Variety Club Tent No. 6 Charities, Inc. v. Commissioner, T.C. Memo. 1997-575 (1997)
Background. Most church treasurers are not familiar with the term "inurement." That is unfortunate, because unfamiliarity with this term can jeopardize a church's tax-exempt status. For this reason it is important for church treasurers, as well as church board members, to be familiar with this term. This article will define inurement, and then review a recent Tax Court ruling that addresses the term.
What is inurement? Churches are exempt from federal income taxes so long as they comply with a number of conditions set forth in section 501(c)(3) of the tax code. One of those conditions is that "no part of the net earnings [of the church or charity] inures to the benefit of any private shareholder or individual." What does this language mean? The IRS has provided the following clarification:
An organization's trustees, officers, members, founders, or contributors may not, by reason of their position, acquire any of its funds. They may, of course, receive reasonable compensation for goods or services or other expenditures in furtherance of exempt purposes. If funds are diverted from exempt purposes to private purposes, however, exemption is in jeopardy. The Code specifically forbids the inurement of earnings to the benefit of private shareholders or individuals …. The prohibition of inurement, in its simplest terms, means that a private shareholder or individual cannot pocket the organization's funds except as reasonable payment for goods or services. IRS Exempt Organizations Handbook section 381.1.
A recent Tax Court ruling. The United States Tax Court addressed the concept of inurement in a recent decision. A charity was organized to benefit disabled and underprivileged children. It conducted bingo games to raise funds. The charity's charter contained the following paragraph:
No part of the net earning of the corporation shall inure to the benefit of, or be distributable to its members, trustees, officers, or other private persons, except that the corporation shall be authorized and empowered to pay reasonable compensation for services rendered and to make payments and distributions in furtherance of [its exempt] purposes.
The IRS revoked the charity's tax-exempt status on the ground that some of its earnings "inured" to the benefit of its treasurer and another officer. The IRS based its action on the following grounds:
* The treasurer and another officer of the charity embezzled more than $130,000 of bingo earnings.
* The charity paid the legal fees of the treasurer in defending himself against criminal charges associated with his embezzlement of bingo proceeds.
* The treasurer misappropriated a check that was payable to the charity.
* The charity rented a building owned by its treasurer for the bingo games, and paid him $26,000 in rent for eight months each year.
The charity appealed the IRS ruling. The Tax Court's decision is summarized below.
Did the embezzlement of bingo proceeds by the treasurer and other officer constitute "inurement" of the charity's resources to private individuals? If so, the IRS was justified in revoking the charity's exempt status. The charity insisted that inurement requires an intentional payment of excessive compensation to an officer or employee, and that this requirement is not met when an officer embezzles a charity's funds. The Court agreed with the charity that the embezzlement of funds did not constitute inurement:
- [The treasurer and other officer] worked together to skim part of the proceeds of the bingo games … and to hide this skimming from [the charity's] board of trustees by falsifying the records of the bingo operations. Part of the skimmed funds was used for unauthorized repairs and renovations, part was used for unauthorized and illegal compensation paid to bingo workers, and part went into [the officers'] pockets.
- Neither side has directed our attention to any court opinion in the inurement area involving theft from an organization by an insider with respect to that organization, and our research has not led us to any such opinion …. The boundaries of the term "inures" have thus far defied precise definition. As [the IRS] points out, [the charity's] suggestion that inurement means the intentional conferring of a benefit cannot be allowed to mean that there is no inurement unless "all the organizations' officers and board members have actual knowledge of, and affirmatively act to cause, the prohibited benefit." By the same token, we do not believe that the Congress intended that a charity must lose its exempt status merely because a president or a treasurer or an executive director of a charity has skimmed or embezzled or otherwise stolen from the charity, at least where the charity has a real-world existence apart from the thieving official. We conclude that [the charity in this case] had such a real-world existence … and that [the officers'] thefts were not inurements of [the charity's] net earnings.
Key point. Prohibited inurement must be received by a "private shareholder or individual." This term is defined by the income tax regulations to include "persons having a personal and private interest in the activities of the organization." The Tax Court concluded that this term refers to "those who have significant control over the organization's activities."
payment of attorneys' fees
The IRS insisted that a charity's "payment of legal fees on behalf of its individual members and officers acting in their private capacity constitutes private inurement." And, since the charity in this case had paid legal fees incurred by the treasurer in defending himself against the criminal prosecution, prohibited inurement occurred.
The Court noted that the charity's charter called for the "indemnification" of officers for expenses incurred in a civil lawsuit or criminal prosecution stemming from the performance of their official duties—but only if certain conditions were satisfied. Those conditions were not met. As a result, the Court concluded: "[The charity] did not follow the procedure prescribed by its articles of incorporation for indemnifying an officer. Thus, the net effect of the transaction was that [it] paid a private expense of [its treasurer]. We conclude that this constitutes an inurement of [the charity's] net earnings to a private shareholder or individual."
