Fundraising and Private Inurement
by Rich Johnson
Table of Contents
I. INTRODUCTION............................................................................................................................ 1
A. CHARITIES................................................................................................................................ 2
B. CONTINGENT PAYMENT AGREEMENT ....................................................................................... 2
C. NONPROFIT ORGANIZATIONS, CHARITIES AND FUNDRAISING................................................... 3
D. PRIVATE INUREMENT ............................................................................................................... 3
E. ISSUE ........................................................................................................................................ 4
II. ANALYSIS ................................................................................................................................... 4
A. PRIVATE INUREMENT AND COMPENSATION.............................................................................. 4
B. STRUCTURING THE AGREEMENT............................................................................................... 6
C. OKLAHOMA FUNDRAISING LAW ............................................................................................... 8
D. ASSOCIATION OF FUNDRAISING PROFESSIONALS ...................................................................... 9
E. COMMISSION BASED PAY ....................................................................................................... 10
F. SUMMARY .............................................................................................................................. 12
III. CONCLUSION .......................................................................................................................... 13
A. THE AGREEMENT ................................................................................................................... 14
B. FUTURE OF THE LAW .............................................................................................................. 15
C. FINAL REMARKS .................................................................................................................... 17
I. INTRODUCTION
The issue addressed in this paper is the problem that can arise when fundraisers are paid
on a contingent basis. The central issue is be the appearance of private inurement. Private
inurement may be found where it appears that part of the net earnings of the organization are
coming into the use of a person having a personal and private interest in the organization.
Charities need to plan and take precautionary measures to ensure that contingent payment
agreements with fundraisers are not viewed as private inurement by the Internal Revenue
Service. A contingent payment agreement is one where a fundraiser is paid based on the amount
of money he or she raises. The appearance of private inurement could jeopardize the
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organization's tax-exempt standing. The objective of this paper is to explain the correct way for
charities to structure commission based payment agreements to avoid the appearance of private
inurement, and to suggest ways in which the law in this area may be improved.
A. CHARITIES
The primary focus of this paper is on Internal Revenue Code Section 501(c)(3) charities.
Section 501(c)(3) of the Internal Revenue Code exempts corporations and any community chest,
fund, or foundation 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, no part of the net
earnings of which inures to the benefit of any private shareholder or individual, no substantial
part of the activities of which is carrying on propaganda or otherwise attempting, to influence
legislation, and which does not participate in, or intervene in, any political campaign on behalf of
any candidate for public office1.
B. CONTINGENT PAYMENT AGREEMENT
Many charities wish to pay their fundraisers based on a contingent agreement where the
fundraiser is compensated partially or wholly based on the amount of money he or she raises. For
example a fundraiser may be allowed to keep 20% of funds raised as payment for his or her
services. One of the main reasons that many charities prefer this type of compensation agreement
is that they can ill afford to pay up front for fundraising services that may or may not result in
donations to the organizations2 and they may lack fundraising expertise.
1 IRC Section 501(c)(3).
2 http://nonprofitconsultant.blogspot.com/2007/12/yet-more-on-percentage-based.html
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C. NONPROFIT ORGANIZATIONS, CHARITIES AND FUNDRAISING
Nonprofit organizations are, as the name indicates, organizations that do not make a
profit. In order to remain operative over the years, nonprofit organizations have an excess of
revenues over expenses. In any other organization this excess would be called a profit, but
nonprofit organizations do not speak of the word profit.3
Charitable organizations are a subset of nonprofit tax-exempt organizations. While
section 501(c)(3) lists other organizations they are commonly all referred to as charities with the
exception of public safety testing organizations. A definition for the term charitable has not been
fixed and is a hotly debated topic.4 The Regulations note that the term charitable should be
broadly applied in its generally accepted legal sense.5
Fundraising is defined as the organized activity of soliciting money or pledges for
charitable organizations.6 Contingent fundraising is the practice of fundraising where the
fundraisers are compensated based on how much they raise. The payment agreement could be
structured as a percentage of funds raised or as a base compensation plus a percent of funds
raised over a set amount.
