Private Benefit and Fiduciary Risk in Tax-Exempt Organizations

The Private Benefit Doctrine

Tax-exempt organizations exist to serve a public or charitable purpose. When an organization’s net earnings or assets inure to the private benefit of any individual, it risks losing its tax-exempt status—and, more fundamentally, it violates the basic covenant underlying the tax exemption.

Private benefit is not always obvious. It extends beyond direct payments or transactions. It includes indirect benefits, sweetheart deals, excessive compensation, preferential terms, and arrangements that give insiders advantages not available to the general public or other similarly situated parties.

Forms of Private Benefit

Private benefit can manifest in many forms:

• Executive compensation that is not reasonable in amount
• Loans to insiders on preferential terms
• Rental arrangements that favor insiders
• Purchasing decisions that benefit particular vendors or consultants
• Employment practices that discriminate in favor of related parties
• Contract terms that are more favorable to insiders than competitive alternatives

Fiduciary Governance as Protection

The most effective protection against private benefit violations is disciplined fiduciary governance:

Board Oversight and Approval

The board must approve all significant transactions involving insiders or related parties. This includes employment relationships, consulting arrangements, loans, leases, and service contracts.

Conflict of Interest Policies

Organizations should maintain written conflict of interest policies that require disclosure of financial interests and define procedures for handling conflicts.

Compensation Benchmarking

For organizations with salaried executives, periodic benchmarking studies help ensure that compensation is reasonable in light of the organization’s mission, size, and geographic context.

Related Party Transaction Procedures

Specific procedures should govern transactions between the organization and insiders or related entities, including comparative analysis and documentation.

IRS Focus Areas

The IRS examines private benefit issues closely, particularly in Form 990 audits. Areas of particular scrutiny include:

• Management compensation and bonuses
• Related party transactions
• Related entity relationships
• Board composition and independence
• Loan arrangements with insiders
• Use of organization assets

Practical Steps for Governance

Organizations can reduce fiduciary risk through practical governance measures:

1. Maintain current written policies on conflicts of interest, related party transactions, and executive compensation
2. Document board discussions regarding insider transactions and compensation decisions
3. Use comparative data to support compensation decisions
4. Require competitive bidding for significant contracts and services
5. Maintain arm’s length terms in all insider transactions
6. Conduct periodic reviews of ongoing insider relationships and arrangements
7. Train board and staff on private benefit concepts and policies

The goal is not to prevent organizations from engaging insiders—nonprofits regularly employ founders, board members’ families, and other insiders. The goal is to do so transparently, on terms that are reasonable and comparable to what would be available from unrelated parties, and with appropriate board oversight and documentation.