(a) Meaning of Compensation

The concept of compensation paid to an individual or other person by a tax-exempt organization is not confined to items such as a salary. All forms of compensation (economic benefits) are aggregated for this purpose; in the case of an employee, the elements include salary, wages, bonuses, commissions, royalties, fringe benefits, deferred compensation, severance payments, retirement and pension benefits, expense allowances, and insurance coverages,⁷⁷ and in the case of an independent contractor, the payment of advances, fees, and expense reimbursements.⁷⁸

In one instance, private inurement was found where a nonprofit organization was conducting ostensible research on dietary supplements, where the supplements were manufactured by a related entity and related entities funded the research; a director received “substantial” compensation and made considerable sums selling shares of stock in a related corporation that were purchased at a discount from another related entity.⁷⁹

(b) Determining Reasonableness of Compensation

The private inurement doctrine mandates that the compensation amount paid by most tax-exempt organizations to insiders with respect to them be reasonable. In other words, the payment of excessive compensation can result in a finding of private inurement.⁸⁰ Whether an amount of compensation is reasonable is a question of fact, to be decided in the context of each case;⁸¹ it is not an issue of law.

The process for determining the reasonableness of compensation is conceptually much like that entailed when valuing an item of property. It requires an appraisal—an evaluation of factors that lead to a determination of the value. It is an exercise of comparing a mix of variables pertaining to the compensation of others in similar circumstances. The basic standard has been in the federal tax law for years; it is cited in the business expense regulations⁸² and the intermediate sanctions regulations⁸³ as follows: Reasonable compensation is that amount as would ordinarily be paid for like services by like enterprises under like circumstances. This alchemy—what the intermediate sanctions rules refer to as an accumulation and assessment of data as to comparability⁸⁴—yields the conclusion as to whether a particular item of compensation or a compensation package is reasonable or it is excessive.⁸⁵

Traditionally, the case law has dictated the criteria to be used in ascertaining the reasonableness of compensation. This approach has come to be known as utilization of the multifactor test. The elements—factors—to be utilized in a particular case can vary, depending on the court. (Even though the reasonableness of compensation is a matter of fact, the selection and application of the appropriate factors are a matter of law.) Much of the law in this field is based on case law concerning payments by for-profit corporations to their chief executives. This is because a payment of compensation, to be deductible as a business expense,⁸⁶ must be an ordinary and necessary outlay; the concepts of reasonable and ordinary and necessary are essentially identical.⁸⁷ Also, as will be discussed, the advent of the intermediate sanctions rules has greatly informed this aspect of the law of tax-exempt organizations.

The factors commonly applied in the private inurement setting (and similar settings) to ascertain the reasonableness of compensation are the levels of compensation paid by similar organizations (tax-exempt and taxable) for functionally comparable positions, with emphasis on comparable entities in the same community or region; the need of the organization for the services of the individual whose compensation is being evaluated; the individual's background, education, training, experience, and responsibilities; whether the compensation resulted from arm's-length bargaining, such as whether it was approved by an independent board of directors; the size and complexity of the organization, in terms of elements such as assets, income, and number of employees; the individual's prior compensation arrangement; the individual's performance; the relationship of the individual's compensation to that paid to other employees of the same organization; whether there has been a sharp increase in the individual's compensation (a spike) from one year to the next; and the amount of time the individual devotes to the position.⁸⁸

If the issue is litigated, the individual whose compensation is being challenged and the IRS are both likely to have expert witnesses, who produce reports and testimony incorporating some or all of these factors. The judge in the case is called on to determine whether there has been payment of excessive compensation. Most of these cases originate in the U.S. Tax Court. A federal court of appeals observed (articulating a fact that, until then, no court had ventured to mention), however, that the “judges of the Tax Court are not equipped by training or experience to determine the salaries of corporate officers; no judges are.”⁸⁹

This appellate court excoriated the multifactor test, characterizing it as “redundant, incomplete, and unclear.”⁹⁰ The test was found to “not provide adequate guidance to a rational decision.”⁹¹ Rather, wrote the court, the test to be applied when determining the reasonableness of an individual's compensation package paid by a for-profit business is the independent investor test.⁹² This test establishes a presumption that an executive's compensation is reasonable if the investors in the company (actual or hypothetical) believe that the return on their investment is reasonable, with the investment return percentage determined by an expert witness. This court proclaimed that, when these investors are obtaining a “far higher return than they had any reason to expect,” the executive's salary is “presumptively reasonable,” even if the compensation may otherwise be considered “exorbitant.”⁹³ Under this approach, the presumption can be rebutted if the government shows that, although the executive's salary was reasonable, the company “did not in fact intend to pay him [or her] that amount as salary, that his [or her] salary really did include a concealed dividend though it need not have.”⁹⁴ Also, according to this court, if the executive's salary is approved by the other owners of the corporation, who are independent of the executive—that is, who lacked an incentive to disguise a dividend as a salary—that approval “goes far” to rebut any evidence of “bad faith.”⁹⁵

It initially appeared that a federal court of appeals would use either the multifactor test or the independent investor test in determining the reasonableness of executive compensation. For example, a federal appellate court, considering this issue for the first time, elected to utilize the multifactor test.⁹⁶ In one instance, a court used the independent investor test to find an executive's compensation reasonable, portraying the individual as the “locomotive” of the company.⁹⁷ However, another federal court of appeals, in one of these cases, applied a multifactor test and then used the independent investor test to interpret one of the factors.⁹⁸ On another occasion, a court used the independent investor test to establish the presumption that an individual's compensation was reasonable, and then applied the multifactor test to rebut the presumption and determine that the compensation was unreasonable.⁹⁹ The independent investor test will not be applied in determining the reasonableness of the compensation of executives of tax-exempt organizations;¹⁰⁰ rather, ongoing application of that test will provide additional illustrations of use of the multifactor test.¹⁰¹

A large salary paid by a tax-exempt organization can be considered private inurement, particularly where the employee is concurrently receiving other forms of compensation from the organization (for example, fees, commissions, and/or royalties) and more than one member of the same family is compensated by the same organization.¹⁰² Thus, where the control of an organization was in two ministers whose contributions were its total receipts, all of which were paid to them as housing allowances, the exemption of the organization was revoked; the court said that the compensation was not “reasonable” although it may not be “excessive.”¹⁰³ Yet large salaries and noncash benefits received by an exempt organization's employees can be reasonable, considering the nature of their services and skills, such as payments to physicians by a nonprofit entity that was an incorporated department of anesthesiology of a hospital.¹⁰⁴