D. PRIVATE INUREMENT
One of the requirements to qualify as a section 501(c)(3) charity is that no part of the net
earnings may inure to the benefit of any private shareholder or individual. Black's Law
Dictionary defines inure as to take effect or to come into use.7 The phrase any private
shareholder or individual refers to persons having a personal and private interest in the activities
3 Cafardi and Cherry, Tax Exempt Organizations, 2d Edition (2008)
4 Id.
5 26 CFR 1.503-(d)(2)
6 The American Heritage Dictionary of the English Language, 4th Edition (2006)
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of an organization, including founders, trustees, officers, directors, and donors, but not members
of the beneficiary class contemplated by the organization’s governing instrument and exempt
purposes.8
E. ISSUE
The goal for charities is to enter into contingent payment agreements, as described above,
while avoiding the appearance of private as defined above. In the course of my research, I have
found several tools non profit organizations can use to avoid private inurement including setting
an upper limit on compensation and negotiating at arm's length.
II. ANALYSIS
A. PRIVATE INUREMENT AND COMPENSATION
The disallowance of private inurement means that no benefit may come into the use of a
private individual or shareholder. However nonprofit organizations must compensate their
employees. Compensating employees does not create a private inurement problem unless the
employee has a private interest in the organization. If the employee does have a private interest
in the organization, the benefit which flows to him must be incidental. In most cases fundraisers
are not employees of the organization, but if they have control over the organization may be
considered to have a private interest.
Traditionally the Internal Revenue Service has not treated employees of charities as
having a private interest unless they have control over the activities of the organization.9
7 Blacks Law Dictionary, 3d Edition (2007)
8 Bittker & Lokken: Federal Taxation of Income, Estates, and Gifts, Part 14, Chapter 100, Paragraph 100.4,
Inurement of Earnings to Private Individuals.
9 Rev. Rul. 69-383
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However in the early to mid 1980s the IRS began to expand its views on which persons may have
a private interest.
In General Counsel Memorandum 39498, the IRS said that employees or other
individuals with a close professional working relationship were considered to be persons with a
personal and private interest.10 The IRS concluded that a physician recruitment program, where
a hospital guaranteed a minimum salary for two years, could adversely affect the hospital's
exempt status because the payments may result in an inurement of the hospital's net earnings to
the physicians. As employees or individuals with a close working relationship with the hospital
the physicians are persons who have a personal and private interest in the activities of the
hospital which may be more than incidental.
General Counsel Memorandum 39598 announced the stance that an incidental
flow of private benefits to an organization's control persons would not jeopardize the
organization's exempt status.11 That memorandum also lays out a two part test for determining
whether a private benefit is incidental to the organization's exempt status. The benefit must be
necessarily associated with the organization's activities which benefit the public. The private
benefit must also not be substantial after considering the overall public benefit generated by the
activity.
In Truth Tabernacle, Inc. v. Commissioner of Internal Revenue the IRS established that
where an organization establishes a relationship in which private benefits flow to a control
person in negotiations that were not at arm's length, a reasonableness determination will be made
10 GCM 39498
11 GCM 39598
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by comparison to what would be provided by the same organization to someone with whom it
dealt with at arm's length.12
B. STRUCTURING THE AGREEMENT
The cases below are instances where contingent payment agreements entered into by
501(c)(3) organization were reviewed by United States Courts or the Internal Revenue Service.
A review of these cases provides insight as to what factors the courts will consider when
determining if a contingent payment agreement is private inurement. By properly taking into
account these factors charities can structure contingent payment agreements to avoid private
inurement.
