Private Inurement and Excess Benefit Transactions
¶320 Private Benefit Doctrine
An organization cannot qualify as a tax-exempt charitable organization where it transgresses
the private benefit doctrine. The concept of private benefit, a derivation of the operational test, is
separate from the private inurement doctrine, yet is broader than, and in many respects subsumes,
that doctrine. The involvement of an insider (¶313) is not required for application of the private
¶321 General Rules
The private benefit doctrine is a manifestation of the common-law rule that charities may not
be operated for private ends and is a by-product of the statutory rule that charitable organizations
must be operated primarily for exempt purposes (Treas. Reg. §1.501(c)(3)-1(c)).
The private benefit rule was articulated by the U.S. Tax Court in a 1989 opinion, which is one
of the most significant explications of the doctrine
(American Campaign Academy v.
Commissioner, 92 T.C 1053). The case concerned an otherwise exempt school that trained individuals for careers as
political campaign managers and consultants. At issue was the benefit that accrued to entities of the
Republican Party and its candidates, since nearly all of the school's graduates became employed by,
or consultants to, these entities or candidates. The court concluded that the school was not
primarily engaged in activities that accomplish educational purposes because it benefitted private interests
to more than an insubstantial extent; that is, the school was found to substantially benefit the
private interests of Republican Party entities and candidates.
The court noted that the prohibition against private benefit is not limited to circumstances
where the benefits accrue to an organization's insiders; that is, the court held that this prohibition is
not limited to persons having a personal and private interest in the activities of the organization
and embraces benefits to what the court labeled "disinterested persons." Having thus defined the
bounds (or lack thereof) of the private benefit doctrine, the court ruled that it was violated in this case.
The court wrote that the school "conducted its educational activities with the partisan objective
of benefiting Republican candidates and entities." Elsewhere in the opinion, the court wrote that
the school operated to "advance Republican interests."
The heart of this opinion is the analysis of the concept of primary private benefit and secondary private benefit. (This dichotomy of private benefit was first articulated in this opinion, and no
court has referenced it since.) In this setting, the beneficiaries of primary private benefit were the
students, and the beneficiaries of secondary private benefit were the employers of the graduates. It was
the secondary private benefit that caused the school to fail to acquire tax exemption.
The court accepted the IRS's argument that "where the training of individuals is focused
on furthering a particular targeted private interest, the conferred secondary benefit ceases to be
incidental to the providing organization's exempt purposes." The beneficiaries, at the secondary level,
were found to be a "select group." The "particular targeted private interest" and the "select group"
were, in the court's view, the Republican entities and candidates served by the school's graduates.
The school unsuccessfully used as precedent several IRS revenue rulings holding tax-exempt,
as educational organizations, entities that provide training to individuals in a particular industry
or profession. The court accepted the IRS characterization of these rulings, which was that the
"secondary benefit provided in each ruling was broadly spread among members of an industry … as opposed to being earmarked for a particular organization or person." The court said that the
secondary benefit in each of these rulings was, because of the spread, "therefore incidental to the
providing organization's exempt purpose."
¶322 Incidental Private Benefit
Although charitable and certain other types of tax-exempt organizations may provide benefits
to private individuals, benefits of this nature must to avoid jeopardizing tax-exempt status
be incidental both quantitatively and qualitatively in relation to the furthering of tax-exempt
purposes. To be quantitatively incidental, the private benefit must be insubstantial when measured in
the context of the overall tax-exempt benefit conferred by the activity. To be qualitatively
incidental, private benefit must be a necessary concomitant of the exempt activity, in that the exempt
objectives cannot be achieved without necessarily benefiting certain private individuals.
A nonprofit organization was formed to generate community interest in
retaining classical music programs on a commercial radio station, by seeking sponsors for
the programs, urging listeners to patronize the sponsors, and soliciting listener
subscriptions to promote the programs. The IRS ruled that the organization could not
qualify for tax exemption because these activities increased the station's revenues and
thus benefitted it in more than an incidental manner.
By contrast, a charitable organization that allocated Medicaid patients to physicians
in private practice was held to provide qualitatively and quantitatively incidental
private benefits to the physicians, including some on the organization's board of
directors, since it would be "impossible" for the organization to accomplish its exempt
purposes without providing some measure of benefit to the physicians.
Thus, the principal distinctions between the private inurement doctrine and the private
benefit doctrine are
that the law is clear that there can be incidental private benefit, where there is no de
minimus benefit under the private inurement doctrine (see ¶318
that the private benefit doctrine can operate without the involvement of insiders.
¶323 Import of Joint Venture Cases
Recent years have seen the IRS and courts accord considerable attention to the matter of
the involvement of charitable organizations in joint ventures (other than partnerships (¶1800)),
usually structured using limited liability companies. The resulting law has considerably expanded
and modernized the private benefit doctrine.