Another basis for finding private inurement is where the compensation paid annually is reasonable but the year-to-year increases of it are not justifiable. In one case, salary increases were found to be “abrupt,” resulting in a “substantial” amount of compensation, leading the court to the conclusion that the salaries were “at least suggestive of a commercial rather than nonprofit operation.”¹⁰⁵ Spikes in compensation amounts of this nature can also be seen in large bonuses.¹⁰⁶ Yet it is also possible to cast salary increases, abrupt or otherwise, as payments, in whole or in part, for prior years' services, where the executive was undercompensated in those years.¹⁰⁷

Other forms of compensation are subject to the private inurement doctrine. For example, although a court held that an excessive parsonage allowance may constitute private inurement,¹⁰⁸ the same court subsequently ruled that another parsonage allowance was “not excessive as a matter of law.”¹⁰⁹ The IRS revoked the tax-exempt status of a health care institution on the ground of several instances of private inurement, including various forms of compensation.¹¹⁰

(c) Percentage-Based Compensation

Some compensation arrangements are not fixed payments based on a salary, wage, or (perhaps) bonus but, in whole or in part, on a percentage of the tax-exempt organization's revenue. (In the intermediate sanctions setting, these forms of services are often revenue-sharing arrangements.)¹¹¹ The law on this point is unclear and inconsistent. In one case, a court held that a percentage compensation arrangement involving an exempt organization amounted to private inurement, because there was no upper limit as to total allowable compensation.¹¹² This court subsequently restricted the import of this decision when it held that private inurement did not occur when an exempt organization paid its president a commission determined by a percentage of the contributions obtained by him. The court in the second of these cases held that the standard is whether the compensation is reasonable, rather than the manner in which it is ascertained. Fundraising commissions that are “directly contingent on success in procuring funds” were held by this court to be an “incentive well suited to the budget of a fledgling [charitable] organization.”¹¹³ Another court subsequently introduced more confusion in this area when it ruled that “there is nothing insidious or evil about a commission-based compensation system” and thus that an arrangement by which those who successfully secured contributions for a charitable organization were paid a percentage of the gift amounts is “reasonable,” despite the absence of any limit as to an absolute amount of compensation (and despite the fact that the law requires compensation to be reasonable, not the percentage by which it is determined).¹¹⁴

The IRS will likely closely scrutinize compensation programs of tax-exempt organizations that are predicated on an incentive feature by which compensation is a function of revenue received by the organization, is guaranteed, or is otherwise outside the boundaries of conventional compensation arrangements. These programs—sometimes termed gainsharing arrangements—have developed largely in the health care context. For example, the IRS concluded that the establishment of incentive compensation plans for the employees of an exempt hospital, with payments determined as a percentage of the excess of revenue over a 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.¹¹⁵ Employing similar reasoning, the agency approved guaranteed minimum annual salary contracts pursuant to which physicians' compensation was subsidized so as to induce them to commence employment at a hospital.¹¹⁶ The IRS promulgated guidance concerning the tax law consequences of physician recruitment incentives.¹¹⁷

The agency has explored other forms of productivity incentive programs¹¹⁸ and contingent compensation plans.¹¹⁹ Outside the health care field, the IRS concluded that a package of compensation arrangements for the benefit of coaches of sports for schools, colleges, and universities, including deferred compensation plans, payment of life insurance premiums, bonuses, and moving expense reimbursements, did not constitute private inurement.¹²⁰ In one instance, the IRS approved of a “sharable income policy” by which a tax-exempt scientific research organization provided one-third of the revenue derived from patents, copyrights, processes, or formulas to the inventors and 15 percent of the revenue received from the licensing or other transfer of the organization's technology to valuable employees.¹²¹

(d) Multiple Payors

An individual may 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 must be made in the aggregate.

(e) Role of Board

The law surrounding the private inurement doctrine does not mandate any particular conduct by the governing board of a tax-exempt organization. The contemporary trend, however, is imposition by regulators of corporate governance principles that include involvement by these boards in transactions and arrangements that may have private inurement implications. For example, the IRS prefers that a board of directors or trustees of an exempt organization, particularly a charitable one, be involved in deciding the compensation amounts of at least an organization's key employees. The IRS also is actively encouraging the boards of exempt organizations to adopt conflict-of-interest policies, in part to help bring relationships that have the potential for private inurement to the fore.¹²²

(f) Board Member Compensation

The private inurement doctrine, to date, when applied to members of the board of a tax-exempt organization, tends to be focused on the compensation of board members for rendering services in an additional capacity, such as an officer or key employee. As the duties and responsibilities (and potential for liability) of exempt organization board members increases (due in part to emerging corporate governance principles),¹²³ so too does the propensity of board members to consider compensation for their services as board members. Also, some exempt organizations have board members who expend considerable time managing the affairs of the organization; these are becoming known as executive trustees. These practices are contrary to the culture of most charitable and many other types of exempt organizations; thus, there is little experience or documentation of compensation amounts in this context.¹²⁴

From the standpoint of the private inurement doctrine, the test again is whether such compensation is reasonable; nonetheless, inasmuch as this type of board member compensation is so uncommon, it is nearly impossible to gauge the reasonableness of this compensation by means of the multifactor test, which stresses comparables.¹²⁵ A federal court of appeals remanded a case, finding “clearly erroneous” the conclusion of the trial court that most of an individual's compensation was unreasonable, where the appellate court concluded that her services to a corporation were extensive and critical to its survival; the trial court had determined that her role in the affairs of the corporation was equivalent to that of “outside board chair.”¹²⁶

(g) Actuality of Services Rendered

Aside from the reasonableness of compensation, it is axiomatic 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 and kept the funds before earning commissions equal to or exceeding their advances.¹²⁷

(h) Illegal Payments

Aside from the matter of reasonableness, private inurement can arise where the payment of compensation is contrary to law. In one instance, the IRS revoked the tax-exempt status of an organization that was subject to the private inurement doctrine, where state law required workers in the particular field to be volunteers yet the organization nonetheless compensated them.¹²⁸

(a) Rental Arrangements

A tax-exempt organization subject to the doctrine of private inurement generally may lease property and make rental payments for the use of property in a transaction involving an insider. The rent payments, and other terms and conditions of the arrangement, must, however, be reasonable; the arrangement should be beneficial for the exempt organization. That is, an inflated rent amount favoring the insider is private inurement.¹⁴³ For example, an organization striving to be a tax-exempt church was ruled ineligible for exemption because a substantial portion of its revenue was paid to lease a currently unusable warehouse, to ultimately be used for religious purposes, from its president.¹⁴⁴