In National Foundation, Inc. v. The United States, the United States Claims Court
rejected the government’s argument that a compensation arrangement maintained by the
taxpayer, that involved the payment to a charitable development officer from each application fee
and of a commission percentage of the contributed amount obtained from each donor, was a
benefit to a private individual. Commission based compensation arrangements are part of
business, the court reasoned, and do not preclude tax-exempt status to the taxpayer if such
arrangement is reasonable.13
In United Cancer Council, Inc. v. Commissioner of Internal Revenue the United States
Court of Appeals for the 7th Circuit overturned an earlier Tax Court holding in which a
fundraising company was determined to be an insider and payments to that company were
deemed to be a private inurement. The term any private shareholder or individual in the
inurement clause of section 501(c)(3) of the Internal Revenue Code has been interpreted to mean
12 Truth Tabernacle, Inc. v. CIR, 41 T.C.M. 1405 (1981)
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an insider to the charity. Orange County Agricultural Society, Inc. v. Commissioner, 893 F.2d
529, 534 (2d Cir. 1990). The court interprets this provision as being designed to prevent the
siphoning of charitable receipts to insiders of the charity, not to empower the IRS to monitor the
terms of arm’s length contracts made by charitable organizations with the firms that supply them
with essential inputs whether premises, paper, computers, legal advice, or fundraising services.14
In World Family Corporation v. Commissioner of Internal Revenue the Tax Court held
that World Family corporation was entitled to tax exemption under section 501(c)(3). World
Family Corporation offered commissions of up to 20 percent to fundraisers who procured
contributions for the organization. The court stated that the commissions program did not result
in private inurement even though its president and incorporator were credited with 10 percent
commissions.15
In People of God Community v. Commissioner of Internal Revenue, the Tax Court found
that there was private inurement where a pastor who also set on the board of directors of a church
was compensated based on percentage of gross receipts, subject to no upper limit. The court
reasoned that a portion of the organization’s earnings were being passed on to the pastor who, as
a member of the board directors, was vested with control of the organization. The court stated
that it did not mean to imply that all contingent compensation arrangements made by charitable
organizations will preclude tax-exempt status and that such arrangements are a part of business
life and must occasionally be paid by a charity to salesmen, publishers, support groups, and even
fund raisers. The court also defined the term private shareholder or individual as referring to
13 National Foundation, Inc. v. The United States, 15 Cl. Ct. 209 (Cl. Ct., 1988).
14 United Cancer Council, Inc. v. Commissioner of Internal Revenue, 165 F.3d 1173 (C.A.7, 1999).
15 World Family Corporation v. Commissioner of Internal Revenue, 81 T.C. 958 (Tax Court 1983).
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persons who have a personal and private interest in the payor organization (Sec. 1.501(a)-1(c),
Income Tax Regs.), but not to include unrelated third parties (Broadway Theatre League of
Lynchburg, VA. V. United States).16
In Broadway Theatre League of Lynchburg, Virginia v. United States of America the
United States District Court for the Western District of Virginia held that an organization which
paid 15 percent of its membership dues to a booking agent was not precluded from tax exempt
status.17
In an Action on Decision RE: Plumstead Theatre Society, Inc. the Internal Revenue
Service found that a Corporation was operated for the private benefit of investors where 63.5
percent of the net profits were paid to limited partners whom performed no services for which
reasonable compensation on a percentage basis is paid.18
In Science and Research Foundation, Inc. v. United States of America the United States
District Court for the Southern District of Illinois held that a company which used royalties from
sales to pay expenses and then deposited further royalties into a fund for publication of new
books or further circulation of published books was entitled to income tax exemption.19
C. OKLAHOMA FUNDRAISING LAW
The Oklahoma Solicitation of Charitable Contributions Act is codified in Section 552 of
Chapter 14 of Title 18 of the Oklahoma Statutes and regulates fundraising. Section 552.3
requires charitable organizations which are soliciting funds to register with the state. The
16 People of God Community v. Commissioner of Internal Revenue, 75 T.C. 127 (Tax Court 1980).
17 Broadway Theatre League of Lynchburg, Va., Inc. v. United States of America, 293 F.Supp. 346 (D.C. VA
1968).
