Tuesday, February 14, 2023

Joint Venture Private Inurement

Nonprofit Law Prof Blog

In joint venture private inurement, insider sets up a for-profit entity, obtains an exclusive contract with the insider's non-profit and then pays himself fat salaries derived from the not unreasonable fees paid by the nonprofit to the for profit.  


In my very first scholarly piece as professor  -- a piece for which I was wrongly, rudely, and unjustifiably denied a Pulitzer -- I wrote about private inurement.  My goal was to describe the underlying theory that made private inurement and excess benefit broader than the disguised distribution of dividends.  I thanked David and Evelyn in the footnotes, neither of whom probably remember reading early drafts.  I came up with catchy new labels for the "protean" ways private inurement manifested.  "Strict accounting" private inurement happens when the organization pays too much or realizes too little.  "Incorporated pocketbook private inurement" is when an insider uses the organization's revenues for personal consumption, reaching into the organization's assets like his own pocketbook whenever or wherever.  And then "joint venture" private inurement.  There was the coup de grace.  I was convinced the Supreme Court would soon be quoting and citing my article in a monumental landmark case that would forever be defined by "The Scintilla of Individual Profit."  So I released the article into the stream of intellectual commerce and waited for Bill Clinton's phone call and invitations to speak at lighted venues around the world.  "Ich bin ein Berliner!"  or "Mr. Gorbachev, tear down this wall!" I would be quoted as saying.  And Harvard and Yale would be sorry for not pursuing me with greater vigor [or at all, actually] during the meat market.  But all I got were crickets.  My senior mentors at Pitt Law hardly even looked up from writing their own masterpieces to ask "now what are you working on?"

But a letter ruling released last week finally vindicates me.  It involves revocation of an organization's exempt status for joint venture private inurement.  All the personally identifiable information is redacted and that makes reading the letter somewhat difficult; I am pretty sure I have the essential details correct:

The exempt organization operates youth homes.  Husband and Wife were the executives and apparently comprised the entire board, if not just a voting majority.  They had at least three youth homes in different cities and money -- primarily from contracts with state agencies to which children were remanded -- and revenues were increasing.  One day, they got the idea to open a management company to operate the homes.  They incorporated a for-profit management company; they were majority owners, but its not clear whether there were other investors in the entity.  Then, without bids or other shopping around, the nonprofit entity entered into an exclusive contract with the for profit for management services.  Consistent with industry practice, the for profit would be paid a percentage of revenues from the nonprofit youth home operation for its services.  The Service stipulates that the management fees were within industry practice; there is no assertion that the management company charged unreasonable rates.  But the monies paid to the management company are distributed to its  owners by way of salaries and other payments for services to the management company.  

So no strict account private or incorporated pocketbook private inurement.  But something still doesn't seem right.  Here is what I said about joint venture private inurement too many years ago:

Strict accounting private inurement, representing the literal form, is closest to the statutory language, and even incorporated pocketbook private inurement can be made to fit within the literal prohibition if one thinks of unrelated transactions benefiting insiders as distributions of earnings in kind, rather than of cash. Those two forms of private inurement seem to exhaust the means by which an insider might violate the prohibition. The universe, though, includes a third form of private inurement not contingent upon an unfair or unnecessary transaction. This final category, which I call "joint venture private inurement," can occur even though the entity pays or charges an appropriate amount and even though the transactions are entirely appropriate and necessary to the accomplishment of the tax-exempt purpose. Instead, the violation occurs because the operations of the tax-exempt entity and an insider-controlled taxable entity are so closely related that the insider, by virtue of his interest in the taxable entity, financially benefits from the exempt entity's invariable consumer power. The taxable and tax-exempt entities are engaged in an implicit joint venture.  As such, the exempt entity purchases all of its necessary commodities solely from the insider's for-profit entities or otherwise conducts its affairs through an insider's profit-making apparatus.' Although serving an exempt purpose, the entity necessarily subsidizes individual profit making.'

The private letter ruling concludes that the organization's revenues inured to the benefit of insiders, even though the amounts paid to the management company were within reasonable industry standards and without any evidence that the compensation formula incentivized the management company to cut back on charitable services:  

6.  Organization pays management company a substantial amount of money for management services, the vast majority of which management company pays out to husband and wife in the form of salaries and distributions to themselves and their trusts. 

The operational test is not satisfied where any part of the organization's earnings inure to the benefit of private shareholders or individuals, and where the organization serves a private benefit rather than public interests.  (Regulations § 1.501(c)(3)-1(c)(2)) As in People of God, Youth Home fails to qualify for exemption under section 501(c) (3) . 

 7. Youth Home is the main client of  Management Company.  Management Company benefits substantially from the operation of  Youth Home.

Note that the management company became an "insider" (a requirement to find private inurement) by virtue of its ownership and control by the charitable fiduciaries.  Nice teaching points in this ruling once you get beyond the redactions.  

So yes, there is something called joint venture private inurement after all.  President Biden and the Supremes should be calling me any minute now.  I'll just wait right here.


darryll jones


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