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

(b) Lending Arrangements

A loan involving the assets of a tax-exempt organization subject to the doctrine of private inurement, made to an insider, is likely to be closely scrutinized by the IRS. It is the view of courts that the “very existence of a private source of loan credit from an [exempt] organization's earnings may itself amount to inurement of benefit.”¹⁴⁵

The terms of this type of loan should be reasonable, that is, financially advantageous to the exempt organization (or at least not be disadvantageous) and should be commensurate with the organization's purposes (including investment policies).¹⁴⁶ The factors to be considered when assessing reasonableness in this setting include the duration of the indebtedness, the rate of interest paid, the security underlying the loan, and the amount involved—all evaluated in relation to similar circumstances in the commercial setting. If such a loan is not repaid on a timely basis, questions as to private inurement may well be raised.¹⁴⁷ Thus, for example, the tax exemption of a school 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.¹⁴⁸

A court found private inurement resulting from a loan where a nonprofit organization, formed to assume the operations of a school conducted up to that point by a for-profit corporation, required parents of its students to make interest-free loans to the corporation. Private inurement was detected in the fact that the property to be improved using the loan proceeds would revert to the for-profit corporation after a 15-year term; the interest-free feature of the loans was held to be an unwarranted benefit to individuals in their private capacity.¹⁴⁹ Earlier, this court found private inurement in a situation where a tax-exempt hospital made a substantial number of unsecured loans to a nursing home owned by the founding physician at below-market interest rates; this arrangement reduced his financial risk in and lowered the interest costs for the home.¹⁵⁰

(c) Sales of Assets

Another application of the private inurement doctrine involves the sale of assets of tax-exempt organizations to those who are insiders with respect to them. A charitable or other exempt organization may, for example, decide to sell assets relating to a 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 insiders (usually directors or officers). As with other manifestations of these transactions, they are not prohibited; the requirement is that their terms and conditions be reasonable.

An illustrative case identified some of the difficulties and complexities that can arise in this context. The matter concerned the sale of the assets of an exempt hospital to an entity controlled by insiders with respect to the hospital. The court concluded that the transaction gave rise to private inurement because the sale was not at arm's length, which caused the assets to be sold for less than their fair market value. The purchase price (as determined by the court) was $6.6 million; the court, noting an array of elements that either were not taken into account or were inadequately taken into account in arriving at the price, concluded that the fair market value of the hospital's assets was $7.8 million.¹⁵¹

The court, however, rejected the claim of the IRS that it is necessary to determine a “precise amount” representing the fair market value of property in a private inurement case.¹⁵² All that is required is an amount that is “sufficiently close to the fair market value of the property at the time of the sale.”¹⁵³ The court wrote that, when the amount is within a “reasonable range” of what could be considered fair market value, there cannot be private inurement.¹⁵⁴

An open issue is whether, in assigning a value to an item of property for private inurement purposes, a single valuation will suffice.¹⁵⁵ Moreover, there is no mandated valuation method. The IRS wrote that “no single valuation method is necessarily the best indicator of value in a given case.”¹⁵⁶ Yet the agency has signaled its preference for various appraisal methodologies in valuing property, observing in one instance that “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.”¹⁵⁷

(d) Capital Improvements

Some nonprofit organizations, principally those seeking public charity status, find themselves using real property provided by an insider, perhaps for little or no rent. This type of organization may intend, once recognition of exemption is obtained, to seek funding to make substantial capital improvements to the land. This type of property improvement constitutes private inurement, precluding tax exemption.¹⁵⁸

(e) Equity Distributions

With the emphasis of the federal tax law in the private inurement area on net earnings and the reference to private shareholders, the most literal and obvious form of private inurement is the parceling out of an exempt organization's net income to those akin to shareholders, such as members of its board of directors. It is rare, however, that private inurement is this blatant. In one instance, nonetheless, where the assets of a tax-exempt hospital relating to a pharmacy were sold to a corporation, which then sold pharmaceuticals to the hospital at higher prices, a court held that this practice amounted to the “siphoning off” of the hospital's income for the benefit of the corporation's stockholders.¹⁵⁹

A limited dividend housing corporation, under close supervision of a state, was denied tax exemption as a social welfare entity¹⁶⁰ because it was operated on a for-profit basis (the private inurement doctrine not being expressly applicable at the time).¹⁶¹ Similarly, a “sweat equity housing cooperative association,” formed to engage in restoration of historic properties, was denied recognition of exemption as a charitable entity because its board members held possessory interests in properties owned by the organization and were potentially eligible for cash distributions on dissolution.¹⁶²

In nearly all the states, nonprofit corporations may not be organized as entities with the ability to issue stock. Even in the few instances where tax-exempt organizations may have stockholders, the organizations may not pay dividends. In one instance, memberships in a tax-exempt hospital were found to not entitle the members to a beneficial interest in the capital or earnings of the hospital because the law of the state prohibited the corporation from paying any part of its income to members and required transfer of the assets on dissolution for charitable purposes.¹⁶³

(f) Assumptions of Liability

Generally, a tax-exempt organization can incur debt to purchase an asset at its fair market value, thereafter retire the debt with its receipts, and not thereby violate the private inurement proscription.¹⁶⁴ As is the case with the sale of an asset, however, if the purchase price for an asset acquired from an insider is in excess of the property's fair market value (debt-financed or not), private inurement may result.¹⁶⁵ In one instance, a nonprofit organization, in taking over operation of a school conducted by a for-profit corporation, assumed a liability for goodwill; this assumption was found to be private inurement because it was an excessive amount and benefited the owners of the corporation.¹⁶⁶

(g) Employee Benefits

A tax-exempt organization can provide reasonable compensation, including standard benefits, to its employees.¹⁶⁷ For example, a court found that payments for medical insurance are an “ordinary and necessary” expense of an exempt employer.¹⁶⁸ An organization may not be able to qualify as an exempt charitable one, however, where the provision of employee benefits is its purpose. For example, a trust created by an employer to pay pensions to retired employees failed to qualify as a charitable entity.¹⁶⁹ This would be the result where the recipients are still employees providing services, in part because they do not constitute a charitable class.¹⁷⁰ Thus, a foundation lost its tax-exempt status because it devoted its funds to the payment of the expenses of young performers employed by the foundation's founder, who was in show business.¹⁷¹ Organizations such as these may, however, qualify for tax exemption under other provisions of the federal tax law.¹⁷²

A school's tax exemption was revoked because, for one or more of its officers, it provided interest-free, unsecured loans, paid for household items and furnishings used in their residences, made scholarship grants to their children, paid personal travel expenses, paid their personal automobile expenses, paid the premiums on life and health insurance policies (where the premiums were not paid for other employees), and purchased season tickets for them to sports events.¹⁷³ Yet in another instance, a court concluded that the payment by a church of medical expenses for its minister and family did not constitute private inurement.¹⁷⁴

The IRS came around to the view that charitable and other tax-exempt organizations may establish profit-sharing and similar compensation plans without causing private inurement,¹⁷⁵ having earlier taken the position that the establishment of qualified profit-sharing plans resulted in per se private inurement.¹⁷⁶ This shift in position was based on the reasoning that the principles of qualification of pension and profit-sharing plans,¹⁷⁷ and the protections afforded by the Employee Retirement Income Security Act (enacted in 1974), are sufficient to ensure that operation of these plans would not jeopardize the tax-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 can, without jeopardy, maintain qualified profit-sharing plans,¹⁷⁸ and extended deferred compensation rules¹⁷⁹ to make them applicable to tax-exempt organizations.

