved: If its basic purpose is to benefit individuals in their private capacity (without thereby serving exempt purposes), then it cannot be tax-exempt, even though exempt activities may also be performed. Conversely, incidental benefits to private individuals will not defeat the exemption if the organization otherwise qualifies for tax-exempt status (see Treas. Reg. §1.501(c)(3)-1(d)(i) and (ii)).

The private inurement doctrine does not prohibit transactions between a tax-exempt organization subject to the doctrine and those who are insiders with respect to it. Rather, the doctrine requires that these transactions be tested against a standard of reasonableness. The reasonableness standard focuses essentially on comparisons, that is, on how similar organizations, acting prudently, transact their affairs in comparable circumstances. Usually, the terms of one or more of these transactions are tested against ordinary practices; an overarching test is whether these transactions were negotiated on an arm's-length basis. Of course, a tax-exempt organization may incur ordinary and necessary expenditures in its operations without forfeiting its exempt status (e.g., Birmingham Business College, Inc. v. Commissioner (5th Cir. 1960)). Currently, the law generally holds that the relative insignificance of the private benefit conveyed does not serve as a defense to a charge of impermissible inurement.

The sanction for violation of the private inurement doctrine is revocation or denial of tax-exempt status.

¶312 Concept of Net Earnings

In general, the term net earnings refers to gross earnings less expenses — a meaning that applies the term in a technical, accounting sense. For example, a state supreme court addressed this definition at length in the early decades of the federal tax law. In one opinion, this court wrote that, since the term is not defined in the statute, it "must be given its usual and ordinary meaning of what is left of earnings after deducting necessary and legitimate items of expense incident to the corporate business." This approach was followed in the early years by other state courts and by federal courts.

In the context of tax-exempt organizations law, however, this technical definition of the term was never sufficient as its sole meaning. Some courts applied the term in this restricted manner, where the facts particularly lent themselves to this approach, but most court opinions on the point reflect the broader, and certainly contemporary, view that there can be inurement of net earnings in the absence of transfers of net income (e.g., Gemological Institute of America v. Riddell (S.D. Cal. 1957)). An early proponent of this view was another state supreme court, which observed that the net earnings phraseology "should not be given a strictly literal construction, as in the accountant's sense," and that the "substance should control the form," so that tax exemption should not be available where private inurement is taking place, "irrespective of the means by which that result is accomplished." Likewise, a federal court foresaw today's application of the term when it held that private inurement "may include more than the term 'net profits' as shown by the books of the organization or than the difference between the gross receipts and disbursements in dollars," and that "[p]rofits may inure to the benefit of shareholders in ways other than dividends." This view represents the current application of the term net earnings — as part of a standard assessing the use of a tax-exempt organization's income and assets.

Therefore, the contemporary concept of private inurement goes far beyond any mechanical computation and dissemination of net earnings and embraces a wide range of transactions and other activities.

¶313 Requirement of an 'Insider'

The concept of private inurement contemplates a type of transaction between a tax-exempt organization subject to the doctrine and one or more persons who have some special, close relationship to the organization. The federal tax law has borrowed the term insider from the federal securities laws (which prohibit, among other uses of the term, insider trading) and applies it to describe persons of this nature. Generally, an insider is a person who has a unique relationship with the organization involved, by which that person is in a position to cause application of the organization's funds or assets for the private purposes of the person by reason of the person's exercise of control of or influence over the organization. The term basically means any person that is in a position to exercise a significant degree of control over the affairs of the exempt organization. Insiders thus include an organization's founders, trustees, directors, officers, key employees, members of the family of these individuals, and certain entities controlled by them. All of these persons have been swept into the insider category, from the starting point of the statutory language referencing "private shareholder or individual."

The case law is rich with instances concerning the involvement of insiders in private inurement transactions.

Example 313-A

Example 313-B

Example 313-C

Tax exemption was denied to a college that had five family members as all of its trustees and three of them as its shareholders, because of private inurement in the form of "constant commingling of the funds of the shareholders and the [c]ollege." A court found that the college was "operated as a business producing, or ultimately producing, substantial revenues for its operators … the net earnings, or substantial portions, were to be, and were in fact, distributed to these shareholders for their own personal benefit."

Example 313-D

Example 313-E

Example 313-F

Example 313-G

A hospital's tax exemption was barred by a court, in part because of the advantages obtained by the physicians who organized the institution. Most of the patients admitted to the hospital were attended to by the founding physicians. The court's concern was an arrangement for management services by which these physicians were paid and a lease of office space. The court concluded that the hospital was the "primary source of the doctor's professional income" and that "this virtual monopoly by the … [physicians] of the patients permitted benefits to inure to … [them] within the intendment of the statute."

Example 313-H

Example 313-I

Example 313-J

Example 313-K

Example 313-L

The IRS likewise has adopted the view that the private inurement prohibition relates only to circumstances where unwarranted benefits are provided to insiders.

Example 313-M

By contrast, a trust that was required to pay out its net income for tax-exempt purposes for a period of years or the lives of specified individuals was ruled by the IRS to not qualify for exempt status. At the end of the income payment period, the trust terminated, and the principal reverted to the founder of the trust or his estate. The disqualifying feature in this regard was this reversionary interest, which resulted in inurement of investment gains over the life of the trust to the benefit of the creator of the trust.

The IRS observed in a GCM that the "inurement issue … focuses on benefits conferred on an organization's insiders through the use or distribution of the organization's financial resources" (see GCM 38459, July 31, 1980).