It is important for church treasurers to be familiar with this conclusion. The payment of an officer's legal fees by your church may constitute inurement that will jeopardize your tax-exempt status if the fees were incurred in defending the officer for acts committed in his or her private capacity. This can occur in either of two ways:
(1) Indemnification provision. Does your church charter or bylaws contain an indemnification provision permitting the payment of an officer's legal expenses under certain conditions? If so, then it is essential that these conditions be met before any legal fees are paid. This case suggests that a failure to do so may constitute inurement and jeopardize the church's exempt status.
(2) No indemnification provision. Many churches do not have an indemnification provision in their charter or bylaws. If this is true of your church, then the payment of the legal fees of an officer for acts unrelated to his or her official duties may constitute inurement that will jeopardize the church's exempt status.
Example. A pastor is prosecuted for a traffic offense. The offense did not occur while the pastor was performing his pastoral duties. The church board would like to pay the pastor's legal expenses out of church funds. This case suggests that the payment of the pastor's legal expenses under these circumstances may constitute inurement of the church's resources to a private individual. The effect of this would be to jeopardize the church's tax-exempt status.
Example. A youth pastor is accused of sexual misconduct. The incident occurred off of church property and was not in the course of an official church activity. The family of the victim sues the youth pastor and church. The church's insurance company agrees to defend the church but not the youth pastor. The church board would like to pay the youth pastor's legal expenses. This case suggests that the payment of the youth pastor's legal expenses under these circumstances may constitute inurement of the church's resources to a private individual. The effect of this would be to jeopardize the church's tax-exempt status.
Example. A pastor is audited by the IRS and assessed several thousand dollars in back taxes. The pastor retains a tax attorney and appeals the IRS determination. The church board would like to pay the pastor's legal expenses. This case suggests that the payment of the pastor's legal expenses under these circumstances may constitute inurement of the church's resources to a private individual. The effect of this would be to jeopardize the church's tax-exempt status.
Example. A church issues securities to raise funds for a new building and sells the securities to members of the congregation. Several members lose a significant portion of their investments in these securities, and they sue the pastor and church. The church's insurance policy does not cover this lawsuit, and so the church has to pay its legal expenses. The church charter contains an indemnification provision allowing the church board to pay the legal expenses of any officer as a result of actions committed in the course of church business—so long as there is no finding of criminal activity. The church board would like to pay the pastor's legal expenses. This case suggests that the payment of the pastor's legal expenses under these circumstances would not constitute inurement of the church's resources to a private individual. The payment of legal expenses under an indemnification clause is not inurement if all of the conditions of the clause are satisfied. This assumes, of course, that the pastor is not found guilty of a criminal act in connection with the issuance or sale of securities.
misappropriation of a check
The charity issued a check in the amount of $2,500 to another charity. One of its officers acquired the check and endorsed it to himself. The IRS asserted that this was another example of prohibited inurement that justified a revocation of the charity's tax-exempt status. The Tax Court disagreed, noting that any misappropriation would have been an "unauthorized taking, essentially a theft similar to the bingo proceeds skimming that [the officers] engaged in." As such, it was not inurement since it was not a voluntary and intentional action by the charity.
rental of an officer's building
The IRS insisted that the charity's payment of $26,000 each year to its treasurer to rent his building for bingo sessions amounted to prohibited inurement. The charity argued that it had to pay rent to someone to conduct bingo games and that the amounts it paid to its treasurer were reasonable. The Tax Court announced the following rule:
- An organization's payment of reasonable rent to an insider for the organization's use of the insider's property would not constitute inurement of net earnings but payment of an excessive amount in the form of rent would.
The Court acknowledged that if the charity paid more than reasonable rent to the treasurer for use of his building "then it appears that there was inurement of [its] net earnings to [the treasurer]." However, the Court concluded that the IRS had failed to prove that $26,000 was an excessive amount of rent and therefore no inurement was established.
Example. A church board member owns a building near the church. The church would like to rent a portion of this building for one day each week. The board member and church enter into a lease agreement calling for annual lease payments of $50,000. Such an arrangement will constitute prohibited inurement, and will jeopardize the church's tax-exempt status, if the size of the lease payments is "excessive." Whether or not the lease payments are excessive requires an analysis of all of the facts.
Key point. The lesson for church treasurers is clear—never enter into a lease arrangement with a pastor, officer, or board member unless the lease payments are reasonable in amount. We recommend that you obtain a written opinion from a neutral real estate broker, or attorney, that the amount of the lease payments is reasonable. Such a letter will be very helpful to the church in the event that the IRS asserts that the lease arrangement resulted in prohibited inurement.
The IRS revoked the charity's tax-exempt status retroactively for all of the years in which prohibited inurement occurred. The Tax Court agreed that this was appropriate. The Court observed that "if the revocation, which occurred years after the last of the years in issue, had been made prospective only, then the revocation would have been little more than a meaningless act." This is an important point. It illustrates that if prohibited inurement occurs, the IRS has the discretion to revoke a charity's exempt status retroactively for those years during which the inurement occurred (and for all subsequent years).