Tax-exempt organizations may maintain the qualified cash or deferral arrangements known as 401(k) plans.¹⁸⁰ A charitable organization may maintain a tax-sheltered annuity program for its employees.¹⁸¹ In general, exempt organizations may pay pensions, where the terms are reasonable, to their retired employees without adversely affecting their exempt status.¹⁸²

(h) Tax Avoidance Schemes

Tax-exempt organizations can be used impermissibly as vehicles to avoid income taxation. In one instance, a physician transferred his medical practice and other assets to a controlled organization, which hired him to conduct “research,” which amounted to the ongoing examination and treatment of patients; recognition of exemption for this organization was denied.¹⁸³ In another case, an organization, ostensibly a church, was formed by a professional nurse, who was the organization's minister, director, and principal officer; the organization did not qualify as an exempt organization, the IRS ruled, because it “serve[d] as a vehicle for handling the nurse's personal financial transactions.”¹⁸⁴ In another instance, a court found that “tax avoidance” was a “substantial nonexempt purpose” of an organization, as evidenced by its promotional literature and seminars, and for that reason revoked the organization's exempt status.¹⁸⁵ In still another of these situations, an exempt organization founded and managed by an accountant had its exemption revoked because the accountant concealed receipts from his practice to avoid payment of federal income tax, by treating some payments as having been made to the charitable entity.¹⁸⁶

A court, unwilling to recognize an organization as a church because most of the organization's support was derived from the founder, whose living expenses were paid by the organization, wrote that private “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.”¹⁸⁷ Another “church” failed to gain exemption because of the transfer to it of funds used to furnish a sports car to its donor and pastor.¹⁸⁸

(i) Services Rendered

An organization whose primary purpose is to render services to individuals in their private capacity, generally cannot qualify as a tax-exempt, charitable entity. There are exceptions to this general rule, of course, such as where the individuals benefited constitute members of a charitable class, the individual beneficiaries are considered merely instruments or means for advancement of a charitable objective, or the private benefit involved is incidental and/or unavoidable.

This type of private inurement takes many forms and involves judgments in specific cases that are difficult to quantify or generalize. For example, even though furtherance of the arts can be a charitable activity, a cooperative art gallery that exhibited and sold only its members' works was ruled to be serving their private ends—a “vehicle for advancing their careers and promoting the sale of their work”—and hence to not be tax-exempt, notwithstanding the fact that the exhibition and sale of works of art may sometimes be an exempt purpose.¹⁸⁹ Similarly, although the provision 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 not qualify as a charitable organization.¹⁹⁰ Also, a school's exemption was revoked, in part because it awarded scholarships to the children of two of its officers yet did not make scholarship grants to anyone else.¹⁹¹

The provision of services to individuals, as precluded by the private inurement proscription, takes several forms. For example, an organization created to provide bus transportation for schoolchildren to a tax-exempt private school was ruled to not be eligible for exemption.¹⁹² 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. 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 and thus to not qualify for exemption.¹⁹³ Further, an organization that operated a subscription “scholarship” plan, by which “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.¹⁹⁴ Likewise, the furnishing of farm laborers for individual farmers, as part of the operation of a labor camp to house transient workers, was held to not be an agricultural purpose under the federal tax law but rather the provision of services to individual farmers that they would otherwise have to provide for themselves.¹⁹⁵ Also, a nonprofit corporation was deemed to be serving private purposes where it was formed to dredge a navigable waterway, little used by the public, fronting the properties of its members.¹⁹⁶ Further, an organization that provided travel services, legal services, an insurance plan, an antitheft 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.¹⁹⁷ Moreover, an organization was denied 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.¹⁹⁸

Charitable organizations frequently provide services to individuals in their private capacity when they dispense financial planning advice in the context of designing major gifts. This type of personal service made available by tax-exempt organizations has never been regarded as jeopardizing the organizations' tax exemption, when undertaken by institutions such as churches, universities, colleges, and hospitals. The IRS, however, refused to accord tax 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 that subsequently heard the case upheld the agency's position, finding that tax planning is not an exempt activity (which, of course, it is not—outside of this context) and that the primary effect of the advice is to reduce individuals' liability for income taxes—a private benefit.¹⁹⁹ The court rejected the contention that the organization was merely doing what the subscribing members can do for themselves without endangering their tax exemption: fundraising.

The private inurement proscription may apply not only to individuals in their private capacity but also to corporations, 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.²⁰⁰ 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 operating primarily to serve the private interests of its creators and thus not be tax-exempt.²⁰¹ Further, an association of professional nurses that operated a nurses' registry was held to be affording greater employment opportunities for its members and thus to be substantially operating for private ends.²⁰² A nonprofit organization organized and operated to provide scholarships to students to enable them to enroll in online educational study and coursework programs that prepare the students to earn higher education credits was denied recognition of exemption, in part because the programs were conducted by a related for-profit business; the business was said to be “in a position to profit from” this arrangement.²⁰³ A court held that a genealogical society, the membership of which was composed of persons interested in the migration of individuals with a common name to and within the United States, failed to qualify as an exempt charitable entity on the ground that its activities served the private interests of its members.²⁰⁴

Following this court's holding, the IRS acted to contain the reach of the decision. The agency 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.²⁰⁵ By contrast, the IRS also ruled that an organization cannot qualify as a charitable or educational entity where its membership is 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.²⁰⁶

(j) Business Referral Operations

A nonprofit organization may seek recognition of exemption, usually as an educational entity, where, although it provides some educational benefits, its principal purpose is to serve as a means for generating business opportunities for its insiders. For example, an organization represented to the IRS that its educational activity was the conduct of workshops to provide first-time home buyers with information to help them achieve home ownership in an informed manner. In fact, the entity was operated by a team consisting of two real estate agents, a mortgage banker, an insurance agent, and a lawyer. No fee was charged for the workshops; the operation was funded by the team members. Finding the organization to be a “medium to enrich the private businesses” of its insiders, the IRS found private inurement as the consequence of “client referrals” to the insiders' “private business ventures.”²⁰⁷

