The Fundamentals of the Private Benefit Rule

501(c)(3) nonprofit organizations rightfully focus much of their attention on complying with laws involving conflicts of interest among Board members, officers, and management. However, the “private benefit rule” is often overlooked and reaches far beyond an organization’s insiders. A basic understanding of the private benefit rule can help you navigate potential issues in a wide variety of programs and activities.

The private benefit rule is a doctrine that derives from the definition of charitable, scientific, religious, educational, and other 501(c)(3) exempt purposes, as set forth in the Treasury Regulations. These regulations state that “[a]n organization is not organized or operated exclusively for one or more [501(c)(3)] purposes … unless it serves a public rather than a private interest” (emphasis added). See Treas. Reg. § 1.501(c)(3)-1(d)(1). 

In summary, the “private benefit rule” provides that that the assets and activities of a 501(c)(3) organization must not be used to the benefit the interests of a private persons except to the extent such benefit is incidental to the organization’s 501(c)(3) purpose. The term incidental is meant in both a qualitative and quantitative sense.

Private benefit is quantitatively incidental if such private benefit is “insubstantial” relative to the benefit the activity confers upon the general public.

Private benefit is qualitatively incidental if it is inherent in the conduct of the activity that also confers public benefit, so that one cannot be achieved without the other.

The concept of incidental private benefit is illustrated by Internal Revenue Service (IRS) Revenue Ruling 70-186, which involved an organization that was formed to preserve and clean a lake to enhance its public recreational features. The IRS concluded that the benefits of the organization’s activities flowed principally to the general public, and the private benefit received by lake front property owners as a result of the improvements were incidental, as it would be impossible for the organization to pursue preservation of the lake without providing some benefit to the lake front property owners.

In contrast, in IRS Revenue Ruling 75-286, the IRS ruled that a membership organization formed to preserve and beautify a single city block on which its members owned property did not qualify as a 501(c)(3) organization because the benefits to the individuals and businesses that owned property on that block were more than incidental to the benefits of these activities to the general public in light of the organization’s limited membership and the restricted geographic scope of its activities.

The private benefit rule has two notable differences from the “private inurement” and “excess benefit transaction” rules, which generally govern conflicts of interest and financial transactions with “insiders” who are in a position to exert control over an organization. First, the private benefit rule is more broad, since it applies to all types of individuals, businesses, and non-charitable entities, and not merely to the organization’s insiders.

Second, the concept of “incidental” private benefit does not apply in the inurement and excess benefit transaction context. There is no incidental or de minimis amount of an organization’s assets that Board members, officers, and other “disqualified persons” are permitted to use for their own personal benefit outside of the terms of a fair market value transaction for reasonable compensation, or, in certain cases, participating in widely available programs in the same manner as the general public (for example, being admitted as a patient to a 501(c)(3) hospital, purchasing tickets to a concert presented a 501(c)(3) arts organization, or checking out books from a 501(c)(3) organization library).

The private benefit rule demands consideration and analysis in a very wide range of programs and activities, even those that few people would question as being properly charitable.

For example, as we discussed in Q&A 84, it is not as violation of the private benefit rule to provide financial assistance to individuals so long as the recipients are part of a “charitable class” (financially distressed people, the elderly, the disabled, victims of natural disasters, etc.). Even though financial assistance would, by definition, result in personal benefit to the recipients, serving these groups is generally considered inherent to an organization’s proper 501(c)(3) purposes. Therefore, any private benefit provided to recipients within a charitable class is considered incidental to these charitable purposes.

Similarly, the private benefit inherent in scholarships provided to further the education of the recipients is generally considered incidental relative to the public educational benefits served by the scholarship. However, organizations that provide scholarships must ensure that the pool of applicants and potential recipients is not too narrow (such as is sometimes the case with scholarship programs aimed at a for-profit company’s employees and their relatives), and the application and selection process must be structured in a way that is non-discriminatory and compliant with the private inurement and excess benefit transaction rules and other applicable laws.

Beyond these traditional and relatively straightforward charitable programs, the private benefit rule also arises in more complex and specialized scenarios such as joint ventures with for-profit entities (see e.g., IRS Revenue Ruling 2004-52 and IRS Revenue Ruling 98-15), and scientific research (see e.g., Treas. Reg. § 1.501(c)(3)-1(d)(5), IRS Revenue Ruling 76-296, and IRS Revenue Ruling 68-373).

Planning Tip – When launching a new program that could raise concerns under the “private benefit rule,” it is critical to maintain contemporaneous documentation of your organization’s assessment of the public benefit that would be served by the program (for example, through Board and committee meeting minutes, white papers, etc.). In an IRS audit, concerns about excessive private benefit can often be overcome by highlighting how your organization thoroughly analyzed the issue, prioritized the benefits conferred on the general public, and actively looked for ways to increase the public benefit.

Note that while the private benefit rule technically stems the rules governing 501(c)(3) organizations and (unlike the private inurement rule) traditionally was not applied to 501(c)(4) and other types of non-501(c)(3) organizations, in recent decades the IRS has sometimes applied the private benefit rule as a basis to deny or revoke 501(c)(4) status, as illustrated by this guidance on the IRS website.