Consequently, a tax-exempt organization subject to the private inurement doctrine should be concerned with the doctrine only where there is a transaction or transaction involving one or more insiders with respect to the organization. (Nonetheless, the private benefit doctrine can apply in the absence of involvement of an insider. See ¶320.)

¶314 Private Inurement: Scope of Proscription

The concept of private inurement has many manifestations. While the most common example is excessive compensation, there are several other forms of private inurement, including sales of property, and transactions involving lending and rental arrangements. Although the concepts of private inurement and private foundation self-dealing are by no means precisely the same, the following summary of self-dealing transactions offers a useful sketch of the scope of transactions that may, in appropriate circumstances, amount to instances of private inurement:

1. Sale or exchange, or leasing, of property between an organization and a private individual
2. Lending of money or other extension of credit between an organization and a private individual
3. Furnishing of goods, services, or facilities between an organization and a private individual
4. Payment of compensation (or payment or reimbursement of expenses) by an organization to a private individual
5. Transfer to, or use by or for the benefit of, a private individual of the income or assets of an organization (see IRC §4941(d)(l)(A)-(E)).

Example 314-A

With the emphasis of the federal tax law — in the private inurement area — on "net earnings" (see ¶312) and the reference to private shareholders, it is clear that the most literal and obvious form of private inurement would be the division of an organization's net earnings among those akin to shareholders, such as members of the board of directors. It is rare that such a blatant form of private inurement occurs. In one instance, however, this type of private inurement was identified.

Example 314-B

[i]t is doubtful, too, whether an organization's operation can be exclusively' for charitable purposes … when its income is being accumulated to increase directly the value of the interests of the stockholders which they expect, eventually, to receive beneficially.

In nearly all states, nonprofit corporations — especially charitable and educational organizations — may not be organized as stock corporations. Even in the instances where tax-exempt organizations may have formal stockholders, the organizations may not pay dividends. Where the individual stockholders derive income from the organization's operations through the medium of dividend payments, the organization cannot qualify as a charitable organization or many other types of exempt organizations.

¶314.1 Property Interests, Sale, Lease, Rents

A charitable organization may not be organized so that an individual or individuals retains a reversionary interest, by which the principal would flow to a private individual on dissolution or liquidation (see Example 313-M, above). Instead, in this event, net assets must pass for charitable or public, governmental purposes. The acceptance of an income-producing asset subject to a reserved life estate will not, however, result in private inurement, because only the charitable remainder interest is acquired. Likewise, annuity payments in return for a gift of an income-producing asset are not a form of undue inurement, because the payment of the annuity merely constitutes the satisfaction of the charge on the transferred asset.

A tax-exempt organization subject to the doctrine of private inurement generally may lease property and make rental payments for the use of the property. The rental payments must be reasonable, and the arrangement must be beneficial and desirable to the exempt organization; that is, inflated rental prices may amount to a private benefit inuring to the lessor.

IRS Hospital Audit Guidelines, issued by the IRS in 1992 (Ann. 92-83, 1992-22 IRB 59), point out that one form of private inurement is "payment of excessive rent" and state that "[a]reas of concern" include "below-market leases." The guidelines observe that auditing agents should be alert to the existence of "rent subsidies," noting that "[o]ffice space in the [tax-exempt] hospital/medical office building for use in the physician's private practice generally must be provided at a reasonable rental rate gauged by market data and by actual rental charges to other tenants in the same facility." The guidelines state that it is permissible for a physician to use an exempt organization's facility for both hospital duties and private practice, as long as the "time/use of [the] office … [is] apportioned between hospital activities and private practice activities and a reasonable rent … [is] charged for the private practice activities."

The factors to be considered include the duration of the lease and the amount and frequency of the rent payments, with all elements of the rental arrangement assessed in relation to comparable situations in the community.

¶314.2 Loans

A loan arrangement involving the assets of a tax-exempt organization subject to the private inurement doctrine are likely to be skeptically reviewed by the IRS. Like rental arrangements, the terms of this type of loan should be reasonable, that is, financially advantageous to the organization, and should be commensurate with the organization's purposes. The factors to be considered when assessing reasonableness are the duration of the indebtedness, the rate of interest to be paid, the security underlying the loan, and the repayment amount — all in relation to similar circumstances in the community. If a loan is not timely repaid, questions of private inurement will almost assuredly be raised. The "very existence of a private source of loan credit from an [exempt] organization's earnings may itself amount to inurement of benefit." Thus, for example, a school's tax exemption was revoked in part because two of its officers were provided by the school with interest-free, unsecured loans that subjected the school to uncompensated risks for no business purpose (John Marshall Law School v. United States (Ct. Cl. 1981)).

Example 314.2-A

Example 314.2-B

The above-noted Hospital Audit Guidelines state that another form of private inurement is "inadequately secured loans," and that a loan used as a recruiting subsidy is appropriate (assuming the requisite need for the physician in the first instance) as long as the recruitment contract "require[s] full repayment (at prevailing interest rates)." These guidelines provide the following factors, which the IRS considers in determining whether a loan made to an insider is reasonable:

1. Generally, the loan agreement should specify a reasonable rate of interest (the prime rate of interest plus one or two percent) and provide for adequate security.
2. The loan decision should be reviewed by the board of directors of the tax-exempt organization and should include consideration of the history of payment of prior loans by the insider.
3. Even if determined reasonable, any variance in the terms of the loan from what the borrower could obtain from a typical lending institution must be rated and appropriately reported as compensation.

