Summary. A nonprofit board is asked to raise money aggressively, spend it on mission, and avoid every arrangement in which anyone connected to the organization benefits financially — three demands that pull against each other. Most governance failures at exempt organizations come from not seeing the tension until a transaction has closed. This article covers nonprofit fiduciary duties and how they differ from the corporate versions, the private inurement and private benefit doctrines with no analogue in for-profit law, intermediate sanctions and the rebuttable presumption procedure, the unrelated business income tax and its exceptions, and the reporting, lobbying, and solicitation rules that generate the most avoidable problems.

A community arts organization with a $3.1 million budget needs a new executive director. The board chair — a successful local developer who has personally given $400,000 over eight years — proposes his daughter, who has run a small gallery and is genuinely qualified. The board, grateful and informal, agrees. Compensation is set at $185,000, which the chair says is "about right." He abstains from the vote. Nobody writes anything down beyond the minute reciting that the motion carried.

Two years later a departing employee complains to the state attorney general. The complaint alleges nepotism, an inflated salary, and the organization's purchase of a building from an entity the chair controls.

Consider what the organization can and cannot prove. It can prove the chair abstained. It cannot prove the compensation was reasonable — there is no comparability data, no contemporaneous documentation of the basis for the amount, no independent body that approved it free of conflict, because the chair remained in the room and participated in the discussion. It cannot prove the building was purchased at fair market value, because no appraisal was obtained.

Under 26 U.S.C. § 4958, an excess benefit transaction subjects the recipient to a 25 percent excise tax on the excess, rising to 200 percent if not corrected, and subjects each organization manager who knowingly participated to a 10 percent tax. The organization had a straightforward path to protection — the rebuttable presumption of reasonableness — and did not take it, not because the transactions were improper, but because nobody ran the three-step procedure that would have shifted the burden.

That gap between "we did nothing wrong" and "we can prove we did nothing wrong" is the recurring theme of nonprofit compliance.

Exemption, and what it costs

Section 501(c)(3) exempts organizations organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals.

Two tests.

The organizational test looks at the governing documents: the articles must limit purposes to exempt purposes, must not empower the organization to engage more than insubstantially in non-exempt activities, and must dedicate assets permanently to exempt purposes on dissolution. The dissolution clause is the most commonly omitted provision, and its absence is fatal to the application.

The operational test looks at what the organization actually does. "Exclusively" has been read to mean primarily, and the governing principle is that a single substantial non-exempt purpose defeats exemption regardless of the number or importance of exempt purposes. Better Business Bureau of Washington, D.C. v. United States, 326 U.S. 279 (1945).

Prohibitions. No part of net earnings may inure to the benefit of any private shareholder or individual; no substantial part of activities may be carrying on propaganda or otherwise attempting to influence legislation; and the organization may not participate or intervene in any political campaign on behalf of or in opposition to any candidate for public office.

Public charity or private foundation. Every § 501(c)(3) organization is presumed a private foundation unless it establishes public charity status under § 509(a):

  • § 509(a)(1) — churches, schools, hospitals, governmental units, and organizations receiving substantial public support under the § 170(b)(1)(A)(vi) one-third public support test (with a 10 percent facts-and-circumstances alternative).
  • § 509(a)(2) — organizations receiving more than one-third of support from gifts, grants, and gross receipts from exempt-function activities, with not more than one-third from investment income and UBIT.
  • § 509(a)(3) — supporting organizations, in Types I, II, and III, with Type III non-functionally integrated organizations subject to significantly more restrictive rules.
  • § 509(a)(4) — public safety testing organizations.

The distinction matters enormously. Private foundations face an excise tax on net investment income, a 5 percent minimum distribution requirement (§ 4942), an absolute prohibition on self-dealing with disqualified persons (§ 4941, with no reasonableness defense — self-dealing is prohibited even at fair market value), excess business holdings limits (§ 4943), jeopardizing investment rules (§ 4944), and taxable expenditure rules (§ 4945) requiring expenditure responsibility for grants to non-public charities and prohibiting lobbying entirely. Deductibility limits for donors are also lower.

