By definition, Section 501(c)(3) public charities must serve the public good. But what does this mean in practice? Generally speaking, a public charity’s activities are required to benefit a charitable class and may not benefit the interests of private persons. At some level, however, all public charities do benefit private persons. This paradox forms the heart of one of the most important but often elusive legal concepts for 501(c)(3) organizations: the private benefit doctrine. Interestingly, it also the most common reason nonprofits lose or fail to qualify for tax-exemption under 501(c)(3).
Consider the following examples. Churches operate for the benefit of their parishioners whether the parishioners are needy or not. Social service organizations provide financial resources, support services, and job-training to private individuals. A parent’s donation to a school will often benefit the parent’s child, along with other children there too. Are these acceptable private benefits? In many contexts, yes. Then, how may nonprofit organizations distinguish between permissible and impermissible private benefit?
According to the IRS, under the private benefit doctrine, a charity’s activities may benefit private persons provided that those benefits are “incidental” to the larger charitable activities. Exceeding the incidental threshold jeopardizes tax-exempt status under 501(c)(3). In evaluating private benefit situations, the IRS typically scrutinizes whether a benefit is “incidental” using qualitative and quantitative analyses.
Under the qualitative analysis, the IRS weighs whether the benefits provided to private persons are a necessary consequence, or mere by product, of the charity’s exempt activities benefitting the public at large. If the charity cannot accomplish its exempt activities without also benefitting certain private individuals, this benefit may be viewed as an incidental private benefit qualitatively.
Under the quantitative analysis, the IRS reviews the private benefit against the public benefit advanced by the public charity. Any private benefit must be quantitatively less than the public benefit created by the exempt activity. Two main questions are involved. First, how many individuals or organizations privately benefit (apart from the bona fide charitable beneficiaries)? Second, what is their net financial benefit? The smaller the pool of individuals or organizations that benefit, the likelier an impermissible private benefit exists – contrary to public charity status. Likewise, the greater the private financial benefit as compared to the public’s financial benefit, the likelier such benefit is impermissible. The quantitative approach prioritizes actual results, so metrics can be helpful. For new organizations, a careful business plan may be important to successfully demonstrate a truly public charitable nature.
In application, the qualitative and quantitative analyses often lack sufficient clarity to answer the fundamental question of “how much is too much private benefit?” Keep in mind that the IRS is the gatekeeper, using an inherently imprecise “facts and circumstances” test. Since the determination of whether excessive private benefit exists ultimately rests upon the IRS, remember that actual facts as well as impressions matter. In addition, remember that the common theme under both tests is the incidental nature of the benefits conferred. Generally speaking, so long as the private benefits resulting from a charity’s activities are de minimus – i.e., incidental – tax-exempt status under 501(c)(3) should not be in jeopardy.
Tales from the IRS: Private Benefit Examples
Consider an organization formed to preserve and enhance a large lake as a public recreational facility, with public beaches, launching ramps, and other public facilities. The organization is financed by contributions from lakefront property owners, members of the adjacent community, and municipalities bordering the lake. The IRS’s determination: public charity status, despite the admitted qualitative private benefits, since the benefits flow principally to the general public. Indeed, it would be impossible to accomplish the organization’s purposes without benefitting the lakefront property owners.
The IRS similarly found that a nonprofit organization that promotes and assists in city beautification projects benefitted the public greatly, with only incidental private benefit to business owners and other individuals. Significant factors included the public spaces involved, alleviation of government burdens, and additional charitable activities. Bottom line: the organization’s overall impact was to combat community deterioration, so it qualified as a public charity.
Contrast these cases with a members-only, member-supported community block organization focusing on improving one block through measures such as picking up trash, and encouraging residents to plant shrubbery. The private benefits were qualitatively and quantitatively too excessive for IRS recognition of public charity status.
To develop and protect an organization’s public charity status, both qualitatively and quantitatively, keep the following strategic planning considerations in mind.
- Use a corporate purpose statement that clearly articulates a strong, unquestionably tax-exempt purpose. The purpose statement should serve as the organization’s compass.
- Keep the charitable class of beneficiaries as large as possible and identifiable (e.g., a city or neighborhood, not a block or other small group; cancer survivors generally, not just a few people with a certain medical condition; broadly available scholarships).
- Make sure the nonprofit’s business plan focuses on charitable impact, which is helpful for both IRS compliance and successful donor cultivation.
- Avoid conflicts of interests in administering benefits (e.g., family members of scholarship applicants disqualified from participating in scholarship selection or related nonprofit governance).
- To the extent an organization allows sales to benefit individuals (e.g., artists selling their work through a nonprofit arts organization), make sure such activity is insubstantial in relation to the organization’s overall charitable activity – in terms of both the activity itself and resulting financial benefits.
- Be very careful about partnering with for-profit business, informally or formally. Any joint ventures must primarily further charitable purposes, with minimal conflicts of interest for the nonprofit in terms of its joint venture obligations. Any fee arrangements profiting private interests should be closely scrutinized, as well as demonstrably connected to the charity’s public benefit purposes. (e.g., strategic structured nonprofit partnerships with local businesses, in order to provide job training, employment, and other opportunities to alleviate poverty.)
- Guard against improper political benefits flowing to candidates for public office; a nonprofit’s activities should always be nonpartisan.
Public charities need to wear their charitable nature well, clearly demonstrating that public benefit is primary and that any private benefit is merely incidental. Such strategic efforts are good not only for IRS approval and compliance, but also for their ultimate success in serving their well-defined charitable beneficiaries, garnering donor support, and otherwise doing good.