¶314.3 Provision of Goods or Services

A tax-exempt organization subject to the private inurement doctrine cannot have as its primary purpose the provision of goods or refreshments (e.g., in the nature of social or recreational activities) to private individuals. Of course, the organization may incidentally bear the expense of meals and refreshments (such as working luncheons and annual banquets), and the like, but, in general, "[r]efreshments, goods and services furnished to the members of an exempt corporation from the net profits of the business enterprise are benefits inuring to the individual members." Thus, a discussion group that held closed meetings at which personally oriented speeches were given, followed by the serving of food and other refreshments, was ruled by the IRS to not be tax-exempt because the public benefits were remote at best, and the "functions of the organization are to a significant extent fraternal and designed to stimulate fellowship among the membership." Likewise, a school's tax exemption was revoked by the IRS in part because the school paid for a variety of household items and furnishings used in the home of one of its officers.

An organization, the primary purpose of which is to render services to individuals in their private capacity, generally cannot qualify as a charitable entity. There are exceptions to this principle, such as where the individuals benefited constitute a bona fide charitable class, the individual beneficiaries are considered merely instruments or means to a charitable objective, or the private benefit is merely incidental.

This type of private inurement takes many forms and involves judgments governing in the individual cases that are difficult to quantify. For example, the advancement of the arts is a charitable activity. A cooperative art gallery that exhibited and sold only its members' works, however, was ruled by the IRS to be serving the private purposes of its members ("a vehicle for advancing their careers and promoting the sale of their work") and hence not tax-exempt, even though the exhibition and sale of paintings may otherwise be an exempt purpose.

Similarly, although the rendering of housing assistance for low-income families may qualify as an exempt purpose, an organization that provided this form of assistance but gave preference for housing to employees of a farm proprietorship operated by the individual who controlled the organization was ruled to be not a charitable organization. Also, a school's tax exemption was revoked in part because the school awarded scholarships to the children of two of its officers, yet did not make scholarship awards to anyone else.

The provision of services to individuals, as precluded by the private inurement proscription, takes many forms:

• An organization created to provide bus transportation for school children to a tax-exempt private school was ruled to not be tax-exempt itself. The IRS said that the organization served a private, rather than a public, interest in that it enabled the participating parents to fulfill their individual responsibility of transporting children to school. The IRS concluded: "When a group of individuals associate to provide a cooperative service for themselves, they are serving a private interest."
• A testamentary trust established to make payments to charitable organizations and to use a fixed sum from its annual income for the perpetual care of the testator's burial lot was ruled to be serving a private interest.
• An organization that operated a subscription "scholarship" plan, whereby "scholarships" were paid to preselected, specifically named individuals designated by subscribers, was ruled to not be exempt, since it was operated for the benefit of designated individuals.
• The furnishing of farm laborers for individual farmers (as part of the operation of a labor camp to house transient workers) was held not to be an agricultural purpose under federal tax law, but rather the provision of services to individual farmers that they would otherwise have to provide for themselves.
• A nonprofit corporation was deemed to be serving private purposes where it was formed to dredge a navigable waterway (little used by the general public) fronting the properties of its members.
• An organization that provided travel services, legal services, an insurance plan, an anti-theft registration program, and discount programs to its members was held to be serving the interests of the members, thereby precluding the organization from qualifying as an exempt educational organization.
• An organization was denied tax-exempt status because a substantial portion of its funds was to be used to pay for the medical and rehabilitative care of an individual who was related to each of the trustees of the organization.

On occasion, the rule that unwarranted services to members can cause denial or loss of an organization's tax-exempt status leads to bizarre consequences. This general limitation is, from time to time, stretched — to bring about adverse consequences for the organization involved — far beyond what Congress surely intended in legislating the proscription on private inurement.

Example 314.3-A

While the IRS and the court conceded that some of the society's activities were charitable and educational, they determined that the compilation and publication of the genealogical history of this "family" group was an activity that served the private interests of the organization's members. The court "note[d] specifically… [the organization's] emphasis on compiling members' family lives and the… [group's] family history" and held that "[a]ny educational benefits to the public created by … [the organization's] activities is incidental to this private purpose."

This rationale ignored the discipline of "kinship studies," in which social history focuses extensively on families and family-related institutions and strained to place a negative, private orientation on the term "family," when, in fact, the use of a family is merely a research technique whereby the tracings of genealogy are undertaken pursuant to an objective standard. This case presented a major threat to genealogical societies particularly "family associations" — because the opinion characterized genealogical study as private inurement.

Following this court holding, the IRS publicly ruled that a genealogical society may qualify as a tax-exempt educational organization by conducting lectures, sponsoring public displays and museum tours, providing written materials to instruct members of the general public on genealogical research, and compiling a geographical area's pioneer history. The organization's membership, however, was open to all interested persons in the area, rather than members of any one "family," and the society did not conduct genealogical research for its members, although its members researched genealogies independently using the society's research materials.

By contrast, the IRS also ruled that an organization cannot qualify as a charitable or educational entity where its membership was limited to descendants of a particular family; it compiled family genealogical research data for use by its members for reasons other than to conform to the religious precepts of the family's denomination; it presented the data to designated libraries; it published volumes of family history; and it promoted occasional social activities among family members. In a final rule issued in 2008, the IRS provided an example reflecting the position that where a geneological organization serves the interests of one family and limits membership to that one family, the result is private benefit and the organization would not receive a tax-exempt designation. Treas. Reg. §1.501(c)(3)-1, Example 1.