Other exempt categories worth knowing: § 501(c)(4) social welfare organizations (which may lobby without limit and engage in some political activity, but contributions are not deductible); § 501(c)(6) business leagues and trade associations; § 501(c)(7) social clubs; and § 527 political organizations.

Application. Form 1023, or the streamlined Form 1023-EZ for small organizations, which is faster and materially worse — it collects almost no information, which means it provides almost no protection, and organizations that used it frequently discover on examination that their actual operations never fit their claimed purposes. Recognition is generally retroactive to formation if filed within 27 months.

Governance and fiduciary duty

Nonprofit corporations are creatures of state law, and nearly every state has a nonprofit corporation act — many based on the Revised Model Nonprofit Corporation Act. Directors owe three duties.

Duty of care — to act in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in a manner reasonably believed to be in the organization's best interests. In practice: attend meetings, read materials before them, ask questions, oversee finances, and ensure the organization has systems for compliance. Directors may rely on officers, employees, counsel, accountants, and committees they reasonably believe reliable and competent — but reliance is not a substitute for engagement. The classic articulation of nonprofit oversight failure remains Stern v. Lucy Webb Hayes National Training School for Deaconesses and Missionaries, 381 F. Supp. 1003 (D.D.C. 1974), where trustees who never reviewed the institution's finances were held to have breached their duties.

Duty of loyalty — to put the organization's interests ahead of personal interests. This is where the conflict of interest policy lives, and where the private inurement rules attach.

Duty of obedience — a duty distinctive to nonprofits: to be faithful to the organization's stated mission and to honor donor restrictions. Spending restricted funds on general operations is a breach, and in most states the attorney general has standing to enforce it.

The business judgment rule generally protects nonprofit directors who act on an informed basis, in good faith, and without a conflict — but the protection is weaker where the duty of obedience or a restricted gift is at issue, and it does not apply at all to a director on both sides of a transaction.

Who enforces. Not shareholders — there are none. The state attorney general has primary enforcement authority over charitable assets in nearly every state. Members may have standing where the organization has members. Donors generally do not have standing to enforce restrictions, though the Uniform Prudent Management of Institutional Funds Act and some state statutes give limited rights, and a well-drafted gift agreement can create contractual rights that otherwise would not exist.

What a functioning board actually does:

  • Meets regularly with an agenda and materials distributed in advance.
  • Keeps minutes that record what was considered, not merely what was voted. Minutes reciting only motions and outcomes are worthless as evidence of process.
  • Maintains a conflict of interest policy with annual written disclosures, and follows it — recusal from discussion as well as voting, and documentation of both.
  • Reviews financial statements at least quarterly, and understands them.
  • Approves an annual budget and monitors variances.
  • Ensures an audit or review appropriate to size, with an audit committee independent of management. Many states require an audit above a revenue threshold, and many funders require one regardless.
  • Reviews and approves the Form 990 before filing — a question the form itself asks.
  • Adopts document retention and whistleblower policies, both of which the Form 990 asks about.
  • Sets executive compensation through an independent process (below).
  • Conducts periodic executive session without management present.
  • Oversees fundraising practices and restricted fund compliance.

Private inurement, private benefit, and excess benefit

Three overlapping doctrines, frequently conflated, with different scopes and different consequences.

Private inurement — the statutory prohibition in § 501(c)(3) itself. No part of net earnings may inure to the benefit of an insider: a person with a personal and private interest in the organization's activities, such as a founder, director, officer, or major donor. It is absolute — there is no de minimis exception — and the sanction is revocation of exemption. It reaches unreasonable compensation, below-market sales to insiders, above-market purchases from insiders, non-arm's-length loans, rent-free use of property, and personal expenses paid by the organization.

Private benefit — a broader doctrine derived from the operational test, reaching benefits to anyone, insider or not. Benefit to private interests must be incidental both qualitatively (a necessary concomitant of the exempt activity) and quantitatively (insubstantial in relation to the public benefit). A job training program that primarily serves one employer, or a research program whose results are licensed exclusively to a single company on favorable terms, raises private benefit even with no insider involved.

