PUBLIC TRUST - - "PRIVATE BENEFIT"
"501(c)(3) organizations are supposed to be operated for charitable purposes,
not for the benefit of private interests. How do you draw the line?"

by Edward Gonzalez, Esq.

Date: Fall, 1994

The Grantsmanship Center Magazine

Federal tax law requires that an organization must serve "a public rather than a private interest" in order to qualify for exemption as a charity. But even the most legitimate charitable endeavors will to some degree, directly or indirectly, benefit certain non-charitable interests. After all, a nonprofit organization's employees receive salaries, its landlord gets rent, and its vendors make a profit on what they sell to the organization. The question is not whether such benefits are permissible. The question is, what kinds are permissible and to what extent?

One relevant part of Section 501(c)(3) of the tax code recognizes organizations "operated exclusively" for exempt purposes. This is the so-called "operational test". By definition an, an organization is not "operated exclusively" for a permissible exempt purpose unless "it serves a public rather than a private purpose. In other words, if an organizations activity is shown to benefit a private interest, it will fail the operational test.

There are, of course, special-purpose non-profits -- such as trade associations -- that are exempt from paying federal income tax, but they are not eligible to receive tax-deductible charitable contributions.) Private benefit can arise in a number of ways, but one of the most obvious occurs when the benefited persons or groups are in a position to control the organization. Consider the case of Westward Ho, an organization created by three restaurant owners in Burlington, Vermont. Westward Ho attempted to facilitate the movement of homeless persons off the streets of Burlington by offering them one-way air-fares -- anywhere. The articles of association described the organization's purpose as follows: "Providing travel grants or loans to certain indigent and antisocial persons who may have a strong desire to need to leave the Burlington, Vermont area, but who lack the means to pay for transportation to their destination of choice."

Westward Ho's only beneficiary accepted a one-way ticket to Portland, Oregon. This individual had a history of harassing the customers and employees of a downtown restaurant. On one occasion, he even threw a planter filed with poinsettias at a bartender.

The tax court held against a tax exemption for Westward Ho on private benefit grounds. The court found that the organization's founders were more concerned with financial loss than with helping the homeless.
An Exception: "Incidental" Private Benefit

Clearly, there are many situations in which an exempt organization will provide some degree of private benefit to specific groups and individuals in the course of conducting a charitable program. The law provides that where the serving of private interests is "incidental" to the accomplishment of charitable purposes, and does not represent a substantial non-exempt purpose, exemption will not be jeopardized. To qualify, the private benefit must be incidental both "qualitatively" and "quantitatively".

The classic illustration of "qualitatively incidental" private benefit is found in Revenue Ruling 70-186. That case concerns an organization, which was formed to preserve a lake as a public recreational facility and improve the condition of the water. Although the organization benefited the public at large, there was also significant benefit to the private individuals who owned lakefront property.

The IRS determined that such benefit was "incidental", stating "Any private benefits derived by the lakefront property owners does not lessen the public benefits flowing from the organization's operation. In fact, it would be impossible for the organization to accomplish its purposes without providing benefits to the lakefront property owners."

Determining whether a particular activity is "quantitatively incidental" involves balancing the benefits bestowed on private individuals against the benefits to the public. For example in Revenue Ruling 74-146, the IRS held that an organization of educational institutions was exempt, even though some of its members were for-profit schools.

According to the filing, the organizations accrediting program provided a significant incentive for maintaining high-quality education. The benefit according to the few for-profit members was "incidental" to the greater public benefit.

Examples of Private Benefit
These are some common transactions that can cause problems involving private benefit when conducted with persons or groups that the law might consider "private interests":
o Free or below-market rent for space
o Below-market charges for services
o Loans at below-market rates, on favorable terms, and/or that are inadequately secured
o Outright cash payments
o Purchase of property or services at an excessive price

One of the most complicated issues concerning private benefit has to do with compensation. "Unreasonable" compensation--payment that exceeds the fair-market value of the services provided-can jeopardize an organization's exempt status. Such overpayments confer an unjustifiable benefit on an individual or entity.

(Because the benefit is economic in nature and the parties benefited are frequently "insiders", unreasonable compensation is often challenged as a violation of the prohibition against "private inurement", not just on "private benefit" grounds.)

In determining what constitutes unreasonable compensation, a number of factors are taken into account, including:

Factors relating to the employee:
o Arms-length relationship to the organization
o Control of organization by family or founder related to the employee
o Availability of comparable services from a third party
o Employees salary history
Factors relating to the organization:
o Salary scale of similar organizations
o Size of the organization
o Salary scale for employees generally
o Amount of organization's income devoted to compensation
Factors relating to the compensation itself:
o Criteria for compensation
o Abrupt increases in compensation
o Salary fixed many years in advance
o Substantiation of duties performed and salary paid

Recent scandals involving high-profile charities like the United Way have put all exempt organizations under increasingly greater scrutiny. Even small, community-based non-profits can run afoul of the IRS if they don't pay sufficient attention to private benefit issues, as the Westward Ho case makes clear. Regardless of their size, exempt organizations build the public's trust and support by conducting programs that meet not just the letter of the law, but its spirit as well- by demonstrating clear and consistent public benefit.