Charitable organizations frequently provide services to individuals in their private capacity when they dispense financial planning advice in the context of designing planned gifts. This type of personal service made available by a tax-exempt organization has never been regarded as jeopardizing the organization's tax exemption. The IRS, however, refused to accord exemption to an organization that engaged in financial counseling by providing tax planning services (including charitable giving considerations) to wealthy individuals referred to it by subscribing religious organizations. The court involved upheld the government's position, finding that tax planning is not an exempt activity and that the primary effect of the advice is to reduce individuals' liability for taxes — a private benefit. The court rejected the contention that the organization was merely doing what the subscribing members can do themselves without endangering their tax exemption: fund raising.

¶314.4 Corporations, Industries, and Professions

The private inurement proscription may apply not only to individuals in their private capacity, but also to corporations involved in industries, professions, and the like. Thus, an organization primarily engaged in the testing of drugs for commercial pharmaceutical companies was ruled to not be engaged in scientific research or testing for public safety, but to be serving the private interests of the manufacturers. Similarly, an organization composed of members of a particular industry to develop new and improved uses for existing products of the industry was ruled to be operated primarily to serve the private interests of its creators and thus not tax-exempt. Further, an association of professional nurses that operated a nurses' registry was ruled to be affording greater employment opportunities for its members and thus to be substantially operated for private ends.

As a general proposition, a tax-exempt organization can incur debt to purchase an asset at fair market value and subsequently retire the debt with its receipts and not thereby violate the private inurement proscription. If the purchase price for the asset is in excess of the property's fair market value, however, private inurement may result.

Example 314.4-A

¶314.5 Employee Benefits

The IRS looks skeptically on allegedly charitable organizations established to benefit employees, particularly where the entity is controlled and funded by the employer. Thus, a trust created by an employer to pay pensions to retired employees was ruled to not be an exempt charitable organization. This same result obtains where the recipients are present employees, in part because they do not constitute a charitable class.

Example 314.5-A

Perhaps the best example of this rule is that of the foundation that lost its tax exemption because it devoted its funds to the payment of expenses of young performers employed by the foundation's founder, who was in show business.

Example 314.5-B

Example 314.5-C

Nonetheless, the IRS has come around to the view that charitable organizations — and thus other categories of tax-exempt organizations — may establish profit-sharing and similar compensation plans without causing prohibited private inurement (see GCM 39674), having earlier taken the position that the establishment of qualified profit-sharing plans resulted in private inurement per se (see GCM 35869). This alteration of position is based on the reasoning that the principles of qualification of pension and profit-sharing plans and Title I of the Employee Retirement Income Security Act of 1974 are sufficient to ensure that operation of these plans would not jeopardize the exempt status of the nonprofit organizations involved. Thereafter, legislation enacted in 1986 amended the employee plan rules to make it clear that tax-exempt organizations may maintain qualified profit-sharing plans (IRC §401(a)(27)) and extended certain deferred compensation rules to make them applicable to tax-exempt organizations (IRC §457).

Tax-exempt organizations may maintain the qualified cash or deferral arrangements known as "401(k) plans" (IRC §401(k)(4)(B)(i)). A charitable organization may maintain a tax-sheltered annuity program for its employees (IRC §403(b)). In general, tax-exempt organizations may pay reasonable pensions to retired employees without adversely affecting their tax-exempt status.

¶314.6 Tax Avoidance Plans

The IRS classifies tax avoidance plans involving nonprofit organizations as representing a category of private benefit. Here, the IRS is concerned about the business or professional person who transfers his or her business assets to a controlled nonprofit entity solely for the purpose of avoiding taxes and then continues to operate the business or profession as an employee of the transferee organization. The IRS characterizes these schemes as follows:

Transactions of this type are lacking in substance in the sense that the transferor is still, in effect, engaging in his business or profession in his individual capacity. Since the organization is operated by the transferor essentially as an attempt to reduce his personal Federal income tax liability while still enjoying the benefits of his earnings, the organization's primary function is to serve the private interest of its creator rather than a public interest.

Example 314.6-A

In another case, an organization characterized as a church was formed by a professional nurse (who was the organization's minister, director, and principal officer). It held assets and liabilities formerly owned and assumed by the nurse and provided the nurse with a living allowance and use of the assets (including a house and automobile). The organization was ruled to not be tax-exempt because the corporation "serves as a vehicle for handling the nurse's personal financial transactions."

A court in one case found that "tax avoidance" is a "substantial nonexempt purpose" of an organization, as evidenced by its promotional literature and seminars, and for that reason revoked the organization's tax-exempt status.

Another court, unwilling to recognize an organization as a church because most of the organization's support was derived from its founder and the organization paid the living expenses of the founder, wrote that "[p]rohibited inurement is strongly suggested where an individual or small group is the principal contributor to an organization and the principal recipient of the distributions of the organization, and that individual or small group has exclusive control over the management of the organization's funds."

¶314.7 Partnerships and Joint Ventures

Tax-exempt organizations frequently become involved in partnerships or joint ventures with individuals and/or nonexempt entities. Real estate ventures with the tax-exempt organization as the general partner in a limited partnership — are a common manifestation of this practice. The IRS has a concern that some of these ventures may be a means for conferring unwarranted benefit on the private participants. Nonetheless, one court decision sanctioned the involvement of a charitable organization as a general partner in a limited partnership.

