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Understanding Private Inurement And How It Impacts Your Nonprofit

Understanding Private Inurement and How It Impacts Your Nonprofit

Inurement is one of those terms a lot of nonprofit board members may be unfamiliar with, yet it strikes a chord with the IRS – and not in a good way.

The IRS has strict rules about nonprofits giving away their earnings to private shareholders or any individual.

Allegations of private inurement can occur at any time, but they commonly happen when an executive leaves a nonprofit’s service if the nonprofit gives them an excessive severance package.

To avoid problems with the IRS and protect the nonprofit’s reputation, nonprofit board members must understand the limitations in the 501(c)(3) law, especially as they pertain to private inurement.

Understanding Inurement in the 501(c)(3) Law

To understand why private inurement is troublesome for the IRS, you have to consider the government’s original goal and intent for nonprofits. The purpose of nonprofits is to improve the quality of life for people in a community. It’s not the the government’s intention to advance anyone’s private or financial gain. Rather, the overarching goal is to advance the public interest.

A notable part of the 501(c)(3) law states:

“The organization must not be organized or operated for the benefit of private interests, and no part of a section 501(c)(3) organization’s net earnings may inure to the benefit of any private shareholder or individual.”

That statement directly defines private inurement. Inurement isn’t a term that people use every day or even around the water cooler. In layman’s terms, it means that a nonprofit organization may not use its income or assets to directly or indirectly benefit an individual that has a close relationship with the nonprofit. Private inurement also applies to people who can effectively exercise significant control over the organization.

The portion of the 501(c)(3) statute that speaks about inurement was designed to prevent insiders from controlling the organization, thus defeating the purpose of having an entire board making decisions.

The IRS is concerned about two types of control:

  1. Direct control – refers to direct control as enacted by a board director, high-level manager, founder, major donor, highest-paid employees, or family members of influential people within the nonprofit.
  2. Indirect control – refers to control over others who are officers, directors, or those who have a strong influence over decision-making.

The IRS will cast a critical eye any time a nonprofit channels funds or assets to benefit an organization’s insiders, directly or indirectly. Simply put, nonprofits aren’t allowed to distribute profits for the private benefit to anyone who has control over the organization.

Understanding Essential Terms in Conjunction with Private Inurement

Nonprofit board members need to have a clear understanding of two terms concerning inurement – private benefit and private inurement. Each term has a different meaning, but they go hand-in-hand.

Private Benefit

It’s perfectly acceptable for nonprofits to pay reasonable and customary salaries to executives and other individuals who provide leadership duties to the nonprofit. Private benefit comes into play when an individual (or an organization) receives a monetary or nonmonetary benefit from a 501(c)(3) organization. Tax-exempt organizations aren’t allowed to provide a substantial private benefit to anyone. If they do, the nonprofit organization risks losing its tax-exempt status.

Private Inurement

Private inurement occurs when an individual working on the inside (commonly known as an insider) receives any of the organization’s net income or inappropriately uses any of its assets for personal gain. To be clear, an insider is an individual who has a personal and private interest in the organization (key employees, board directors, officers, executives, etc.) Even a small amount of inurement can put your nonprofit at risk of scrutiny by the IRS.

The difference between private benefit and private inurement is that private benefit can be provided to insiders and outsiders. By contrast, private inurement is a transaction that pertains specifically to insiders. In either case, a nonprofit’s income or assets are distributed for private gain rather than for the intended purpose of the nonprofit’s mission.

Consequences of Private Inurement

What happens if your nonprofit is facing an allegation of private inurement?

The IRS has full authority to revoke your nonprofit’s tax-exempt status. They may also impose intermediate sanction penalties instead of or in addition to disqualifying your nonprofit as tax-exempt.

The IRS publishes standards that are available to the public to describe how they decide when or if they should revoke a nonprofit’s 501(c)(3) status over inurement and excess benefit. In doing an investigation, the IRS will consider all the relevant facts and circumstances before making their final decision.

The IRS will take into account the degree of inurement in relation to the scope of the nonprofit’s activities, repeat allegations of inurement, efforts toward safeguards against inurement, and efforts to correct issues with inurement.

How Your Board Can Safeguard Against Inurement

Now that you have a better understanding of private benefit and private inurement, we’ve got some tips to help your board safeguard against inurement.

  • Compose a board of independent individuals and ask them to sign a conflict-of-interest policy that requires them to disclose any potential conflicts of interest annually.
  • Establish an employment contract for officers and senior employees that includes a description of inurement and details the consequences of it.
  • Establish a plan for accountability and use a system of checks and balances to verify that reimbursable expenses are directly connected to a nonprofit business.
  • Regarding loaning money to officers, it’s best to avoid it. If your nonprofit chooses to do it, be sure that the loan is “at arm’s length”, keep loan agreements on record, and require recipients to pay the principal back with interest.
  • Carefully devise your executive compensation policies, incorporate language about inurement, and document your policies and contracts.
  • Keep detailed documents and records.

While your board may have some of these safeguards in place already, it’s a good idea to review them periodically to make sure they’re still relevant and appropriate.

With a BoardEffect board management system, your board has the tools to collaborate around the issue of inurement and store policies and documents safely in the cloud. If the IRS ever questions your nonprofit’s involvement with inurement, you’ll be able to pull documents swiftly and speak answer their questions readily.

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