Likewise, an organization providing services for foreclosure mitigation was found by the IRS to be a “conduit” linking potential customers to its founders in the nature of a “consulting referral service.”²⁰⁸

(k) Provision of Goods or Refreshments

A tax-exempt organization subject to the private inurement doctrine cannot have as its primary purpose the provision of goods or refreshments (in the nature of social or recreational activities) to individuals in their private capacity. Of course, an organization of this nature may incidentally bear the expense of meals, refreshments, and the like (such as working luncheons and annual banquets), 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.”²⁰⁹ 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 to not be tax-exempt, inasmuch as 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.”²¹⁰

(l) Retained Interests

A charitable organization may not be organized so that one or more individuals retain a reversionary interest, by which the principal would flow to an individual on the entity's dissolution or liquidation; instead, in this event, net assets and income must be transferred to one or more other charitable or governmental entities.²¹¹

By contrast, a charitable organization may, in appropriate circumstances, accept an asset subject to a life estate or other income interest for one or more individuals; the fact that only a charitable remainder interest is acquired is not private inurement. Thus, there are bodies of law concerning permissible partial interest gifts to charitable organizations of income and remainder interests.²¹² Likewise, annuity payments made in exchange for a gift of property are not a form of private inurement to the annuitants, inasmuch as the payment of the annuity merely constitutes satisfaction of the charge on the transferred asset.²¹³

(m) Embezzlements

Private inurement does not occur when an insider steals money from a charitable or other tax-exempt organization (even though the insider has derived an economic benefit from the entity). In a case where insiders stole proceeds from a charity's bingo games, private inurement was not found. The court wrote: “[W]e do not believe that the Congress intended that a charity must lose its exempt status merely because a president or a treasurer or an executive director of a charity has skimmed or embezzled or otherwise stolen from the charity, at least where the charity has a real-world existence apart from the thieving official.”²¹⁴ It would be anomalous, indeed, for an exempt organization to suffer the loss and indignity of an embezzlement, only to then incur additional suffering in the form of revocation of its exemption because it was the victim of the crime.²¹⁵

(n) Other Forms of Inurement

Promotion of the career advancement of an individual (an insider) within a nonprofit entity was ruled by the IRS to be a form of private inurement; an entity seeking classification as a charitable and religious organization was supporting the candidacy of its pastor for the position of bishop of a church.²¹⁶ The IRS denied recognition of tax exemption to an organization, in part on the ground that it was engaging in activities constituting unwarranted private benefit;²¹⁷ because members of this entity's governing board were recipients of this benefit, the IRS converted the private benefit to private inurement.²¹⁸

(a) General Rules

The private benefit doctrine differs from the private inurement doctrine in two significant respects. One is that the law formally recognizes the concept of incidental private benefit—that is, types of private benefit that will not cause loss or denial of tax-exempt status.²⁹⁹ The other is that the private benefit doctrine is applied in the absence of undue benefit to insiders.³⁰⁰ As to the latter, a court noted that the private benefit doctrine embraces benefits provided to “disinterested persons.”³⁰¹ Subsequently, this court wrote that impermissible private benefit can be conferred on “unrelated” persons.³⁰² As the IRS characterized the point, the private benefit doctrine applies to “all kinds of persons and groups.”³⁰³

A principal case in the private benefit context concerned an otherwise tax-exempt school that trained individuals for careers as political campaign professionals. Nearly all of the school's graduates became employed by or consultants to Republican Party organizations or candidates. A court ruled that this school could not be exempt because it was substantially benefiting the private interests of these entities and candidates, in the form of secondary private benefit flowing to those who hired the graduates.³⁰⁴ The school unsuccessfully presented as precedent several IRS rulings holding tax-exempt, as educational organizations, entities that provide training to individuals in a particular industry or profession.³⁰⁵ The court accepted the IRS's characterization of these rulings, which was that the “secondary benefit provided in each ruling was broadly spread among members of an industry…, as opposed to being earmarked for a particular organization or person.”³⁰⁶ The court said that the secondary benefit in each of these rulings was, because of the spread, “incidental to the providing organization's exempt purpose.”³⁰⁷

The IRS has been advancing the private benefit doctrine as well. The most striking recent example of this was application of the doctrine, for the first time, in the private foundation setting. An individual requested access to an archive of materials held by a foundation, concerning a distant and famous relative who had recently died, for the purpose of writing a book about the decedent. The book project was to be a commercial one; the foundation was not to be compensated for the author's use of the collection. The IRS ruled that, although provision of the materials to the author would not constitute self-dealing,³⁰⁸ because the individual was not a disqualified person,³⁰⁹ it would amount to substantial private benefit, which could endanger the tax-exempt status of the private foundation.³¹⁰

The private benefit doctrine is sometimes applied in connection with activities involving an organization's members. (These individuals, as such, are rarely insiders with respect to an organization.) In one instance, the IRS concluded that an organization that functioned as a “bartering exchange” could not qualify for exemption because it was operated only for the private benefit of its members.³¹¹ Likewise, an organization failed to gain recognition as a tax-exempt charitable organization in part because its extensive social and networking activities, its mentoring and scholarship programs (where only members or their family members were eligible recipients), and the fact that it charged nonmembers more than its members for its events were considered forms of private benefit to the members.³¹² Similarly, a nonprofit organization, formed to provide training to softball and baseball umpires, and to coordinate games and tournaments, was also involved in assigning umpires to games and promoting ethical standards among baseball officials; this organization was denied recognition of exemption as a charitable or educational entity, in part because it was serving the private interests of the umpires, who are compensated for their services.³¹³

Although tax-exempt charitable organizations may permissibly provide benefits to persons in their private capacity, benefits of this nature must—to avoid jeopardizing exempt status—be incidental both quantitatively and qualitatively in relation to the furthering of exempt purposes. To be quantitatively incidental, the private benefit must be insubstantial, measured in the context of the overall exempt benefit conferred by the activity.³¹⁴ To be qualitatively incidental, private benefit must be a necessary concomitant of the exempt activity, in that the exempt objectives cannot be achieved without necessarily benefiting certain individuals privately.³¹⁵

(b) Incidental Private Benefit

As noted, the federal tax law recognizes the concept of incidental private benefit, that is, private benefit that does not jeopardize or preclude a charitable organization's tax exemption.³¹⁶

