The Dangers of Nonprofit Inurement and Private Benefit

In working with thousands of nonprofit startups over the years, one of the most frequent challenges we face when working with clients is conflict-of-interest concerns.  New 501(c)(3) organizations are particularly vulnerable to this for a number of reasons, chief among them being the relative concentration of control in the early years.  Conflict-of-interest is often hard to avoid in these situations, and is even occasionally advantageous to maintain, while the organization is getting up and running.  What you have to avoid at all costs, however, is allowing conflict-of-interest to devolve into inurement and/or private benefit.

The term inurement is defined as an insider (an officer, director, key employee, or anyone related to those individuals) in a nonprofit unfairly benefiting from a nonprofit’s resources by virtue of position. In other words, an abuse of power resulting in personal gain from a nonprofit’s assets. The most common offenders tend to be nonprofit employees who also hold board seats, but can extend to any board position or employee.

The most common types of inurement are excess compensation and the improper use of assets.

Excess compensation is any salary or wages deemed above what the IRS considers “reasonable” for the job in question. Examples of improper use of assets could include using company vehicles for personal travel, using lines of credit for personal expenses, or using a company mailing list to promote a personal business. In the worst cases, these infringements involve embezzlement and criminal liability. Plainly put, all insider crime found in nonprofits is inurement. But not all activities defined as the IRS as inurement are criminal in extent.

Inurement can be found in both public charities and private foundations.  Public charities can be guilty of this when proper arms-length procedures are not followed when dealing with insiders.  For example, a board member who is also a paid employee should have no input into their own compensation.

Private foundations, on the other hand, aren’t held to the same standards of arms-length dealing due the allowance for close control, even by members of the same family.  As a result, the IRS considers officers, directors, and significant contributors of a private foundation to be disqualified persons.  Such individuals are barred from employment within the organization, except for a limited ability to provide professional services for a reasonable fee (legal, accounting, investments, etc.).  Ironically, the IRS calls these personal services, though the phrase is defined to mean what is typically credentialed professional work.

Nonprofits found to engage in inurement can lose their tax-exempt status.  But for most organizations found guilty of inurement in an audit, loss of 501(c)(3) status isn’t usually what happens.  The IRS typically will assess intermediate sanctions penalties as a way of punishing the bad behavior.

The first word in the phrase tells you that this is an interim step of penalty.  The IRS is making this financially painful, but not issuing the death penalty.  And to make sure the message is received, intermediate sanctions penalties are not levied against the nonprofit itself, but rather against the board members individually who are being held accountable for allowing inurement to happen on their watch.

These penalties are levied under Section 4958 of the Internal Revenue Code, and are two-stage in nature.  The first stage is a fine equal to 20% of the monetary value of the inurement, levied against each board member.  Failure to fix the problem may result in a second wave of fines equal to 200% of the amount of the infraction!  Of course, loss of tax-exempt status is always on the table, and is usually reserved for the most egregious examples of inurement.

Audacious Charity, Inc. is a 501(c)(3) nonprofit located in Spokane, Washington.  In case you’re wondering, no, this is not a real charity.

Audacious was formed 5 years ago by James, and James serves as both board President and as the salaried Executive Director.  James was hired by the board of directors and had his salary established by them at arms-length.  He is the only employee, as everyone else who helps with the mission are volunteers.  So far, so good.  But there are problems.

Audacious purchased a van 3 years ago for food distribution to the needy.  Not only is the van used for that, but for the past 2 years James has used the van as his own personal vehicle without charge to him.  Audacious pays for all vehicle expenses, including gas, maintenance, and insurance.  James does not track his personal usage, and in fact, sold his own vehicle and exclusively uses the company van.  This is textbook inurement.

For whatever reason, the IRS performs an audit of Audacious’s Form 990 and discovers this inurement.  The auditor determines that the value of the impermissible benefit is equal to $20,000 over the past 2 years.  Each of the 7 board members is fined $4,000 ($20,000 x 20%).  It doesn’t matter that the total fines are in excess of the inurement amount.  Also, the IRS forbids Audacious to pay the fine on behalf of any board member.  Should this situation not be corrected in a reasonable amount of time, the IRS could additionally levy a fine of $40,000 per board member ($20,000 x 200%), and/or revoke the tax exempt status of Audacious.

Private benefit is similar, but distinctly different from inurement.  Private benefit refers to nonprofits serving the interests of a specific individual or entity rather than the public.  Unlike inurement, private benefit includes benefits conferred on entities that are not insiders.  But the consequences of a case of private benefit can look very much the same as those for inurement.

Distinguishing between inurement and private benefit can seem a little fuzzy.  While inurement specifically concerns benefits conferred on insiders, private benefit encompasses any enrichment to individuals or entities, regardless of their relation to the nonprofit.  It violates the requirement that a nonprofit must serve a public rather than a private interest.

It’s also helpful to consider that inurement almost always involves money or assets, while private benefit can include impermissible intangible benefit to a third party, such as driving customer traffic to a specific private business that is unrelated to the organization’s purpose.

Similar to inurement, engaging in private benefit can lead to Section 4958 financial penalties (intermediate sanctions again!), and even loss of tax-exempt status.

Another consequence of both inurement and private benefit is the reputational harm.  I think this issue is not talked about enough, frankly.  Yes, your organization may survive a round of intermediate sanctions penalties, although most don’t.  Let all of your board members be substantially fined and see how many stick around.  Assuming you still have an organization that technically exists after all this, loss of reputation can be the kiss of death with your donors and beneficiaries, rendering your nonprofit ineffective at best, and functionally dead at worst.

Board of Directors’ Role

The board must play an active role in oversight.  This includes regularly reviewing compensation arrangements, adopting conflict-of-interest policies, and ensuring that decisions are made in the best interest of the nonprofit.

Transparent Financial Reporting

This starts with making sure your bookkeeping solution is solid.  Most nonprofits do not have the internal skills necessary for compliant accounting, so outsource it to someone who does, like Foundation Group.  For larger nonprofits, you will likely have state-required annual audits by a CPA firm.

Transparent financial reporting builds trust with donors and the public.  It is an indespensable component of good management and inurement/private benefit prevention.

Educating Staff and Stakeholders

Your internal team needs to understand what constitutes inurement and private benefit, then be committed to ensuring it doesn’t occur in your nonprofit.  Establish a culture of accountability and integrity to minimize the risks.

Proper Documentation

It’s essential to maintain proper records of the decision-making processes, transactions, and agreements conducted or entered-into by the nonprofit.  This documentation serves as evidence of the organization’s commitment to avoid impermissible benefit.

Consulting Legal and Financial Experts

Finally, when dealing with complex transactions, especially those involving insiders, consulting legal and nonprofit compliance experts is essential.  They can provide guidance on compliance and help nonprofits navigate the regulatory landscape.

So what happens if you become aware that inurement or private benefit is occurring in your organization?

Reporting Mechanisms and Whistleblowing Policies

Nonprofits should establish clear reporting mechanisms for employees and stakeholders to report suspected instances of either.  Whistleblowing policies protect those who report wrongdoing and encourage a culture of accountability.

Corrective Actions

When inurement or private benefit is identified, nonprofits must take immediate corrective actions.  This could include terminating contracts, recovering assets, revising policies, or, in extreme cases, removing board members or staff involved.

Communicating with Stakeholders

Nonprofits should also communicate transparently with stakeholders regarding any issues and corrective actions being taken.  This openness is essential for rebuilding trust and demonstrating commitment to ethical practices.