Example 314.7-A

In disagreeing with the IRS position that the organization — solely by involvement in the limited partnership — was being operated for private interests, the court noted the following: the sale of the interest in the play was for a reasonable price; the transaction was at arm's-length; the organization was not obligated for the return of any capital contribution made by the limited partners; the limited partners had no control over the organization's operations; and neither the limited partners nor any officer or director of the for-profit corporation was an officer or director of the arts organization.

Example 314.7-B

See ¶1800 for more on joint ventures.

¶314.8 Sales of Assets to Insiders

Another application of the private inurement doctrine involves sales of assets of tax-exempt organizations to their insiders. It is becoming common for a charitable (and perhaps other exempt) organization to decide to sell assets relating to a particular program activity, because the organization no longer wishes to engage in that activity. Sometimes, for a variety of reasons, these assets are sold to one or more individuals who are directors, officers, and/or other types of insiders with respect to the organization. A PLR illustrated how the doctrine may apply in this setting.

Example 314.8-A

Soon after the sale, the purchasing organization began receiving inquiries as to resale of the facility. The new organization added beds to the hospital and obtained a certificate of need for additional beds. Less than two years after the initial sale of the hospital facility, it was resold. The resale price was $29.6 million. Each member of the board of the selling organization received in excess of $2.3 million as his or her share of the sales proceeds. The attorney general of the state involved filed a lawsuit, alleging that the initial sale price was not fair and reasonable. The court agreed, also concluding that the directors of the tax-exempt organization acted with a lack of due diligence. At trial, the facilities were appraised using five appraisal methodologies. The conclusion was that the value of the assets at the time of the initial sale was approximately $18 to $21 million. A subsequent analysis by the IRS set the value of the facility at $24 million.

The factual question before the IRS was whether the tax-exempt organization received fair market value when it sold its hospital facility. A detailed analysis of the appraisals led the IRS to the conclusion that fair market value had not been received. The appraisals done for the court and the IRS were based on various appraisal methodologies. The appraisal relied upon by the tax-exempt organization used one. The IRS conceded that "no single valuation method is necessarily the best indicator of value in a given case." The IRS added, however, "it would be logical to assume that an appraisal that has considered and applied a variety of approaches in reaching its 'bottom line' is more likely to result in an accurate valuation than an appraisal that focused on a single valuation method." Having resolved that factual issue, the IRS concluded as a matter of law that the tax-exempt organization, in selling the hospital facility for substantially less than fair market value, contravened the private inurement doctrine. Accordingly, the organization's exempt status was revoked, effective as of the date of sale of the facility.

In so doing, the IRS observed: "There is no absolute prohibition against an exempt §501(c)(3) organization dealing with its founders, members, or officers in conducting its economic affairs." There is no doubt, however, that transactions of this nature will be subject to special scrutiny, with the IRS concerned about a (in the language of the ruling) "disproportionate share of the benefits of the exchange" flowing to the insiders. Thus, in this case, there was nothing inherently improper about the organization's decision to cease being a hospital and to sell the appropriate assets to an organization controlled by its directors.

Second, the organization followed the correct approach in acquiring an independent appraisal. In most circumstances, this would have been enough. However, when the directors resold the hospital facility after approximately only a two-year period and experienced a $21.3 million dollar profit and a lawsuit by the state's attorney general (with the court having found a breach of fiduciary responsibility), the IRS determined that private inurement occurred.

This PLR offers two points of IRS thinking that previously were not known:

1. A breach of fiduciary responsibility by the directors or trustees of a tax-exempt charitable organization under state law principles can be the basis for a finding of private inurement.
2. The IRS prefers an appraisal that has "considered and applied a variety of approaches" in reaching a valuation rather than an appraisal that "focused on a single valuation method."

¶315 Emphasis on Compensation

The payment of reasonable compensation by a tax-exempt organization for services rendered does not constitute private inurement. (A tax-exempt organization subject to the private inurement doctrine may pay compensation to an employee in the form of a salary, hourly wage, bonus, commission, and/or the like, or make payments to a vendor, consultant, or other independent contractor.) Conversely, excessive compensation can result in private inurement (e.g., Northern Illinois College of Optometry v. Commissioner (Tax Ct. 1943)). Whether the compensation paid is reasonable is a question of fact, to be decided in the context of each case. One court observed that the "law places no duty on individuals operating charitable organizations to donate their services; they are entitled to reasonable compensation for their efforts" (Mabee Petroleum Corp. v. U.S., 203 F2d 872 (5th Cir. 1953).

The process for determining reasonable compensation is much like that of appraising an item of property: it is an evaluation of factors that have a bearing on its value; that is, it is an exercise of comparing a mix of variables pertaining to the compensation of others. This alchemy is supposed to yield the determination as to whether a particular item of compensation is "reasonable" or "excessive."

While the law is relatively clear as to the criteria to be used in ascertaining the reasonableness of compensation (see, e.g., Rev. Rul. 69-383 (1969-2 CB 113); GCM 39670 (Oct. 14, 1987)), application of these principles is not always easy. Some preliminary concepts are relatively obvious. One is, as established in Mabee above, that charitable and other exempt organizations can compensate individuals for services rendered. Another is that all forms of compensation paid to an individual by a tax-exempt organization are aggregated for this purpose; it is not merely a matter of the salary or the wage — bonuses, commissions, royalties, fringe benefits, insurance coverages, unpaid deferred compensation, retirement benefits, and the like are also taken into account. A third concept is that the amount of time an individual devotes to the task is a factor; an amount of compensation may be reasonable when paid to a full-time employee, yet be unreasonable when the employee is only providing services on a part-time basis.