As an illustration, a tax-exempt charitable organization that allocated Medicaid patients to physicians in private practice was held to provide qualitatively and quantitatively incidental private benefit to the physicians, including some on the organization's board of directors (where the private inurement rules would properly come into play), inasmuch as it was “impossible” for this organization to accomplish its exempt purposes without providing some measure of benefit to these physicians.³¹⁷ Likewise, an exempt hospital received a ruling that it, having constructed new facilities, had the only economically viable alternative of transferring its prior facilities to an unrelated for-profit organization, at a below-market price, for the purpose of leasing space in the renovated facility to community businesses; the IRS held that this rental activity would create new jobs in the hospital's economically depressed community³¹⁸ and entail only incidental economic benefit to the for-profit company.³¹⁹ Similarly, the IRS ruled that an exempt hospital's investment in a for-profit medical malpractice insurance company, using funds paid by its staff physicians, furthered charitable purposes³²⁰ and was deemed to not extend impermissible private benefit, because the investment was required for the writing of insurance for the physicians, the physicians needed the insurance to practice at the hospital, and the hospital needed the physicians to provide health care services in its communities.³²¹

Likewise, the IRS held that a supporting organization operating for the benefit of a tax-exempt college³²² may make grants to a capital fund for advancement of a business incubator program, with the business thus created contributing importantly to the college's teaching program; the benefit conferred to the companies by the incubator investments was considered incidental to the advancement of the college's educational purposes.³²³ A public charity that educated the public about the history and architecture of a cemetery was allowed to participate in a burial lot exchange with a donor, with the IRS observing that “any benefit to the donor in connection with the exchange will not lessen the public benefits” flowing from the organization's operations, and dismissing any adverse application of the private benefit doctrine.³²⁴ The IRS announced that it does not treat the benefits an exempt hospital provides to its medical staff physicians—in the form of electronic health records software and technical support services—as impermissible private benefit if the benefits fall within the range of electronic health records items and services that are allowable under Department of Health and Human Services regulations, and if the hospital operates in a certain manner.³²⁵ The IRS began issuing favorable ruling letters to regional health information organizations after being reassured by Congress that the private benefit necessarily involved was incidental.³²⁶

Also, a research agreement between an exempt scientific organization and a for-profit business was held to not jeopardize this tax exemption because the resulting private benefit, to overlapping directors involving the exempt organization and another for-profit business, was considered by the IRS to be incidental in relation to the benefit accruing to the scientific organization.³²⁷ The IRS's lawyers ruled that construction and maintenance of a recreational path on an island was charitable activity, with any resulting private benefit accruing to the residents of the island and a private corporation owning property there dismissed as being incidental.³²⁸ The IRS ruled, in connection with the operations of a regional health information organization,³²⁹ that the participating physicians' access to a database and clinical quality reports confer private benefit on the physicians that is “qualitatively incidental because those benefits are a necessary concomitant of the activities that benefit the general public.”³³⁰ A public charity's administrative services agreement with a for-profit corporation was ruled to provide only incidental private benefit to the corporation, which provides the charity with seconded employees, because the corporation does not control the charity, the minuscule amount of business to the corporation, and the corporation's waiver of fees.³³¹ The IRS ruled that a public charity may restore a tax-exempt social club's historic building, where the public will be given substantial access to the facility, with the resulting private benefit to the club and its members being incidental.³³² In what appears to be its most generous interpretation of incidental private benefit, the IRS ruled that a public charity may provide its research results to a major for-profit global media corporation for fees, format the information specifically for the company, license rights to derivative works to the company, allow the company to use the charity's information for its internal business purposes, agree to not deliver information to the company's competitors, and agree that the company may have a perpetual license to use the information, with this package of private benefits considered incidental.³³³

By contrast, a nonprofit organization was formed to generate community interest in retaining classical music programming on a commercial radio station, by seeking sponsors for the programs, urging listeners to patronize the sponsors, and soliciting listener subscriptions to promote the programs; the IRS ruled that the organization could not qualify for tax exemption as a charitable and educational entity because these activities increased the station's revenues and thus benefited it in more than an insubstantial manner.³³⁴ Likewise, an inventor was ruled to receive unwarranted private benefit when he licensed a patent on one of his inventions to a would-be charitable organization, which would then employ him; the organization was seen by the IRS as merely a vehicle to enable him to complete his work on the patent and thereafter be “richly compensated.”³³⁵ Similarly, an organization formed to improve the quality of health care available to consumers, with its first priority being promotion of adoption of standardized performance measures of health care quality and efficiency, was ruled by the IRS to not constitute an exempt charitable and educational entity in part because it was characterized as a “cooperative enterprise” that primarily benefited its members, who were large for-profit businesses and health care insurance companies.³³⁶ Also, the IRS ruled that a nonprofit organization, by allowing its members to advertise and sell property in its magazine, was operating for their private benefit.³³⁷ An organization participating in a “health delivery network,” where it “merely facilitate[d] negotiations between physicians on the medical staff [of its member hospital] to provide physician medical services to consumers,” was held to be “serving private interests” by operating primarily for the benefit of the physicians.³³⁸ A nonprofit organization was ruled to be in violation of the private benefit doctrine where its purpose was provision of scholarships for students attending an art academy, as well as funding acquisition of equipment for the school; the academy was structured as a for-profit entity.³³⁹ Unwarranted private benefit was also found where a scholarship-granting organization was making grants only to members of one family; a court allowed revocation of this entity's tax exemption.³⁴⁰

Courts can be overly exuberant when applying the private benefit doctrine, in slipping past the element of the law that incidental private benefit is permissible. This point was nicely illustrated in the case of a sports booster club that lost its tax exemption in part because a court found unwarranted private benefit to the children participating in the sports program because the club facilitated fundraising by their parents to help defray competition costs.³⁴¹ The offensive private benefit amounted to about $33,000 accorded to 110 families—$300 per family.

The private benefit doctrine is nearly boundless.³⁴² The doctrine's use by the IRS is pliant; the IRS can be generous in dismissing private benefit as incidental. Yet when the agency embarks on a massive campaign to eradicate tax exemption in a particular field, such as exemption for employee hardship assistance funds,³⁴³ credit counseling organizations,³⁴⁴ housing provider entities,³⁴⁵ or down payment assistance organizations,³⁴⁶ the IRS will swiftly and strictly apply the private benefit doctrine.

