Part 4: Prohibited Pursuits

In our first installment in this series on nonprofit formation, we discussed what organizations and activities can qualify for tax exemption and what to consider before starting a nonprofit. In Part 2, we discussed selecting your organization’s initial directors and officers and drawing up your organization’s governance documents. In Part 3, we discuss the different categories of nonprofit organizations that the IRS recognizes as tax-exempt under Section 501(c)(3).

In this post, we will discuss the two biggest “no-no” activities for 501(c)(3) organizations. These activities can get your organization and your directors into big trouble with the IRS. The first set of prohibited activities is known as “private benefit” or “private inurement.” The second involves restrictions on legislative lobbying and political campaigning.

Prohibited Payments, Profits, & Procedures: Private Benefit & Private Inurement

1. The Private Benefit Doctrine

Section 501(c)(3) of the Tax Code provides that a tax-exempt non-profit must be “organized and operated exclusively for religious, charitable, scientific" and other specified purposes. This language in the statute is the basis of the “private benefit doctrine.” This rule, in a nutshell, states that an exempt organization must engage primarily in activities that accomplish one or more exempt purposes and that primarily benefit the public rather than private interests.

The logic behind this restriction is as follows: exempt organizations are excused from taxation and receive tax-deductible contributions from donors because they are supposed to devote all of their funds and assets to benefiting the public. Therefore, it is inappropriate for the money and assets, which are non-taxable and which donors contributed for public, charitable purposes, to end up benefitting private parties.

There are usually incidental private benefits that flow from nonprofit work. But the private benefit doctrine applies when the benefit to one or a few private interests outweighs the general benefit to the public. For example, let’s say there is a non-profit organization that plants trees and removes trash from the banks of a local river. All of the parties who use the river, drink water from the river, or own property along the river will benefit from this organization’s work. However, if this organization only does this work on the riverbanks that are owned by a few private landowners, then the benefit of the organization’s activities will be too concentrated on those landowners to be considered to benefit the public. This would violate the private benefit doctrine.

2. The Private Inurement Doctrine

Section 501(c)(3) further provides that no part of the net earnings of a tax-exempt non-profit may “inure to the benefit of any private shareholder or individual.” This is the basis of the so-called “private inurement doctrine.” Private inurement can be understood as a subset of private benefit. All private inurements are private benefits, but not all private benefits are private inurements. For example, in our river clean-up hypothetical, if those private landowners were also on the board of the nonprofit, there would be private inurement, not just private benefit.

Private inurement refers to a prohibited act of self-dealing. The rules against private inurement require that an organization’s officers, directors, employees, or those persons family members and businesses (all known as “disqualified parties”) not use their positions to derive any excess benefit from the non-profit. The private inurement rule can be understood as a particular application of the private benefit rule to an organization’s insiders. The rule prohibits disqualified persons from using an organization’s assets or influence to benefit them, their family members, or their own businesses.

The rule affirmatively requires an organization’s officers and directors to make decisions in a way that prevents excess benefits to insiders. This can include following a conflicts-of-interest policy and consulting with outside experts or objective market data to determinate reasonable compensation and appraisal of services or property to ensure that a non-profit is not paying too much under a contract.

These restrictions on private benefit and private inurement have several important practical implications for non-profit organizations, which include the following:

• Compensation of officers and employees must not be unreasonably high;
• Insiders of an organization must not use the organization’s activities to promote their own private businesses or those of their family members;
• Directors and officers must not participate in decisions affecting their own compensation;
• Directors, officers, and employees generally must not use the organization’s assets (money, equipment, vehicles, facilities, etc.) for their own personal use;
• The organization must not enter into transactions that confer an excess benefit to private individuals or companies. The organization must pay no more than a fair and reasonable price for purchases or services;
• Anyone purchasing property from the organization must pay fair market value for it;
• No assets or property of the organization can be given to private party outside of a charitable grant program; and
• Upon the dissolution of an exempt organization, all of its assets and funds must be distributed only to one or more other 501(c)(3) organizations.

The rules against private benefit and inurement have very broad implications that can affect a range of scenarios and transactions. Nonprofits should be educated and work with knowledgeable legal counsel to avoid violating these rules.

Prohibited Promotions, Propaganda & Politics: Restrictions on Political Activities

1. Restrictions on Legislative Lobbying

Section 501(c)(3) also includes restrictions on certain political activities. First, the statute provides that “no substantial part of the activities” of an exempt organization can be “carrying on propaganda, or otherwise attempting, to influence legislation.” This restriction prohibits lobbying or other intentional efforts to directly influence legislation at the state, local, or federal level.

However, this rule is not a categorical bar on such activities, but only prohibits them from being a “substantial part” of an organization’s activities. Moreover, exempt organizations may engage in certain non-partisan voter education activities (e.g., creating public forums and publishing voter education guides). An organization may also engage in programs that promote participation in the democratic process (e.g., voter registration and get-out-the-vote drives).

2. Restrictions on Political Campaigning

Section 501(c)(3) also states that an exempt organization may not “participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.” This provision is often referred to as the “Johnson Amendment,” as it was introduced in 1954 by then Senator (later President) Lyndon B. Johnson.

Unlike the limitation on “influencing legislation,” the prohibition on election campaign activities is absolute. A 501(c)(3) organization may not publicly endorse or oppose candidates for political office or make contributions to a candidate’s political campaign.

This restriction is very controversial and is subject to considerable First Amendment concerns. Many churches make an annual practice of openly testing this restriction with Election Day sermons that endorse or oppose candidates. However, while the IRS has issued several warning letters for alleged violations, only one church and a handful of other non-profit organizations have ever been subjected to any actual penalties for violating this restriction on campaigning.

Penalties & Pitfalls

The repercussions for violating any of these restrictions can be steep. Usually, low-level or unintentional violations receive no more than a stern warning letter from the IRS, instructing the organization to cease its prohibited activities. However, an organization may be subject to excise taxes as a penalty for violations. An organization’s officers and directors may personally be subject to what are known as “intermediate sanctions,” which are fines of up to $20,000.00 imposed for approving or pursuing decisions or activities that violated the private benefit rule. Recipients of excess benefits in transactions with non-profits (including employment) can also be subject to a special excise tax on those benefits.

Another major penalty for violating either the private benefit rules or the restrictions on political activities can be denial or revocation of an organization’s exempt status. In light of these steep penalties, organizations should generally consult with legal counsel to stay compliant.

Conclusion

In our next and final installment in this series, we will examine the process of applying for 501(c)(3) status and how to maintain that status going forward. Stick around.

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Featured Image by Rebecca Sidebotham.