The following factors may come into play during an assessment of compensation for reasonableness:

• Whether the employer and employee negotiated the compensation agreement at arm's length
• Availability of comparable services
• Degree of control by one family
• Nature of employee's duties
• Employee's contributions to organization's exempt purpose
• Time devoted to job
• Salary scale paid to others in "like enterprises" under "like circumstances"
• Salary scale of all employees
• Organizational size
• Percent of organization's income devoted to compensation
• Criteria for compensation
• Large, sudden increases in compensation
• Establishment of future salary
• Documentation and substantiation of duties¹

¶315.1 Evolution of Intermediate Sanctions

The evolution of the intermediate sanctions rules (see ¶330) is likely to clarify the process of determining reasonable compensation, as well as the procedural and substantive elements to be evaluated. This body of law is an alternative to the sanction of revocation of the tax exemption of the organization that participated in the private inurement transaction. The enactment of these rules is forcing clarification of the means by which reasonableness of compensation is determined.

Rebuttable Presumption of Reasonableness. The intermediate sanctions rules include a rebuttable presumption of reasonableness with respect to a compensation arrangement with a disqualified person if the arrangement was approved by an independent board of directors (or an independent committee authorized by the board) that

1. was composed entirely of individuals unrelated to and not subject to the control of the disqualified person(s) involved in the arrangement;
2. obtained and relied upon appropriate data as to comparability; and
3. adequately documented the basis for its determination (such as a record that includes an evaluation of the individual whose compensation was being established and the basis for determining that the compensation was reasonable in light of that evaluation and data).

As to the second criterion, the "appropriate data" are items, such as

1. the compensation levels paid by similarly situated organizations, both tax-exempt and taxable, for functionally comparable positions;
2. the location of the organization, including the availability of similar specialties in the geographic area;
3. independent compensation surveys by nationally recognized independent firms; and
4. actual written offers from similar organizations competing for the services of the disqualified person.

Personal Expenses and Benefits. The payment of personal expenses and benefits to disqualified persons and non-fair-market-value transactions benefiting these persons are treated under these rules as compensation only if it is clear that the organizations intended and made the payments as compensation for services. In determining whether the payments of transactions are, in fact, compensation, the relevant factors include

1. whether the appropriate decision-making body approved the transfer as compensation in accordance with established procedures; and
2. whether the organization and the recipient reported the transfer as compensation on the relevant federal tax forms (e.g., Form W-2 or Form 1099).

¶315.2 Applying Criteria in Private Inurement Setting

These criteria and processes for assessing the reasonableness of compensation are equally applicable in the private inurement setting.

Large Salary or Wage. A large salary or wage in absolute dollar amount, rather than as a percentage of gross receipts, can be considered the receipt by the employee of the organization's net earnings, particularly where the employee is concurrently receiving other forms of compensation from the organization (e.g., fees, commissions, royalties) and more than one member of the same family are compensated employees. Thus, where the control of an organization was in two ministers who contributed all of its receipts, all of which were paid to them as housing allowances, the tax exemption of the organization was revoked. The court said that the compensation was not "reasonable" although it may not be "excessive." Large salaries and noncash benefits received by an organization's employees can, however, be reasonable, considering the nature of their services and skills, such as payments to physicians by a nonprofit group that is an incorporated department of anesthesiology of a hospital. B.H.W. Anesthesia Foundation, Inc. v. Commissioner, 72 T.C. 681 (1979).

High Annual Increases. Another basis for construing the presence of private inurement is where the compensation paid is reasonable, but the year-to-year increases in it are not justifiable. For example, a court considered a case where three executives of a nonprofit organization had salaries in 1970 of $25,000, $16,153, and $5,790, and in 1978 of $100,000, $72,377, and $42,896, respectively. This was held to be an "abrupt increase" in the salaries and a "substantial amount" of compensation, leading to the conclusion that the salaries "are at least suggestive of a commercial rather than nonprofit operation." Incorporated Trustees of the Gospel Worker Society v. U.S., 510 F. Supp. 374, 379 (D.D.C. 1981), aff'd, 672 F.2d 894 (D.C. Cir. 1981), cert. den., 456 U.S. 944 (1982).

Other Forms of Compensation. Other forms of compensation are subject to the private inurement doctrine. For example, although one court had held that an excessive parsonage allowance may constitute private inurement, the same court ruled subsequently that another parsonage allowance was "not excessive as a matter of law."

Also, a split-dollar life insurance plan benefiting, in part, an organization's directors is considered a form of compensation.

As a general rule, any arrangement that results in a benefit to the insider may be considered compensation, including rents, payment of personal expenses, and use of the organization's facilities.

Fund-Raising Commissions. In one instance, a compensation arrangement established by a tax-exempt organization based on a percentage of gross receipts was held by a court to constitute private inurement, where there was no upper limit as to total compensation. The court, however, subsequently restricted the reach of this decision by holding that private inurement does not occur when an exempt organization pays its president a commission determined by a percentage of contributions procured by him. The court held that the standard is whether the compensation is reasonable, not the manner in which it is ascertained. Fund-raising commissions that "are directly contingent on success in procuring funds," were held to be an "incentive well-suited to the budget of a fledgling organization." In reaching this conclusion, the court reviewed states' charitable solicitation acts governing payments to professional solicitors, which the court characterized as "sanction[ing] such commissions and in many cases endors[ing] percentage commissions higher than" the percentage commission paid by the organization involved in the case. World Family Corporation v. Commissioner, 81 T.C. 958 (1983).

