A not-for-profit organization, in order to assure its tax-exempt status is not jeopardized, must ensure that no “insiders” receive private inurement from business dealings with the company. Who is an “insider”? Any individual in a position to exercise substantial influence over the organization’s affairs, including officers, directors, trustees, key employees, founders, major donors, and their family members. If an individual or organization is found to have received private inurement, there are penalties for both the not-for-profit and the individual or organization receiving the improper benefit. That can range from the non-profit losing tax-exempt status to excise taxes on the individuals or organizations involved.
It is imperative that all business dealings between a provider and a tax-exempt entity be arm’s length transactions. Those dealings could be compensation agreements, leases, or agreements to purchase equipment, services, or even practices. In an integrated delivery system involving a tax-exempt hospital, physicians must not vote on compensation issues related to their practices. Below market loans are also forbidden.
The inurement prohibition goes back to the Corporation Tax Law of 1909, but the Internal Revenue Service has expanded its application by broadening the definitions both of an insider” and inurement so that essentially any flow of value resulting in a tangible or intangible, direct or indirect benefit to a person other than the non-profit and the charitable class that properly benefits from its operations can be analyzed as a potential source of inurement.
Since compensation arrangements can be complex, it is important to examine all aspects to be sure none of the components cross the line and become deemed inurement. Consider the case of the revocation of tax-exempt status of a hospital where:
- Direct compensation exceeded the average level of the industry.
- Certain executives also received compensation from an affiliated offshore insurance company that was funded by excessive charges to the hospital.
- Constructive retirement payments were made to employees who continued to work and receive full salary.
This case is a clear example of what not to do.
An individual entering into an arrangement with a not-for-profit should assure that it establishes best practices to avoid any implication of private inurement by:
- Actively soliciting competitive bids from suppliers of the goods and services.
- Reviewing every financial relationship with an insider for reasonableness (there is no de minimis rule for the prohibition against private inurement).
- Documenting the price for the sale of property to, or purchase of property from, an insider by an independent appraisal that is properly prepared by an expert.
- Properly documenting all transactions.
- Determining if any applicable state laws are violated by a transaction and correcting the transaction if necessary to comply with state law.
If an excess benefit transaction occurs, the “insider” or “disqualified person” is subject to a 25% excise tax on the excess benefit, i.e. the amount by which the benefit exceeds the value of what the organization received in return. If the excess benefit is not corrected withing the taxable period, an additional 200% excise tax is imposed on the disqualified person. Correction of the transaction, by repayment including interest, can abate the 200% tax if completed within the correction period.
Organization Managers such as officers, directors, or trustees who knowingly participate in the transaction may also be liable for a 10% excise tax on the excess benefit, up to $20,000 per transaction, unless their participation was not willful and was due to reasonable cause.
These excise taxes are designed as “intermediate sanctions” to penalize improper insider transactions without necessarily revoking the organization’s tax exempt status.
What’s the best practice? Conduct all business dealings with insiders at arm’s length and be sure it is properly documented to avoid any implication of private inurement.
Article Submitted by Terri L. Marakos, CPA, CHBC
