Protecting Your Nonprofit Status
The IRS has strict rules for nonprofit corporations. If they are broken, tax-exempt status can be lost and you could owe additional taxes and penalties. This section explains the most important rules and how to comply with them.
The private inurement doctrine is one of the most important concepts of nonprofit law. It states that the funds and benefits of a nonprofit organization cannot go to any particular persons, but must be used for the approved purpose of the organization. The rule keeps people from using the form of a nonprofit organization to avoid taxes for private transactions.
Example: If a wealthy individual wants to start a foundation to hire relatives and pay them more than the value of their services instead of giving them taxable gifts or inheritance, that person cannot use the form of a nonprofit organization.
The rule does not make sense for organizations such as social clubs or trade associations, whose whole purpose is to give benefits to members rather than to society. For these organizations, the law contorts to say that the members can benefit from the organization, but only if all the members benefit, not just a few. Also, these groups are limited in how much of their funds can come from outside the group. Dues and contributions from members are not taxable, but if the group raises too much money from outsiders, that income may be taxable.
To help you understand what the private inurement doctrine requires, the following are some examples.
- A trade association can be formed by apple growers to promote the eating of apples, but it cannot only work to sell its members' apples. It must promote the eating of apples in general.
- A social club can be set up for the benefit of an ethnic group, such as an Italian Americans club, but it cannot give special benefits to some members, such as reduced dues, that are subsidized by other members.
- A scientific organization can be formed to test electrical products for safety, but it cannot work for the interests of just a few manufacturers.
- A museum can be set up to display and sell works of art, but not if its purpose is selling its members' works for their financial gain.
Excess Benefits Transactions
Besides not having the purpose be to benefit private parties, the actual operations of the group must not give excess profits to private individuals.
Nonprofit organizations are allowed to hire employees, rent property, and pay for services. In most cases, there is no prohibition against hiring, renting from, or buying from their own directors or officers-as long as it is a fair transaction. The salary must not exceed what is fair in the community, the rent must be fair market rent, and the services must not be overpriced compared to other providers of the same services.
Transactions between nonprofits and their directors, officers, and members are looked at carefully by the IRS, so you should keep careful records and be able to backup all transactions.
Example: If a director rents office space to your organization, you should have evidence of how much rent is charged to others and what other rentals are available to the organization. If the organization pays salaries to employees and officers, you should document how much money those people earned elsewhere and what similar organizations are paying similar employees.
Excess Benefits Rules
Because of abuses, the IRS has tightened the rules about private benefits from nonprofits. Rather than costing the organization its exemption as in the past, the IRS now imposes an excise tax on any benefits it deems excessive. The tax can be up to 25% on the recipient and 10% on the organization's members who approved it (up to $10,000 per transaction).
The rules do list some ways that a benefit can be safe from being categorized as excessive, if it is:
- clearly spelled out in the organization's records
- based on fair market value or comparable worth
- approved by disinterested members of the organization