In the health care field, there have been many instances where an institution, in its
entirety, became a member of a joint venture. This type of venture became known as the whole-hospital joint venture or, more generically, the whole-entity joint venture. The tax law focus in this context is
on the element of control, that is, whether the charitable organization, by involving itself in this type
of arrangement, ceded effective control over its assets and interests to for-profit interests.
Factors evaluated in this regard are
The composition of the governing board of the venture;
Any relationship between a for-profit co-venturer and the company managing the venture;
The duration of the contract with the management company; and
Any provisions in the venture documents that assure that charitable interests will prevail
over private ones in the event of a conflict.
If a charitable organization loses control of its assets and activities in this manner, it is regarded
as operating for private interests and cannot qualify for, or will lose its, tax-exempt status (see, e.g., Rev. Rul. 98-15).
Subsequently, this line of law became trained on the ancillary joint venture, where less than
the entirety of a charitable organization's activities becomes housed in the venture. There are two
fundamental types of ancillary joint ventures:
The venture where an incidental portion of a charitable organization's activities are in
The venture where the charitable organization's activities in the venture are more
than incidental but less than entire
The IRS ruled that a public charity an exempt college involved in a partnership
arrangement with a for-profit entity will not lose its exempt status if the involvement is an insubstantial
part of its total operations and will not be subject to unrelated business income taxation if the
charity retains control over the partnership arrangement and operations which constitute one or more
related businesses (Rev. Rul. 2004-51).
In this case, the university offers, as part of its educational programs, summer seminars to
enhance the skill level of elementary and secondary school teachers. To expand the reach of
these seminars, the university, along with a for-profit company, formed a limited liability company
(LLC). The for-profit company specializes in the conduct of interactive video training programs. Its
governing instruments provide that the sole purpose of LLC is to offer teacher training seminars at
locations off the university's campus using interactive video technology.
The university and the for-profit company each hold a 50 percent interest in LLC, which
is proportionate to the value of their respective capital contributions to LLC. The governing
documents of LLC provide that all returns of capital, allocations, and distributions are to be made in
proportion to the members' respective ownership interests.
Its governing documents provide that LLC will be managed by a governing board comprised
of three directors selected by the university and three directors selected by the for-profit company.
LLC will arrange and conduct all aspects of the video teacher training seminars, including
advertising, enrolling participants, arranging for the necessary facilities, distributing the course materials,
broadcasting the seminars to various locations. LLC's teacher training seminars will cover the
same content that is covered in the seminars that the university conducts on its campus. School
teachers will participate through an interactive video link at various locations, rather than in person.
LLC's governing documents grant the university the exclusive right to approve the
curriculum, training materials, and instructors, and to determine the standards for successful completion of
the seminars. The for-profit company is granted the exclusive right to select the locations where
participants can receive a video link to the seminars and to approve other personnel (such as
camera operators) necessary to conduct the video seminars. All other actions require the mutual consent
of the university and the for-profit company.
The governing documents require that the terms of all contracts and transactions entered into
by LLC, with the university, the for-profit company, or any other party, be at arm's length and that
all contract and transaction prices be at fair market value determined by reference to the prices
for comparable goods or services. These documents limit LLC's activities to the conduct of the
teacher training seminars and also require that LLC not engage in any activities that would jeopardize
the tax-exempt status of the university. LLC operates, in all respects, in accordance with its
The university's participation in LLC will be an insubstantial part of its activities. LLC is
classified as a partnership for federal tax purposes.
Inasmuch as LLC is a partnership for federal tax purposes, its activities are attributed to
the university for the purpose of determining whether it continues to qualify for exemption (that
is, whether it is operating primarily for charitable and educational purposes) and whether it is
engaging in an unrelated business.
The activities that the university is conducting through LLC are merely an insubstantial part of
its activities. Therefore, the university participation in LLC, taken alone, will not adversely affect
its continuing qualification for exemption.
The university's activities conducted through LLC constitute a business that is
substantially related to the exercise and performance of the university's purposes and functions. Even
though LLC arranges and conducts all aspects of the teacher training seminars, the university alone
approves the curriculum, training materials and instructors, and determines the standards for
successful completion of the seminars. The fact that the for-profit entity selects the seminar locations
and approves the other personnel does not change the conclusion that the seminars are a related
The teacher training seminars are conducted using interactive video technology and embrace
the same content as the seminars conducted by the university on its campus. LLC's activities
have expanded the reach of the university's teacher training seminars. Therefore, the IRS concluded
that the manner in which LLC conducts the seminars contributes importantly to the accomplishment
of the university's educational purposes; the activities of LLC are substantially related to
the university's educational purposes. Thus, the university is not required to pay any unrelated
business income tax on its distributive share of LLC's income.
¶324 Scope and Future of Private Benefit Doctrine
The outer bounds of the private benefit doctrine are unknown. The IRS sees great expanse in
the doctrine. One court held that private benefit, warranting revocation of the tax-exempt status
of charitable organizations, was present notwithstanding the facts that the organizations were
engaged exclusively in exempt functions and the compensation paid to for-profit companies was
reasonable; the private benefit was found to be inherent in the sheer existence of the relationship. The
IRS adheres to this view.
