Understanding Inurement and the impacts on your 501(C)(3)

Understanding Inurement and the impacts on your 501(C)(3)

Inurement is one of those terms that many nonprofit board members are unfamiliar with, yet it’s something the IRS monitors and, if ignored, can result in the loss of 501(C)(3) status.

The IRS has strict rules about how nonprofits use and distribute their earnings, and those earnings cannot benefit board members, officers, or supporters of the organizations.

The IRS explicitly states, “A section 501(c)(3) organization must not be organized or operated for the benefit of private interests, such as the creator or the creator’s family, shareholders of the organization, other designated individuals, or persons controlled directly or indirectly by such private interests. No part of the net earnings of section 501(c)(3) organization may benefit any private shareholder or individual. A private shareholder or individual has a personal and private interest in the organization’s activities.”

The IRS is concerned about control of the organization:

Direct control – refers to direct control as enacted by a board director, high-level executive, manager, founder, major donor, highest-paid employees, or family members of influential people within the nonprofit.

Indirect control – refers to control over others who are officers, directors, or those who strongly influence decision-making.

In other words, board members, officers, or key supporters cannot unfairly benefit from a nonprofit’s resources by virtue of position. The IRS is concerned with the potential for abuse of power resulting in personal gain from a nonprofit’s assets. The most common offenders tend to be nonprofit employees that also hold board seats but can extend to any board position or employee.

Being found guilty of Inurement in an audit can result in penalties at the state and federal levels. These penalties can include fines, called intermediate sanctions, and may even result in the loss of tax-exempt status in the most extreme examples.

To avoid problems with the IRS and protect the nonprofit’s reputation, nonprofit board members must understand the limitations of the 501(c)(3) law, especially as they pertain to private Inurement.

Examples of Inurement

Examples of arrangements that will result in the Inurement of earnings are:

Excessive compensation. This is the most common violation. It must be negotiated at arms-length, reasonable for the services performed, and not structured as a profit distribution mechanism. Compensation must be documented as fair and reasonable and not disproportionate to the overall earning of the nonprofit.
Loans or extensions of credit at below-market rates or with no interest to employees, board members or involved parties of the nonprofit.
Sales or leases of property to (or by) an organization at prices over (or below) fair market value
Use of an organization’s property for personal use without adequate compensation or a compensatory purpose
Commingling of Funds of personal and exempt organization assets. Keep bank accounts separate.

Preventing Inurement

Now that you better understand the private benefit and private Inurement, we’ve got some tips to help your board safeguard against Inurement.

Fair and Reasonable Executive Compensation- Have good policy and documentation of how Executive compensation is calculated and is fair value and not structured as a mechanism for distributing profits.
Don’t Issues Loans – Avoid issuing loans from the organization to officers, board members or employees.
Compose a board of independent individuals – Build a knowledgeable and engaged board with the organization’s needs in mind (e.g. accounting, finance, compensation, and ethics).
Strong Conflict of Interest Policy– Require all Board Members disclose all conflicts of interest and to sign a conflict-of-interest policy.
Employment Contracts – For officers and senior employees that includes a description of Inurement and details the consequences of it.
Accountability – Use a system of checks and balances to verify that reimbursable expenses are directly connected to a nonprofit business.
Keep detailed documents and records- Maintain all signed conflict of interest policies, employment agreements or documents around policies associated with private benefit or inurement.