(c) Joint Venture Law

The private benefit doctrine has been repeatedly invoked in a line of cases concerning the involvement of tax-exempt charitable organizations in partnerships and other joint ventures. The IRS has an ongoing concern that some of these ventures may constitute a means for conferring unwarranted private benefit on nonexempt participants. The agency initially lost these cases, but recently its victories have propelled the private benefit doctrine into one of the major elements of the law of tax-exempt organizations.³⁴⁷

Originally the IRS was of the view that involvement by a tax-exempt charitable organization as a general partner in a limited partnership would automatically lead to revocation of its exempt status, irrespective of the organization's purpose for joining the venture. This per se rule³⁴⁸ surfaced when the IRS ruled that participation by a charitable organization in a partnership, where the organization would be the general partner and private investors would be limited partners, would be inconsistent with eligibility for exempt status in that private economic benefit would flow to the limited partners. The agency wrote that, if the charity “entered [into] the proposed partnership, [it] would be a direct participant in an arrangement for sharing the net profits of an income producing venture with private individuals and organizations of a noncharitable nature.” By serving as the general partner in the project, the IRS said, the charity would be furthering the “private financial interests” of the limited partners, which would “create a conflict of interest that is legally incompatible with [the charity] being operated exclusively for charitable purposes.”³⁴⁹ This was the position of the IRS, even though the purpose of the partnership was to advance a charitable objective—the development and operation of a low-income housing project.

The per se rule was followed again the next year, when the IRS issued an adverse ruling to a charitable organization that was the general partner in a limited partnership, also created for the purpose of maintaining a low-income housing development. As before, the agency declared that the organization was a “direct participant in an arrangement for sharing the net profits of an income producing venture” with private individuals, so that the organization was “further[ing] the private financial interest of the [limited] partners.”³⁵⁰ The organization took the matter to court; the case was settled.³⁵¹

Another IRS ruling, concerning whether certain fees derived by a tax-exempt lawyer referral service were items of unrelated business income,³⁵² reflected this IRS position. The agency ruled that, while flat counseling fees paid by clients and registration fees paid by lawyers were not taxable, the fees paid by lawyers to the organization based on a percentage of the fees received by the lawyers for providing legal services to clients referred to them constituted unrelated business income. The reason: The subsequently established lawyer-client relationship was a commercial undertaking, and the ongoing fee arrangement with the percentage feature placed the exempt organization in the position of being in a joint venture in furtherance of these commercial objectives.³⁵³

The first of the court decisions concerning a charitable organization in a joint venture sanctioned the involvement of a charitable organization as a general partner in a limited partnership. The case concerned an arts organization that, to generate funds to pay its share of the capital required to produce a play with a tax-exempt theater, sold a portion of its rights in the play to outside investors, utilizing the limited partnership. The arts organization was the general partner, with two individuals and a for-profit corporation as limited partners. Only the limited partners were required to contribute capital; they collectively received a share of the profits or losses resulting from the production. In disagreeing with the IRS's position that the organization, solely by involvement in the limited partnership, was being operated for private interests, the court noted that 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 contributions made by the limited partners, the limited partners lacked control over the organization's operations, and none of the limited partners nor any officer or director of the for-profit corporation was an officer or director of the arts organization.³⁵⁴

Around that same time, the IRS approved an undertaking between a tax-exempt blood plasma fractionation facility and a commercial laboratory, by which the parties acquired a building and constructed a blood fractionation facility. This arrangement enabled the facility to become self-sufficient in its production of blood fractions, to reduce the cost of fractionating blood, and thus to be able to more effectively carry out its charitable blood program. Each party had an equal ownership of, and shared equally in the production capacity of, the facility. The IRS concluded that the exempt organization's participation in this venture was substantially related to its exempt purposes and that there was no private benefit.³⁵⁵

One of the most significant of the private benefit court cases³⁵⁶ concerned the matter of whole-entity joint ventures, where a health care facility places its entire operations in a venture with a for-profit entity, perhaps ceding authority over all of its resources to the co-venturer.³⁵⁷ A fundamental concept in this context is control, with the IRS and the courts examining relationships between public charities and for-profit organizations to ascertain whether the former have lost control of their facilities and programs to the latter. Examples include relationships reflected in management agreements, leases, fundraising contracts, and, of course, partnership, limited liability company, or other joint venture agreements.³⁵⁸ In this setting, it can be irrelevant if the public charity is in fact engaging substantially in exempt activities³⁵⁹ and if fees (if any) paid by the exempt organization to a for-profit entity are reasonable.³⁶⁰

The sweeping rule of law in this regard was articulated, in one of the two most extreme of these cases, by a federal court of appeals, which wrote that the “critical inquiry is not whether particular contractual payments to a related for-profit organization are reasonable or excessive, but instead whether the entire enterprise is carried on in such a manner that the for-profit organization benefits substantially from the operation of” the tax-exempt organization.³⁶¹

In the other of these cases, two for-profit corporations that did not have any formal structural control over the nonprofit entity whose tax exemption was at issue nevertheless were found to have exerted “considerable control” over its activities.³⁶² The trial court, in this case, concluded that the nonprofit organization was “part of a franchise system which is operated for private benefit and…its affiliation with this system taints it with a substantial commercial purpose.”³⁶³ The “ultimate beneficiaries” of the nonprofit organization's activities were found to be the for-profit corporations; the nonprofit organization was “simply the instrument to subsidize the for-profit corporations and not vice versa.”³⁶⁴ The nonprofit organization was held to not be operating exclusively for charitable purposes.

As an example of application of this opinion, an organization providing health care services was denied recognition of exemption because it was “effectively controlled” by two for-profit medical practices and because the provision of the services “enhances these businesses [the medical practices] and improves their reputation in the community.”³⁶⁵ In another illustration, an organization was denied recognition of exemption because it was “totally dependent” on its for-profit creator for material and operations, the two entities are “functionally inseparable,” and the organization “ceded control to a for-profit [organization] that has an independent financial interest in your activities and no obligation to operate for exempt purposes.”³⁶⁶

Matters worsen in this context when there is actual control. This is the principal message of the decision concerning whole-entity joint ventures. In that case, a tax-exempt subsidiary of a public charity (hospital) became a co–general partner with a for-profit organization in a partnership that owned and operated a surgery center. A for-profit management company affiliated with the for-profit co–general partner managed the arrangement. The subsidiary's sole activity was participation in the partnership. The court termed this relationship “passive participation [by the charitable subsidiary] in a for-profit health-service enterprise.”³⁶⁷ The court concluded that it was “patently clear” that the partnership was not being operated in an exclusively charitable manner. The income-producing activity of the partnership was characterized as “indivisible” between the nonprofit and for-profit organizations. No “discrete part” of these activities was “severable from those activities that produce income to be applied to the other partner's profit.”³⁶⁸