Another court subsequently introduced even more confusion on these points when it held that "there is nothing insidious or evil about a commission-based compensation system" and, thus, that an arrangement, by which those who successfully procure contributions to a charitable organization are paid up to six percent of the gifts, is reasonable despite the absence of any limit as to an absolute amount of compensation (and despite the fact that the law requires the compensation to be reasonable, not the percentage by which it is determined).

Incentive-Based Compensation. The IRS may closely scrutinize compensation programs of tax-exempt organizations that are predicated on an incentive feature by which compensation is a function of revenues received by the organization, is guaranteed, or is otherwise outside the boundaries of conventional compensation arrangements. These programs seem to occur most frequently in the health care context. For example, the IRS concluded that the establishment of incentive compensation plans for the employees of a hospital, with payments determined as a percentage of the excess of revenues over the budgeted level, will not constitute private inurement where the plans are not devices to distribute profits to principals, are the result of arm's-length bargaining, and do not result in unreasonable compensation. Using similar reasoning, the IRS approved guaranteed minimum annual salary contracts under which physicians' compensation was subsidized in order to induce them to commence employment at a hospital.²

Likewise, the IRS has explored other forms of productivity incentive programs, gainsharing programs, and contingent compensation plans. Outside the health care setting, for example, the IRS concluded that a package of compensation arrangements for the benefit of sports coaches for schools, colleges, and universities, including deferred compensation plans, payment of life insurance premiums, bonuses, and moving expenses, did not amount to impermissible private inurement.³ In one instance, the IRS approved of a "sharable income policy" by which a scientific research organization provided one-third of the revenue derived from patents, copyrights, processes, or formulae to the inventors and 15 percent of the revenue received from the licensing or other transfer of the organization's technology to valuable employees.

Aggregate Compensation. In some instances, an individual will receive compensation (including fringe benefits) and/or other payments from more than one organization, whether or not tax-exempt. A determination as to the reasonableness of this compensation or other payments is made in the aggregate. Thus, for example, in the college and university examination guidelines developed by the IRS, auditing agents are advised as follows: "If an employee is compensated by several entities, even if the entities have independent boards or representatives, examine the total compensation paid to such person by all entities over which the institution has significant control or influence."

Compensation Requires Services. Aside from the reasonableness of compensation, it is fundamental that a tax-exempt organization subject to the private inurement doctrine may not, without transgressing the doctrine, pay compensation where services are not actually rendered. For example, an organization was denied exempt status because it advanced funds to telephone solicitors, to be offset against earned commissions, where some of the solicitors resigned before earning commissions equal to or exceeding their advances.

¶316 Per Se Private Inurement

As discussed, most instances of private inurement arise where a payment — such as compensation for services, rent, or interest — to one or more insiders is not reasonable or is excessive. There are, however, forms of private inurement that have that status because they amount to per se private inurement. This means that the structure of the transaction is inherently deficient; private inurement is found in the very nature of the transaction. Thus, it is irrelevant, under this rule, that the benefit conferred on the insiders in some way also furthers the organization's exempt purposes and/or that the amount paid is reasonable. To date, this rationale has not been applied with respect to forms of compensation.

The doctrine of per se private inurement was publicly articulated when the IRS made known the view of its Chief Counsel's office regarding the impact on the tax-exempt status of a hospital involved in a joint venture with members of its medical staff. The hospital sold to the venture the gross or net revenue stream derived from operation of an existing hospital department or service for a defined period. The IRS's view: the hospital jeopardized its tax exemption, on the ground of private inurement, solely by entering into the transaction.

In arriving at this conclusion, the IRS Chief Counsel's office revisited the position taken in three PLRs issued in the 1980s. Essentially, the facts in these cases involved the purchase, by a joint venture or partnership, of the revenue stream of a hospital program.

Example 316-A

In these situations, the hospital continued to own and operate the facilities and to establish the amounts charged patients for their use. The hospital paid the partnership the net revenue from operations of the facilities. At the time of the ruling request, the surgical facility in the first of these cases was only 54 percent utilized. The arrangement was undertaken to allow the hospital's medical staff physicians to participate, on an investment basis, in the technical or facility charge component of the outpatient surgery program and gastroenterology laboratory. As part of the filing request, the IRS was told that this arrangement would offer a financial incentive to the physicians to increase usage of the hospital's facilities. In each instance the purchase price for the revenue stream was established at fair market value as the result of arm's-length negotiations and was discounted to present value.

The IRS recognized that "there often are multiple reasons why hospitals are willing to engage in joint ventures and other sophisticated financial arrangements with physicians." Two of these reasons are the "need to raise capital and to give physicians a stake in the success of a new enterprise or service." The hospital, in addition "to the hope for or expectation of additional admissions and referrals," may act "out of fear that a physician will send patients elsewhere or, worse, establish a new competing provider." The IRS added, however, "Whenever a charitable organization engages in unusual financial transactions with private parties, the arrangements must be evaluated in light of applicable tax law and other legal standards."

