Private Benefit vs. Private Inurement Explained

Tax-exempt organizations are granted a privileged status because they operate to serve a public good. To maintain this status, particularly for charities under Section 501(c)(3) of the Internal Revenue Code, their activities must primarily benefit the community, not private interests. The Internal Revenue Service (IRS) enforces this public-service requirement through two distinct but related legal principles: the private inurement prohibition and the private benefit doctrine. Both rules prevent the diversion of charitable assets for private gain, but they apply to different situations and have different thresholds for violation. Understanding the difference is important for anyone involved with a tax-exempt organization.

The Private Inurement Prohibition

The prohibition against private inurement is a strict rule stating that no part of an organization’s net earnings may benefit any private shareholder or individual. This rule targets transactions with individuals who have a significant relationship with the organization and can influence its decisions for personal gain. These individuals are referred to by the IRS as “insiders” or, in the context of penalty taxes, “disqualified persons.”

An insider is anyone with a personal and private interest in the organization’s activities and a position of influence. This category includes the organization’s board members, officers, and key employees, who are often defined as those with substantial responsibilities. The definition also extends to substantial contributors, their family members, and any corporation or partnership in which insiders collectively own more than a 35% interest.

Inurement occurs when an insider receives financial benefits from the organization that are not in furtherance of its exempt mission. A common example is paying unreasonable compensation, where an executive’s salary is significantly above fair market value. Other examples include selling assets to an insider below fair market value, leasing property from an insider at an inflated rate, or making loans to insiders at below-market interest rates.

The private inurement prohibition is absolute. There is no acceptable minimum amount of inurement, as even a small amount diverted to an insider can trigger a violation. The IRS applies a zero-tolerance standard, meaning any transaction with an insider must be conducted at arm’s length and be fair to the organization.

The Private Benefit Doctrine

The private benefit doctrine is broader than inurement and stems from the requirement that a 501(c)(3) organization must operate exclusively for exempt purposes. This means it must serve a public rather than a private interest. While the inurement rule focuses on insiders, the private benefit doctrine applies to benefits given to any private individual or for-profit entity, regardless of their relationship to the nonprofit.

The core of the private benefit doctrine is a “substantiality test.” A private benefit is only a violation if it is considered more than “insubstantial” in the context of the organization’s overall activities. This is a qualitative and quantitative assessment where the IRS weighs the public benefit derived from an activity against the private benefit it confers.

A private benefit that is a necessary and incidental byproduct of a larger public-serving activity is permissible. To be incidental, the benefit to a private party must be a necessary consequence of an activity that furthers the exempt purpose, and it must be insubstantial in amount compared to the public benefit. For example, a nonprofit that restores a historic building’s facade provides an incidental benefit to nearby businesses through increased foot traffic, which is acceptable.

A violation occurs when the private benefit becomes the primary focus. For instance, if a nonprofit formed to clean a river focuses its efforts almost exclusively on the section fronting a single real estate developer’s property, the IRS might find a substantial private benefit. Even with the public benefit of a cleaner river, the disproportionate gain for the developer could jeopardize the organization’s tax-exempt status.

Consequences and Penalties

Violating the prohibitions against private inurement and private benefit can lead to significant consequences. These enforcement actions are designed to protect charitable assets and ensure organizations adhere to their public-serving missions. The outcomes range from financial penalties on individuals to the revocation of tax-exempt status.

For a private inurement violation, the most significant consequence is the revocation of the organization’s 501(c)(3) status. Because revocation can harm the public by dissolving a charity for the actions of a few, Congress also created “intermediate sanctions” under Internal Revenue Code Section 4958. These sanctions allow the IRS to penalize the individuals involved directly without necessarily revoking the organization’s exemption.

The initial tax on the insider who received the benefit is 25% of the excess benefit amount. If the transaction is not corrected by repaying the organization, an additional tax of 200% is imposed. Organization managers, such as directors or officers, who knowingly participated in the transaction can also face a tax of 10% of the excess benefit, capped at $20,000 per transaction.

For a violation of the private benefit doctrine, the sole remedy is the revocation of tax-exempt status. This is because if a substantial part of an organization’s activities serves private interests, it no longer operates exclusively for exempt purposes. Intermediate sanctions do not apply in a pure private benefit case because they are designed for transactions involving insiders. However, if the person receiving the benefit is also an insider, the IRS could apply them.