Legal Update: Tax Status Risks
By Nan Roytberg
Association executives are always looking for new services to offer their members. But what if that next great idea turns into your worst nightmare . . . the loss of your association’s tax-exempt status?
This can happen if you run afoul of the “no inurement” provisions of section 501(c)(6) of the IRS code. This article will give you an overview of some complex laws as well as the tools to help you recognize when that great new program idea needs to be cleared by your association attorney or tax advisor.
What is inurement?
There are actually two types of activities that fall under what the IRS calls “inurement” or benefiting an individual. One is an activity with direct financial benefit to a member, such as giving cash, rebates, refunds, insider compensation, loans and other financial assistance. The other is when the association provides the member with something he would otherwise have to buy for his business, such as general business software, computers, or office supplies. This second type of inurement is referred to by the IRS as the “performance of particular services.”
Why is inurement dangerous?
Inurement is an activity that is counter to what tax-exempt associations are established to do. According to the IRS, exempt organizations are:
Business leagues, chambers of commerce, real-estate boards, boards of trade, or professional football leagues, that are not organized for profit and no part of the net earnings of which inures to the benefit of any private shareholder or individual.
This means that the primary activities of organizations must be consistent with the purposes for which tax-exempt status was granted. In the case of REALTOR® associations, this is to improve the business conditions of the real estate industry and its members as a whole.
How do I recognize inurement?
Promoting specific brands or products to the benefit of individual members may be inurement, as might entering into unusually lucrative agreements with association directors or officers.
Note we say “might be” inurement here because the IRS takes into account a number of factors when judging inurement. Here are some points the courts and IRS consider when judging whether an association activity is inurement:
· Does the activity primarily serve the organization’s exempt purposes and is any benefit to the individual merely incidental?
· Does the amount of the rebate/refund exceed the amount of dues or other contributions?
· Are members getting financial benefit at the expense of non-members?
· Are some members getting financial benefit at the expense of other members?
· Are the individuals who are getting benefits insiders?
One example of inurement involves an educational organization that lost its tax-exempt status because its seminars were taught by the organization’s permanent board members. The problem was that various course materials promoted the services of these individuals and their for-profit businesses. Because the individuals were directors and therefore had control of the organization’s operations, the IRS decided that there was a “great likelihood of inurement.”
In another case, officers of a tax-exempt organization made high, noncompetitive purchases from a company in which they had a stake. This resulted in the loss of their tax-exemption. Loans to insiders have also cost organizations their tax-exempt status. This is why you should be very careful when engaging a current board member to provide non-director services or products to your association. When doing so, be certain that:
1) The compensation does not exceed the fair market value of the services;
2) The contract terms are comparable to what you would use with other vendors; and
3) The engagement is approved by a majority of directors without a conflict of interest.
While there are examples in which a small amount of inurement did not cost an organization its tax-exempt status because the benefit to the industry greatly outweighed the benefit to the individual, it’s always best to err on the side of caution when contemplating activities listed as inurement red flags below. When in doubt, talk to your attorney or tax advisor before proceeding.
Inurement Red Flags:
These activities may be a risk to your tax-exempt status if they are frequent enough or substantial enough (subject to analysis of facts in each instance):
* Making loans, paying royalties, or providing financial assistance to members or insiders
* Administering referral systems for members
* Promoting specific brands or products
* Compensating or giving special benefits to individuals who operate or control the organization
* Paying rebates or refunds to members
Just because another REALTOR association has instituted a particular service or program doesn’t mean that it’s a good idea for you. Always do your due diligence before offering any type of new service or program. Determining whether a specific association activity or service might jeopardize the association’s tax-exempt status is not simple, which is why you need to bring your attorney or tax advisor in as soon as you recognize any of the red flags for inurement.
But don’t panic. It’s not necessary to automatically toss aside every great new idea that raises a red flag. Your expert may be able to suggest alternatives or modifications to the service so it won’t jeopardize your status. Most of what your association is already doing is probably fine, but to be on the safe side, review your current programs and discuss any that raise red flags with your advisors. At the end of the day, keep a lookout for the next great idea. . .just be looking for those inurement red flags at the same time.
Performance of Particular Services
The IRS and the courts usually give organizations more latitude when determining this type of inurement activity. As we mentioned, the “performance of particular services” is when the association provides the member with something he would otherwise have to buy for his business. Rather than bettering the industry as a whole, this service benefits an individual. With the performance of particular services, the association only loses its tax-exempt status if the service is a “primary activity.”
Some red flag activities for the performance of particular services are:
* Buying insurance for members
* Providing or selling supplies, forms, or sales tools to members
* Providing management, personnel or payroll services to members
* Engaging consultants to advise members on aspects of their businesses
* Operating an MLS
* Paying defense expenses and judgments related to lawsuits (except where subject of lawsuit is of interest to industry)
* Publishing or purchasing advertising for members (not industry as a whole)
* Publishing a directory comprised exclusively of member businesses
* Administering or providing credit checks on prospective buyers or tenants
One of the landmark cases regarding how much ‘particular services’ constitute a primary activity comes from the Evanston-North Shore Board of REALTORS®. Although this is an older decision from 1963 (and the only one to involve our organization since then), the analysis is clear and still useful.
The court decided that when the association added the operation of a multiple listing service as a primary activity, it lost its tax-exempt status. The court first determined that operating an MLS, though in part aimed at improving industry conditions as a whole, was more focused on the commercial success of individual REALTORS® – and thus was the performance of particular services.
This, however, was not the sole deciding factor. What caused the association to lose its tax exemption was the fact that operating the MLS had become a primary activity. The number of employees had increased from one to five and a half (61 percent) of its gross income now came from MLS activity. Additionally, almost half of the expenses of the association were attributable to the MLS, and the MLS produced a significant profit for the board.
In the wake of this case, recommendations for maintaining an association’s tax-exempt status when operating an MLS were developed and can be found in Appendix 3 of the MLS Handbook. These recommendations are applicable to other activities and include showing no profit and operating the MLS as a for-profit subsidiary of the Board, which is how a majority of the MLSs now function. Since the Evanston-North Shore Board decision, many associations have opted to set up their MLSs as separate tax-paying corporations.
Other associations have lost their tax-exempt status because their income-producing activities—such as selling advertising materials, calendars and supplies to members or providing members with managerial and bookkeeping services—took up at least half of staff time and produced 58 percent of total income.
The 50 percent mark is not necessarily the threshold for moving into non-exempt territory, however. In fact, it can be lower than that, or more subjective altogether. One association was deemed non-exempt even though the staff time spent on non-exempt insurance sales and administration was only 15 percent and the income was in the 30 to 40 percent range. The court said that this percentage was still too substantial because the association performed “numerous clerical duties,” kept “voluminous records,” and processed lots of claims.