Its analysis of net revenue stream arrangements led the IRS to conclude that "there appears to be little accomplished that directly furthers the hospitals' charitable purposes of promoting health." The reason the hospitals entered into these arrangements is noted above: to retain and reward the physicians. The IRS wrote, however, "[g]iving (or selling) medical staff physicians a proprietary interest in the net profits of a hospital under these circumstances creates a result that is indistinguishable from paying dividends on stock." Thus, the private inurement prohibition was considered violated because "[p]rofit distributions are made to persons having a personal and private interest in the activities of the organization and are made out of the net earnings of the organization."

The IRS added that, in these cases, the "hospital's profit interests in those [charitable] assets have been carved out largely for the benefit of the physician-investors." The IRS' lawyers opined that "[t]his is enough to constitute inurement and is per se inconsistent with exempt status."

Per se private inurement thus cannot be successfully defended with the argument that the amounts being paid (in the above cases, to the physicians) are reasonable. (It was the hospitals' position that the physicians were being paid to admit or refer patients or for giving up the right to establish or invest in a competing provider, and that these' payments were reasonable.)

¶317 Private Inurement Issues in Higher Education

There is nothing unique about the private inurement doctrine as applied in the higher education arena. As is the case with tax-exempt charitable (including educational) organizations generally, exempt colleges and universities should endeavor to be certain that they understand who the insiders with respect to the institution are and that the terms of transactions with these insiders (e.g., loans, rental arrangements, and asset sales) are reasonable. A growing practice is the use of conflict-of- interest policies to maintain a current tally of insiders and to identify transactions with them at the outset.

The matter of excessive compensation also can arise in the higher education setting. The employee involved may be the president, a faculty member, a physician on the medical staff of a university hospital, or a coach of a sports team. Again, the test is whether the compensation package is reasonable.

¶317.1 Executive Compensation Initiatives

In 2004, the IRS launched an initiative to examine the reasonableness of compensation paid to executives of tax-exempt entities, including colleges and universities. In its report on Phases I and II, IRS found that the entities that it had reviewed generally were in compliance with the executive compensation rules, but they did have difficulty properly reporting the compensation on the Form 990 and its schedules. Where the Service did find problems, these generally fell into the following categories:

• Excessive salary and incentive compensation
• Payments for vacation homes, personal legal fees, or personal automobiles that were not reported as compensation
• Payments for personal meals and gifts to others on behalf of disqualified persons that were not reported as compensation
• Payments to an officer's for-profit corporation in excess of the value of services provided by the corporation

Loans emerged as a particular problem with 53 percent of those loans made with terms more favorable than commercial loans and 31 percent not repaid in accord with the stated terms. These findings have prompted the IRS to launch Part III of the executive compensation initiative, which includes 200 compliance checks and 50 additional single issue examinations focusing on organizations with loans to executives. It is not clear whether colleges and universities are among those included in Phase III.⁴

In late 2008, IRS began its College and University Compliance Project by sending out a questionnaire to 400 colleges and universities. Among the topics on the questionnaire was executive compensation. The questionnaire presented 34 questions, many with subquestions, on the amount paid to the six highest paid individuals, how colleges and universities determine compensation, and a detailed breakdown of the compensation, including fringe benefits, loans, and deferred compensation. In May 2010 IRS issued a preliminary report on the responses to the questionnaire. The preliminary report made no comment on the amount of compensation, only on the fact that the number of schools using the rebuttable presumption safe harbor to protect against the imposition of excise tax was not as high as the IRS had expected.

¶318 Incidental Private Inurement

It is the position of the IRS that there is no de minimis exception to the private inurement doctrine; that is, there is no defense to an allegation of private inurement that it was merely "incidental."

Nonetheless, even though private inurement may be present in a situation, an argument can be made that tax exemption should not be denied for that reason if the private inurement is incidental.

Example 318-A

Example 318-B

Example 318-C

Example 318-D

Example 318-E

Example 318-F

Example 318-G

By contrast, some courts — particularly the U.S. Tax Court — take the position that any element of private inurement can cause an organization to lose or to be deprived of tax exemption. For example, in one opinion, the court stated that "even if the benefit inuring to the members is small, it is still impermissible." This interpretation of the law is reflected in other opinions as well and, as noted, represents the formal position of the IRS. The state — or future — of the law on this point is probably reflected in the view of one federal court of appeals, which observed that "[w]e have grave doubts that the de minimis doctrine, which is so generally applicable, would not apply in this situation [that is, in the private inurement setting]."

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¹ Wright and Rotz, "I. Reasonable Compensation," Exempt Organizations Continuing Professional Education (CPE) Technical Instruction Program for Fiscal Year 1993, www.irs.gov/pub/irs-tege/eotopici93.pdf. [back to text]

²For a review of the IRS position on physician compensation and reasonableness, see Brauer and Kaiser, "C. Physician Incentive Compensation," Exempt Organizations Continuing Professional Education (CPE) Technical Instruction Program for Fiscal Year 2000, www.irs.gov/pub/irs-tege/eotopicc00.pdf. [back to text]

³See GCM 39670 (June 17, 1987); but note that in 2007, Congress asked the NCAA to justify the high salaries paid to coaches and the revenues received by universities from its athletics in the context of the 501(c)(3) tax exemption. [back to text]

⁴See Report on Exempt Organizations Executive Compensation Compliance Project — Parts I and II, March 2007; www.irs.gov/pub/irs-tege/exec._comp._final.pdf. [back to text]

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