The heart of the whole-entity joint venture decision is this: To the extent a public charity “cedes control over its sole activity to for-profit parties [by, in this case, entering into the joint venture] having an independent economic interest in the same activity and having no obligation to put charitable purposes ahead of profit-making objectives,” the charity cannot be assured that the partnership will in fact be operated in furtherance of charitable purposes.³⁶⁹ The consequence is the conferring on the for-profit party in the venture “significant private benefits.”³⁷⁰ In application of this decision, the IRS refused to recognize exemption in a case of a nonprofit corporation with four directors who were also the directors of a for-profit entity; the IRS ruled that the nonprofit entity was “totally dependent upon your for-profit creator” and that it “ceded control” to the for-profit company.³⁷¹

Overall, today, a tax-exempt charitable organization can participate as a general partner in a limited partnership without endangering its exempt status, if the organization is serving a charitable purpose by means of the partnership, the organization is insulated from the day-to-day responsibilities as general partner, and the limited partners are not receiving an undue economic benefit from the partnership.³⁷²

(d) Perspective

The IRS is making much of the private benefit doctrine. Indeed, the agency has evolved to the point where the doctrine may be more significant to it than the private inurement doctrine, writing that “inurement is a subset of private benefit.”³⁷³ Two examples illustrate this phenomenon. The agency is of the view that private benefit is present when the founders of an otherwise tax-exempt school also are directors of a for-profit company that manages the school; the nature of the benefit is largely financial, and the IRS asserted that the educational activities of the school could be undertaken without conferring the benefit (such as by use of employees or volunteers).³⁷⁴ It also believes that certain scholarship-granting foundations are ineligible for exemption, by reason of the private benefit doctrine, because the recipients are individuals who are participants in beauty pageants operated by exempt social welfare organizations; private benefit is thought to be bestowed on the social welfare organizations because the grant programs serve to attract contestants to enter the pageants and on the for-profit entities that are corporate sponsors of the pageants.³⁷⁵

In other instances of application of the private benefit doctrine, the IRS ruled that a public charity engaging in litigation activities in furtherance of its exempt purposes should have its exemption retroactively revoked because the law firm it used acted independently of the organization and received what was deemed to be excessive contingent fees.³⁷⁶

The IRS promulgated regulations that include examples of application of the private benefit doctrine.³⁷⁷ One example concerns an educational organization whose purpose is to study history and immigration; the focus of this entity's studies is the genealogy of one family, tracing the descent of its current members. It solicits for membership only individuals who are members of this family. Its research is directed toward publishing a history of this family that will document the pedigrees of family members. A major objective of the research is to identify and locate living descendants of this family to enable them to become acquainted with each other. These educational activities primarily (according to the example) serve the private interests of members of a single family. This is held to be a violation of the private benefit doctrine; thus, this organization does not qualify for exemption as an educational entity.³⁷⁸

Another example pertains to a museum whose sole activity is exhibition of art created by a group of unknown but promising local artists. The museum's board members are unrelated to the artists whose work is exhibited. The art is for sale at prices set by the artists; the artists have a consignment agreement with the museum, pursuant to which the artist receives 90 percent of the sales price. This, too, is a transgression of the private benefit doctrine, precluding exemption.³⁷⁹

The third of these examples involves an educational organization whose purpose is to train individuals in a program developed by its president. A for-profit company owned by this individual owns the rights to this program. Prior to the existence of the educational entity, the for-profit company conducted the training function. The educational organization licenses rights to the program in exchange for the payment of royalties. The educational entity may develop course materials, but they must be assigned to the for-profit company without consideration if the license agreement is terminated. This arrangement is said to constitute substantial private benefit conferred on the organization's president and the for-profit company, barring tax exemption for the educational organization, even if the royalty amounts are reasonable.³⁸⁰

The courts had traditionally applied the private benefit doctrine only to situations involving charitable organizations. Over the decades, the IRS had done the same. In 2004, however, the IRS suggested that the private benefit doctrine is applicable with respect to tax-exempt status for social welfare organizations.³⁸¹ This position was asserted four times in 2011³⁸² and five times in 2012.³⁸³ Therefore, the agency could take the position that this doctrine is applicable with respect to exempt business leagues and similar organizations.

A decision from the U.S. Tax Court, issued in 2000, is of considerable interest (and should be of immense concern) to the association community, in that it invoked the private benefit doctrine in connection with a “foundation” seeking recognition of exemption that was related to a tax-exempt business league.³⁸⁴ The court held that a nonprofit organization that audited structural steel fabricators in conjunction with a quality certification program conducted by a related trade association did not constitute a charitable organization that lessens the burdens of government, and yielded private benefit to the association and to the fabricators who were inspected. This was the first court case in which the private benefit doctrine was applied with respect to a benefit conferred on a tax-exempt, noncharitable organization.³⁸⁵

Another recent phenomenon is that the IRS is beginning to conflate the private inurement and private benefit doctrines, leading to confusing (and incorrect) outcomes. For example, the long-standing rule is that a tax-exempt organization, subject to the private inurement doctrine, may pay compensation to an insider as long as the compensation is reasonable.³⁸⁶ But, in one instance, even though that rule was satisfied, the IRS still found private inurement because this “arrangement relieves [the insider] of the time, effort, and expense of seeking employment from an unrelated employer.”³⁸⁷ Similarly, the rule is that an exempt organization may lease property from an insider, as long as the rental arrangement is reasonable.³⁸⁸ Yet, even though that rule was satisfied, the IRS nonetheless found private inurement because the arrangement relieved the insider of the “expense of marketing the facility to an unknown, unrelated tenant.”³⁸⁹ Likewise, in connection with a set of facts that clearly warranted application of the private inurement doctrine (and thus the standard of reasonableness), the IRS found private benefit in that a nonprofit organization that will conduct research may contract for services with a for-profit company operating in the same field, where the owner of the company is the founder of the nonprofit entity.³⁹⁰ Also, in connection with an organization that had its exempt status as a charity revoked because it was not a conservation easement-enforcing entity but a “conduit” for its president (an accountant) to help his clients claim “sizeable” charitable deductions, the IRS applied the private benefit doctrine in connection with the officer and the clients, even though the private inurement doctrine should have been applied in conjunction with the president.³⁹¹

Traditionally, then, the private benefit doctrine has been largely applied in cases concerning relationships between public charities and individuals. The application of this doctrine, however, is being expanded to encompass arrangements between charitable organizations and for-profit entities and between charitable organizations and other categories of tax-exempt organizations.³⁹²

The IRS frequently issues rulings denying recognition of, or revoking, tax exemption on the basis of the private benefit doctrine.³⁹³