Excess benefit transactions — § 4958, the "intermediate sanctions" regime, so called because it gives the IRS a remedy short of revocation. It applies to § 501(c)(3) public charities and § 501(c)(4) organizations (not private foundations, which have the stricter § 4941 self-dealing rules).

Elements. A transaction in which an applicable tax-exempt organization directly or indirectly provides an economic benefit to a disqualified person that exceeds the value of the consideration received.

Disqualified person — a person who at any time in the preceding five years was in a position to exercise substantial influence over the organization's affairs, plus family members and 35-percent-controlled entities. Statutorily deemed to have substantial influence: voting members of the governing body, the chief executive and chief operating officer, and the chief financial officer or treasurer. Facts and circumstances govern for others; substantial contributors and department heads with independent authority are frequently included.

Taxes. 25 percent of the excess benefit on the disqualified person, 200 percent if not corrected within the taxable period, and 10 percent on each organization manager who knowingly, willfully, and without reasonable cause participated (capped per transaction). Correction means undoing the transaction to the extent possible and making the organization whole.

Automatic excess benefits. An economic benefit is automatically an excess benefit — regardless of amount or reasonableness — unless the organization contemporaneously substantiated its intent to treat it as compensation, by reporting it on Form W-2 or 1099, on Form 990, or in a written employment contract. This is why unreported perquisites are so dangerous: a $9,000 personal use of an organization vehicle that nobody reported is not evaluated for reasonableness at all. It is simply an excess benefit, taxed at 25 percent, and at 200 percent if not corrected.

The rebuttable presumption

26 C.F.R. § 53.4958-6 provides a procedure that shifts the burden to the IRS. Three requirements, all of which must be satisfied:

  1. The compensation arrangement is approved in advance by an authorized body composed entirely of individuals without a conflict of interest with respect to the arrangement. Conflict includes being the person compensated, being in an employment relationship subject to their control, receiving compensation subject to their approval, having a material financial interest affected by the transaction, or approving a transaction providing an economic benefit to the disqualified person in exchange for approving this one. Recusal must be complete — leaving the room, not merely abstaining from the vote.
  2. The body obtained and relied upon appropriate data as to comparability — compensation paid by similarly situated organizations (taxable or tax-exempt) for functionally comparable positions, in the same or similar communities, for similar services; independent compensation surveys; actual written offers from similar institutions; and for property transactions, independent appraisals. A safe harbor permits smaller organizations (under $1 million in gross receipts) to rely on data from three comparable organizations in the same or similar communities.
  3. The body adequately documented the basis for its determination concurrently — meaning by the later of the next meeting or 60 days, and approved as reasonable within a reasonable time thereafter. The documentation must record the terms approved and the date, the members present and voting, the comparability data relied upon and how it was obtained, and any actions by a member with a conflict.

If all three are satisfied, the IRS must develop sufficient contrary evidence to rebut the presumption. If they are not, the organization bears the burden of proving reasonableness with whatever it happens to have.

This procedure is not expensive. Running it costs a compensation survey, a properly constituted committee, and a memorandum. Not running it is the single most common governance failure at mid-sized nonprofits.

Note also § 4960, imposing a 21 percent excise tax on remuneration over $1 million paid to a covered employee, and on excess parachute payments — a separate regime that applies without regard to reasonableness.

Unrelated business income tax

Exemption is from tax on income from exempt activities. It is not exemption from tax generally. 26 U.S.C. §§ 511–514 impose the unrelated business income tax at corporate rates on income from an unrelated trade or business.

Three elements, all required:

  1. A trade or business — an activity carried on for the production of income from the sale of goods or performance of services, evaluated by whether it is conducted with a profit motive and in a manner comparable to commercial activity.
  2. Regularly carried on — with a frequency and continuity comparable to commercial operations. An annual fundraising event is not regularly carried on; a year-round retail operation is.
  3. Not substantially related to the exempt purpose — meaning the activity itself does not contribute importantly to accomplishing the exempt purpose. The use of the income is irrelevant. A museum's decision to spend gift shop profits entirely on curatorial work does not make the gift shop related; whether the items sold themselves further the educational purpose does.

