The IRS has all sorts of rules about what your nonprofit can and can’t do and still maintain 501(c)(3), tax-exempt status. In this article, we’re focusing on the rules concerning the who. Specifically, who can and can’t fulfill certain roles within the organization.
When it comes to nonprofits, especially 501(c)(3) organizations, one of the IRS’s constant concerns is conflict of interest, private benefit, and inurement. This can be a challenge for a nonprofit whether it is just starting out or has a long history. The core of the concern largely surrounds which parties are involved and if there was an arms-length approach used in the particular situation of concern. These parties can be board members, relatives, employees, etc., but usually, they are also what’s known as a disqualified person.
And, what are they disqualified from?
The IRS wants to ensure that a nonprofit is acting in a way that is in-line with its approved exempt purpose. That’s a given. But, the IRS also wants to ensure that no one is privately benefiting simply for being involved with the organization… or being related to someone who is.
Our CEO has written extensively on private benefit and inurement, as well as conflict of interest with a nonprofit organization, so I won’t belabor that point. If you’ve been around long, you know such situations must be avoided at all costs. Most commonly, the recipients of private benefit and inurement are board members, officers, and/or employees of the organization. These are people who are in a position to exercise substantial influence over the affairs of the organization at any time, regardless of whether or not the person actually exercises the influence.
The IRS identifies these individuals as disqualified persons. But, disqualified from what? The IRS doesn’t answer that question directly, but basically it means they are disqualified from being transacted with in a manner similar to those without substantial influence. Extra care must be exercised to ensure arms-length dealing.
Generally speaking, to be a disqualified person, the individual or entity most commonly fills one or more of these roles:
- Officer, director, or trustee of the organization;
- Key employee, or someone who is paid $150,000 or more a year by the organization and/or makes key management decisions of the organization in a day-to-day capacity;
- Substantial contributor, or someone who gives more than 2% of the total contributions received by an organization from its inception, if it’s at least $5,000;
- A family member of one of the aforementioned parties; and/or
- A foundation, trust, or corporation, of which one or more of the above individuals owns or controls 35% or more of it.
While the criteria to be classified as a disqualified person are the same in both a public charity and a private foundation, the IRS views them very differently depending on the type of organization involved.
In a private foundation, the IRS has very strict rules for transactions with a disqualified person. It’s not that the organization can’t have transactions, financial or otherwise, with the disqualified person, it’s just more heavily scrutinized. This is due to the fact that private foundations allow for a closely controlled board of directors, which means making an arms-length decision is next to impossible. The IRS never assumes that an arms-length decision has occurred, resulting in a higher level of scrutiny. However, the IRS does not prohibit a disqualified person from being hired by a foundation if the following conditions are met:
- The defined job is for a professional service, often translated as targeted and professional in nature (legal, accounting, investment advisory, etc.);
- The job is ordinary and necessary, in other words someone must be hired regardless; and
- Compensation is reasonable.
An example for such a job would be if the organization needs to hire an accountant and there’s an uniquely qualified accountant on the board of directors. Once the job goes outside the realm of a definable task, it becomes harder for the organization to prove to the IRS that an arms-length decision was made, especially for a private foundation. Our recommendation? Private foundations should avoid doing business with a disqualified person when practical. If it is simply in the better interest of the foundation to work with a disqualified person, make sure you understand and follow the three points above. The penalties for getting it wrong are stiff (see below).
In a public charity, a disqualified person still must meet the defined requirements specified above if being compensated, financially or otherwise. The big difference is that there’s much less scrutiny by the IRS. Since public charities are required to have the majority of the board of directors be unrelated to each other either by family or business, it is much more feasible for an arms-length decision to be made. This would be accomplished through the recusal of the interested person and any other parties related to the person.
Regardless of whether it is a private foundation or a public charity, if an arms-length decision cannot be reached, or there was excess benefit, private inurement has occurred. This is unacceptable at any level and can result in severe penalties called Intermediate Sanctions. These penalties are assessed by an IRS agent against the individual board members, not the organization itself. Penalties start at 25% of the determined amount of inurement and can rise to 200% if the situation is not fixed in a timely manner. This also includes the potential for the organization to undergo a more comprehensive audit.
At the end of the day, the nonprofit, whether a private foundation or a public charity, is obligated to fulfill its exempt purpose to the public, not benefit the board members running it. And the IRS wants to ensure that happens, so they implement strict rules. If a transaction with a disqualified person is unavoidable, all decision-making should be documented. While this should be done anyway, this would demonstrate that a proper quorum has been met and a vetting process for comparable services occurred.
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