In Search of Private Benefit

Abstract

For at least the past two decades, the Internal Revenue Service has relied heavily on the "private benefit" doctrine to police economic transactions between tax-exempt charities and for-profit entities. The doctrine has been used to regulate the size of the charitable class needed to justify exemption, prohibit joint venture transactions between nonprofits and individuals or for-profit entities, regulate employee recruiting, and possibly serve as a substantive constraint on contracts with third parties. Because of the variety of transactions to which it has been applied, no one really can define the doctrine. In a 1987 General Counsel's Memorandum, the IRS stated that private benefits must be balanced against public benefits that result from specific transactions in assessing tax exemption, but did not give any specific rationale for the doctrine nor provide specific guidance for what benefits present transactional problems.

This article attempts to identify both a specific rationale for the private benefit doctrine and the paradigm transactions to which it should apply. Specifically, the article suggests that the private benefit doctrine should be invoked in cases in which transactions carry substantial risk that the charity is "failing to conserve" charitable assets for the charitable class. The article identifies two paradigm situations in which the risk of such "failure to conserve" may be especially high: (1) a charitable entity transacts with an individual or for-profit entity in order to provide "core services" (services that form the basis for tax exemption) to the beneficiaries of the charity (the "outsourcing" paradigm) or (2) the charity enters into a transaction with a for-profit entity or individual involving these core services that confers a competitive advantage on the for-profit in its own business activities (the "competitive advantage" paradigm). In situation (1), the failure to conserve may be the result of paying a profit margin to the for-profit entity to perform services that the charity might be able to provide as efficiently (or more efficiently) directly; in situation (2), the failure to conserve may be the failure to capture the full value of the competitive benefit conferred by the charity on the for-profit. In either situation, the charity should be required to present a reasonable justification that the transaction in question does not "waste" charitable resources in order to maintain exemption.