Statutory exclusions from unrelated trade or business (§ 513):

  • Activities in which substantially all the work is performed by volunteers.
  • Activities carried on primarily for the convenience of members, students, patients, officers, or employees.
  • The sale of donated merchandise — the thrift shop exception.
  • Qualified sponsorship payments — an acknowledgment of a sponsor's name, logo, or product line is not advertising, and the payment is excluded. It becomes taxable advertising when it includes qualitative or comparative language, price information, an endorsement, or an inducement to purchase.
  • Qualified convention and trade show activity.
  • Bingo in jurisdictions where it is lawful and not ordinarily carried on commercially.
  • Low-cost articles distributed in fundraising, and certain mailing list exchanges between exempt organizations.

Modifications excluded from UBTI (§ 512(b)): dividends, interest, annuities, royalties, most rents from real property, and gains from disposition of property. Two large caveats. Rent from personal property, rent based on net income or profits, and rent where substantial services are provided lose the exclusion. And the royalty exception turns on passivity — a genuine license of a name or mark for a passive royalty is excluded, while a payment for the organization's active involvement in marketing and endorsement is not. Affinity credit card and insurance programs have been litigated repeatedly on exactly this line, and the drafting of the license determines the outcome.

Debt-financed income (§ 514) is a trap that catches otherwise-excluded passive income. Income from debt-financed property — property held to produce income with acquisition indebtedness — is UBTI in proportion to the average acquisition indebtedness over the average adjusted basis. An organization that borrows to buy a rental building has converted excluded rent into taxable income to the extent of the leverage. Exceptions exist for property substantially related to exempt purposes and, importantly, for qualified organizations' investments in real property under § 514(c)(9).

Siloing. § 512(a)(6) requires an organization with more than one unrelated trade or business to compute UBTI separately for each, with losses from one not offsetting income from another. Regulations use the first two digits of the NAICS code to identify separate businesses, with special rules for investment activities. This eliminated a long-standing planning technique and requires organizations to track activities separately from the start.

Practical consequences. Some UBTI is fine — it is taxed, not fatal. But if unrelated activity becomes substantial relative to exempt activity, exemption itself is at risk under the operational test. Where an unrelated business is material, the ordinary structure is a taxable subsidiary, capitalized at arm's length, with genuine corporate separateness, its own books and board, and arm's-length agreements for any shared services. The subsidiary pays tax; dividends to the parent are generally excluded from UBTI, while interest, rent, and royalties from a controlled subsidiary are subject to § 512(b)(13) and taxable to the extent they reduce the subsidiary's taxable income.

Reporting. Form 990-T is required if gross unrelated business income is $1,000 or more, and it is publicly disclosable for § 501(c)(3) organizations.

Reporting, lobbying, and solicitation

Form 990 — the annual information return, required of most exempt organizations (990-EZ and 990-N for smaller ones, 990-PF for private foundations). It is public, it is indexed and searchable, and it is read by funders, journalists, watchdogs, and regulators.

Its governance section asks whether the organization has a conflict of interest policy and monitors compliance, a whistleblower policy, a document retention policy, whether the process for determining compensation included review by independent persons with comparability data and contemporaneous substantiation, and whether the 990 was provided to the board before filing. None of these is legally required. Answering "no" is not a violation. But the answers are public, and they are the first thing an examiner and a funder look at.

Schedule L discloses transactions with interested persons. Schedule J details compensation. Schedule O is where narrative explanations belong, and organizations underuse it — a well-drafted explanation of an unusual transaction is far better than a bare number that invites a question.

Failure to file for three consecutive years results in automatic revocation of exemption, without notice beyond the statutory scheme. Thousands of organizations lose exemption this way every year, and reinstatement is a paperwork exercise that could have been avoided entirely.

Public inspection. The application for exemption, the last three years of Form 990, and Form 990-T must be available for public inspection and provided on request. Donor names on Schedule B are redacted for public charities.

