Non-profit organizations are subject to what is known as the nondistribution constraint. Simply stated, this means that non-profit organizations cannot distribute profits to those who control it. The nondistribution constraint is the fundamental distinction between non-profit organizations from for-profit organizations.
In the Internal Revenue Code, the nondistribution constraint is embodied in the prohibition against inurement. “Inurement” is an arcane term for “benefit.” The inurement prohibition forbids the use of the income or assets of a tax-exempt organization to directly or indirectly unduly benefit an individual or other person that has a close relationship with the organization or is able to exercise significant control over the organization.
The essence of the inurement proscription is found in the language of Code § 501(c)(3), which provides that no part of a 501(c)(3) organization’s net earnings can inure to the benefit of any private shareholder or individual. Although this would clearly prohibit the distribution of dividends to those in control of the organization, the inurement prohibition is much broader than that in application. Most exempt organizations – including 501(c)(3) and 501(c)(6) organizations – are subject to the inurement prohibition.
The goal of the inurement prohibition is to prevent siphoning off of an exempt organization’s assets by insiders – those in control of the organization. In this context, “control” may be direct (as in the case of formal directors) or indirect (such as control over others who are officers or directors). Any time assets of the organization flow through to benefit the organization’s insiders, whether directly or directly, inurement is an issue.
The inurement restriction is absolute: An organization that violates this prohibition will not qualify (or will cease to qualify) for tax exemption regardless of whether it otherwise meets the appropriate statutory requirements for exemption. Because of the harsh nature of this rule, it has historically been enforced only in the most egregious circumstances.
Because the inurement prohibition was rarely used, Congress enacted a related set of rules that would provide an “intermediate” sanction. The intermediate sanction rules are “intermediate” in the sense that it is not as severe as outright revocation of tax exemption but does penalize the organization. The intermediate sanction regime is discussed in our section on excess benefit transactions.
In cases involving inurement, the IRS may impose the intermediate sanction penalties in lieu of or in addition to the revocation of tax exempt status. The IRS has published standards to determine how it will decide whether to revoke the 501(c)(3) status of an organization that has engaged in a transaction that constitutes both inurement and excess benefit. These standards provide that the IRS will consider all relevant facts and circumstances in making a determination of whether to revoke the tax exempt status of an organization that engages in an excess benefit transaction that constitutes inurement. Factors the IRS will consider include:
- The size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after one or more excess benefit transactions occurred;
- The size and scope of one or more excess benefit transactions relative to the size and scope of the organization’s regular and ongoing exempt functions;
- Whether the organization has been involved in repeated excess benefit transactions,
- Whether the organization has implemented safeguards that are reasonably calculated to prevent future violations, and
- Whether the excess benefit transaction has been corrected or the organization has made a good faith effort to seek correction from the disqualified person or persons who benefited from the excess benefit transaction.
This system effectively gives the IRS two options to enforce the nondistribution constraint. In blatant violations of the inurement prohibition, the IRS can both revoke tax exemption and impose monetary penalties under the intermediate sanction regimes. In less severe cases, the IRS may seek to correct the situation through intermediate sanctions alone.