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IRS Takes a Hard Line on Private Benefit and Private Inurement Rules

Posted on by bentakis

A recent private letter ruling by the IRS denying the tax-exempt status of an organization under section 501(c)(3) of the Code highlights some of the risks inherent in business dealings between an organization and its officers or directors. Under the Internal Revenue Code, a 501(c)(3) organization’s activities must not substantially benefit a private individual or company, other than a benefit that is incidental to the organization’s charitable purpose (the “private benefit” rule). In addition, with limited exceptions, the rules prohibit most types of tax-exempt organizations (not just 501(c)(3) organizations) from using their assets to the benefit of individuals who are in a position to control the organization (the “private inurement” rule). This latest private letter ruling shows the IRS applying these rules quite strictly.

PLR 201235021, released on August 31, 2012, addresses the tax-exemption application (Form 1023) of a non-profit corporation formed “to facilitate the identification of worthy charities and to foster giving by donors in a very timely manner and rapid response time” through online giving and mobile phone technology. The organization developed an online donation management system including a mobile phone application, and contracted with a related for-profit LLC to provide all the necessary hardware, software and administrative services.

The day-to-day affairs of the organization were managed by its Board of Directors, which comprised three individuals, identified in the ruling as B, C, and D. These three individuals were also the sole owners of the for-profit LLC.

The initial agreement between the organization and the LLC provided the LLC with a fee of 20% of the donations collected through the donation management system, which the organization claimed (without supporting documentation) is “well below” the average that charitable organizations ordinarily spend. The organization later restructured, apparently in an attempt to minimize the conflict of interest, by removing C and D from their Board. After D left the organization’s board, an amended contract was signed reducing the fee 8%. B signed the contract on the organization’s behalf and D signed the contract on the LLC’s behalf.

The IRS concluded that the contract with the LLC violated the rules against private benefit and private inurement, and this was fatal to the organization’s application for tax-exempt status. The IRS pointed to several key factors influencing its decision, including:

This ruling illustrates that organizations should proceed with the utmost caution when entering into contracts with related individuals. Procedure is just as important as the substance of the contracts, and at a minimum, organizations should (1) obtain comparable quotes from outside businesses to determine that the fees are not higher than fair market value, (2) hold board meetings to consider the data before entering into the contract (making sure that conflicted members are removed from the discussions); (3) document such meetings contemporaneously with detailed minutes; and (4) structure the contracts to avoid the appearance of a “joint venture” between a tax-exempt organization and a for-profit entity. Of course, circumstances may require more elaborate safeguards, and sometimes an organization may need to steer clear entirely of contracts with related individuals, so it is always safest to consult with a lawyer first.

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