Lobbying. No substantial part of activities may be attempting to influence legislation. Because "substantial" is undefined and evaluated on facts and circumstances, most organizations that lobby at all should make the § 501(h) election on Form 5768, which substitutes a mechanical expenditure test: a sliding-scale limit beginning at 20 percent of the first $500,000 of exempt purpose expenditures, capped at $1 million, with grassroots lobbying limited to 25 percent of the total limit. Exceeding the limits triggers an excise tax; exceeding them by 150 percent on average over four years risks revocation. The election is nearly always advantageous, and it is one of the simplest filings in this area.

Political campaign intervention is absolutely prohibited for § 501(c)(3) organizations, with no de minimis exception. Prohibited: endorsements, contributions, statements of support or opposition, and rating candidates. Permitted, if conducted in a genuinely nonpartisan manner: voter registration and get-out-the-vote drives, candidate forums inviting all candidates with a broad range of questions, voter guides covering a broad range of issues without editorializing, and issue advocacy that does not reference candidates or elections. The line is real and the sanctions include revocation plus an excise tax on political expenditures.

Charitable solicitation registration. Roughly forty states require registration before soliciting contributions from their residents, with annual renewals and financial reporting. Online solicitation raises the question of which states are implicated; the Charleston Principles, though not binding, remain the common framework — targeting a state's residents or receiving repeated and substantial contributions from a state generally requires registration. Professional fundraisers and fundraising counsel face separate registration and bonding requirements.

State-level rules to check: attorney general notice for dissolution, merger, or sale of substantially all assets; UPMIFA rules on endowment spending and release of restrictions; property and sales tax exemption, which are separate determinations from federal exemption and are frequently contested by local assessors; and state charitable trust doctrines governing restricted gifts.

A short case study

A youth education nonprofit with $6 million in revenue considers four transactions in one year.

Hiring the founder's spouse as development director. The board forms a compensation committee of three independent directors, obtains a salary survey for comparable positions in comparable organizations, documents the basis in a concurrent memorandum, and approves. The founder is not present for the discussion or the vote. The rebuttable presumption applies.

Buying a building from a board member's LLC. Two independent appraisals are obtained. The board member recuses entirely. The transaction is approved at the lower appraised value and disclosed on Schedule L. Documented under the same three-step procedure — which applies to property transactions, not only compensation.

Launching a summer camp open to the public at market rates. Analyzed under UBIT. Because the camp's programming is the same educational programming that constitutes the exempt purpose, it is substantially related and not taxable, notwithstanding market pricing and a profit.

Renting the building's ground floor to a coffee shop. Rent from real property is generally excluded — but the building was purchased with a mortgage, making it debt-financed property under § 514, so a proportional share of the rent is UBTI. The organization reports it on Form 990-T. Because it also runs an unrelated online merchandise business, § 512(a)(6) requires the two to be siloed, and the merchandise loss cannot offset the rental income.

A fifth item nobody flagged: the executive director's personal use of a leased vehicle, unreported on her W-2. Caught in the year-end review, it is corrected — reported, and the organization amends — before it becomes an automatic excess benefit.

Conclusion

Exempt status is not a category an organization occupies. It is a set of ongoing conditions, most of which are procedural.

Three points do most of the work. Run the rebuttable presumption procedure for every transaction with anyone who could be a disqualified person — independent body, comparability data, contemporaneous documentation. It converts a fight about reasonableness into a fight about whether the IRS can rebut, and that is an entirely different case.

Report every economic benefit. The automatic excess benefit rule means an unreported perquisite is not evaluated for reasonableness at all. This is the cheapest risk to eliminate in the entire framework.

Understand that UBIT turns on the relatedness of the activity, not the use of the money. Nonprofit boards reason from the destination of the funds, and the statute reasons from the nature of the activity. Where an unrelated business becomes material, move it to a taxable subsidiary before it threatens the operational test rather than after.

And keep minutes that record reasoning. Nearly every failure described in this article was survivable with contemporaneous documentation and unsurvivable without it.