The private benefit doctrine is being applied in contexts where only tax-exempt organizations
are involved. The IRS takes the position that foundations that grant scholarships to those who
participate in beauty pageants conducted by tax-exempt social welfare organizations (IRC §
501(c)(4) entities) cannot qualify for exemption because they confer undue private benefit on the social
welfare organizations by enhancing public interest and participation in the pageants. A court held
that an educational training organization cannot be exempt because the training is in connection with
a certification program operated by a related association (an IRC §501(c)(6)) entity, causing
the conveyance of unwarranted private benefit to the association.
The IRS has released final regulations to illustrate the reach of the private benefit doctrine.
73 Fed. Reg. 16519 (March 28, 2008). In the regulations the IRS provides three examples to
illustrate several points: Example 324-A illustrates that private benefit may involve
non-economic benefits; Example 324-B that private benefit is inconsistent with tax-exempt status under IRC
§501(c)(3) if it is substantial and not merely incidental to the accomplishment of the
organization's exempt purposes; and Example 324-C that private benefit may exist even though the transaction is
at fair market value. The IRS states that "these examples are intended to illustrate the principle
that private benefit remains an independent basis for revocation even if it does not involve
economic benefit or raise fair market value issues."
(i) O is an educational organization the purpose of which is to study history
and immigration. O's educational activities include sponsoring lectures and publishing
a journal. The focus of O's historical studies is the genealogy of one family, tracing
the descent of its present members. O actively solicits for membership only
individuals who are members of that one family. O's research is directed toward publishing
a history of that family that will document the pedigrees of family members. A
major objective of O's research is to identify and locate living descendants of that family
to enable those descendants to become acquainted with each other.
(ii) O's educational activities primarily serve the private interests of members of
a single family rather than a public interest. Therefore, O is operated for the benefit
of private interests in violation of the restriction on private benefit in paragraph
(d)(1)(ii) of this section. Based on these facts and circumstances, O is not operated
exclusively for exempt purposes and, therefore, is not described in section 501(c)(3).
(Treas. Reg. §1.501(c)(3)-1(d)(1)(iii), Example 1)
(i) O is an art museum. O's principal activity is exhibiting art created by a group
of unknown but promising local artists. O's activity, including organized tours of its
art collection, promotes the arts. O is governed by a board of trustees unrelated to the
artists whose work O exhibits. All of the art exhibited is offered for sale at prices set by the
artist. Each artist whose work is exhibited has a consignment arrangement with O. Under
this arrangement, when art is sold, the museum retains 10 percent of the selling price to
cover the costs of operating the museum and gives the artist 90 percent.
(ii) The artists in this situation directly benefit from the exhibition and sale of their art. As
a result, the sole activity of O serves the private interests of these artists. Because O gives
90 percent of the proceeds from its sole activity to the individual artists, the direct benefits
to the artists are substantial and O's provision of these benefits to the artists is more
than incidental to its other purposes and activities. This arrangement causes O to be operated
for the benefit of private interests in violation of the restriction on private benefit in
paragraph (d)(1)(ii) of this section. Based on these facts and circumstances, O is not
operated exclusively for exempt purposes and, therefore, is not described in section 501(c)(3).
(Treas. Reg. §1.501(c)(3)-1(d)(1)(iii), Example 2)
(i) O is an educational organization the purpose of which is to train individuals in a
program developed by P, O's president. The program is of interest to academics and
professionals, representatives of whom serve on an advisory panel to O. All of the rights to the
program are owned by Company K, a for-profit corporation owned by P. Prior to the existence of
O, the teaching of the program was conducted by Company K. O licenses, from Company
K, the right to conduct seminars and lectures on the program and to use the name of
the program as part of O's name, in exchange for specified royalty payments. Under the
license agreement, Company K provides O with the services of trainers and with course
materials on the program. O may develop and copyright new course materials on the program but
all such materials must be assigned to Company K without consideration if and when
the license agreement is terminated. Company K sets the tuition for the seminars and
lectures on the program conducted by O. O has agreed not to become involved in any
activity resembling the program or its implementation for 2 years after the termination of
O's license agreement.
(ii) O's sole activity is conducting seminars and lectures on the program. This
arrangement causes O to be operated for the benefit of P and Company K in violation of the
restriction on private benefit in paragraph (d)(1)(ii) of this section, regardless of whether the
royalty payments from O to Company K for the right to teach the program are reasonable. Based
on these facts and circumstances, O is not operated exclusively for exempt purposes
and, therefore, is not described in section 501(c)(3). (Treas. Reg. §1.501(c)(3)-1(d)(1)(iii), Example 3)
It may be anticipated that the private benefit doctrine will continue to be applied by the IRS
and the courts, and that its scope will increase. Inasmuch as an insider is not required for the
private benefit doctrine to be applied, the doctrine can be invoked where the private benefit doctrine
and/or the intermediate sanctions rules cannot.