Frequently asked questions

Can a nonprofit make a profit? Yes. "Nonprofit" describes the distribution constraint, not the income statement. An exempt organization may and should generate a surplus; what it may not do is distribute earnings to insiders. An organization that consistently operates at a deficit is failing at stewardship, not complying with anything.

Can board members be paid? Yes, for services actually rendered, at reasonable amounts, approved by an independent process. Many organizations choose not to compensate directors for board service because it complicates the independence analysis for every subsequent compensation decision — a director who is paid may not be an independent member of the compensation committee.

Can a nonprofit buy from or sell to a board member? Yes, if the transaction is at fair market value, the conflicted director recuses entirely, an independent appraisal supports the value, and the process is documented concurrently. Private foundations are different: § 4941 prohibits self-dealing with disqualified persons even at fair market value, with almost no exceptions. The single most common error made by advisers is applying the public charity analysis to a private foundation.

Do we need a conflict of interest policy? Federal law does not require one. The Form 990 asks whether you have one, the answer is public, and every state attorney general and institutional funder treats its absence as a signal. Adopt one, collect annual disclosures, and follow it.

What happens if we lose exemption? The organization becomes taxable as a corporation, contributions cease to be deductible, and state exemptions that piggyback on federal status are frequently lost with it. Revocation for private inurement or political intervention is rare; revocation for failing to file for three consecutive years is not.

Is volunteer labor a problem for UBIT? The opposite — an activity in which substantially all the work is performed by volunteers is statutorily excluded from unrelated trade or business, regardless of relatedness.

Can we endorse a ballot measure? A ballot measure is legislation, not a candidate election, so support or opposition is lobbying, not prohibited political intervention. It counts against the substantial part test or, if the § 501(h) election is in place, against the expenditure limits — where it is generally treated as direct lobbying with the electorate as the legislative body.

How much unrelated business is too much? There is no bright line. The operational test asks whether a substantial non-exempt purpose exists. As a working matter, unrelated activity approaching a quarter of revenue or of staff time warrants a taxable subsidiary and a documented analysis rather than an assumption.

Do we have to register in every state where we fundraise? Roughly forty states require registration to solicit their residents, and online solicitation complicates the analysis. Register where you actively target donors and where you receive repeated and substantial contributions, and treat a passive website with a donate button as the fact pattern that requires judgment rather than the one that clearly does not.

What a well-run year looks like

Q1. Annual conflict of interest disclosures collected and reviewed. Prior-year financial statements audited or reviewed. Board approves the audit and meets with the auditor in executive session without management.

Q2. Form 990 prepared, circulated to the full board with a memorandum explaining the governance answers and any Schedule L entries, reviewed, and filed. Schedule O used to explain anything unusual rather than leaving it to inference. Executive compensation reviewed under the three-step procedure, with a new comparability study every two to three years.

Q3. Charitable solicitation registrations renewed. Restricted fund compliance reviewed against the gift instruments — a line-by-line reconciliation, not an assurance. Insurance reviewed, including D&O coverage and whether it responds to attorney general proceedings and excise taxes, which many policies exclude.

Q4. Budget approved. Unrelated business activities reviewed and siloed for § 512(a)(6). Lobbying expenditures totaled against the § 501(h) limits. Document retention schedule applied. Board self-assessment and a review of whether any director's circumstances have changed in a way that affects independence.

Continuously. Every transaction with a director, officer, substantial contributor, or family member routed through the conflict policy before it closes — not after. That single habit prevents most of what this article describes.

Who can sue us for a governance failure? In most states, the attorney general, and in some circumstances members, co-fiduciaries, or a donor with contractual rights under a well-drafted gift agreement. The absence of shareholders means the ordinary derivative-suit pressure is missing, which is exactly why regulators fill the gap and why the Form 990's public governance answers carry so much practical weight.

Related articles

This article is provided for general informational purposes and does not constitute legal or tax advice. Exempt organization rules are detailed and state nonprofit corporation and charitable solicitation requirements vary substantially. Consult qualified exempt organizations counsel before approving a transaction with an insider, launching a revenue-generating activity, or making a § 501(h) election.