18 Internal Revenue Service, Action on Decision, Re: Plumstead Theatre Society, Inc., AOD 1981-125 (1980).
19 Science and Research Foundation v. United States of America, 181 F.Supp. 526 (D.C. Ill. 1960).
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registration fee is $15. Section 552.4 exempts organizations which collect less than $10,000 per
year from registering and paying the fee. Section 552.5 requires all charities organized in
Oklahoma which received contributions during the year to file information reports. Section
552.7 requires professional fundraisers to register with the Secretary of State and to pay a $50
fee. The applicant must also file a bond, in which the applicant shall be the principal obligor, in
the amount of $2,500. Section 552.14 allows an action for violation of the act to be prosecuted
by any district attorney or by the Attorney General.20
D. ASSOCIATION OF FUNDRAISING PROFESSIONALS
The Association of Fundraising Professionals (AFP) is the largest association of
philanthropic fundraisers and has been the standard-bearer for professionalism in fundraising for
more than 40 years. The AFP has more than 30,000 members in 200 chapters spread across the
world. The association works to promote high ethical standards in fundraising. One of the main
functions of the association is to keep its members up to date on fundraising concerns throughout
the world. In order to maintain public trust the AFP has laid out ethical standards, guidelines,
and principles for not only its members but for donors as well.
AFP members must agree to abide by the ethical standards developed by the organization.
The failure to do so can result in disciplinary measures including expulsion. Five of the AFP
standards address compensation specifically. Members shall not accept compensation or enter
into a contract that is based on a percentage of contributions; nor shall members accept finder’s
fees or contingent fees. Business members must refrain from receiving compensation from third
parties derived from products or services for a client without disclosing that third-party
20 Oklahoma Solicitation of Charitable Contributions Act, 18 O.S. 14 §§ 552.1 – 552.18
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compensation to the client (for example, volume rebates from vendors to business members).
Members may accept performance-based compensation, such as bonuses, provided such bonuses
are in accord with prevailing practices within the members’ own organizations and are not based
on a percentage of contributions. Members shall neither offer nor accept payments or special
considerations for the purpose of influencing the selection of products or services. Members shall
not pay finder’s fees, commissions or percentage compensation based on contributions, and shall
take care to discourage their organizations from making such payments. Any member receiving
funds on behalf of a donor or client must meet the legal requirements for the disbursement of
those funds. Any interest or income earned on the funds should be fully disclosed.2122
E. COMMISSION BASED PAY
As expressed above the AFP disallows commission based pay. The AFP explained its
reasoning in a 2001 position paper prepared by the AFP Ethics Committee. The AFP bases its
view on the fact that private benefits cannot inure to individual's with an interest in the charity
thus private benefits should not be allowed to inure to the fundraiser. The AFP believes that
compensation based on skill, effort, and time does not result in private inurement, but that
commission based compensation does constitute private inurement. The position paper goes on
to list six specific reasons as to why commission based compensation violates their ethical
standards. First, commission based compensation puts the interest of the fundraiser ahead of the
interest of the donor and the public. Second, such compensation compromises the trust of the
donors on which the charity relies. Third, a commission based compensation arrangement may
foster inappropriate behavior by fundraisers. Fourth, tying compensation to the amount of funds
21 www.afpnet.org
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raised may discourage the volunteer work which charities rely on. Fifth, commission based
compensation may provide rewards without merit. Finally, such compensation arrangements
may cause the donor's interest to no longer be paramount.23
It is important to distinguish between ethical obligations and legality. The AFP does not
contend that commission-based fundraising is illegal, only that it is unethical. In a legal sense
commission-based compensation is fine as long as the fundraiser discloses that a percentage of
the donation is going towards compensation. Many people in the fundraising industry do not
adhere to the AFP's view that commission based compensation is unethical. Proponents of
commission based compensation see it as a way for individuals to achieve the American dream
and point to the positive aspects of these agreements such as excitement, motivation, and
rewarding hard work. Doug Tieman, President and CEO of the Caron Foundation, is baffled as
to why national fundraising organizations, such as AFP, take such a strong stance against
commission based compensation. Tieman continues to say that it builds longevity and makes
people feel good about what they are doing. Tieman goes on to say that there have been
countless studies showing that people who have some financial stake in what they are doing
perform better than when they have no financial interest. Tieman also points to the burden the
high turnover rate of fundraisers creates for non-profit organizations. Commission based
compensation would allow these organizations to pay their fundraisers more and would cause the
fundraisers to stay longer, alleviating the burden caused by high turnover.24
22 The remainder of the standards can be found on the AFP website at www.afpnet.org
23 AFP Ethics Committee Position Paper, 2001
24 http://www.iteachfundraising.com/articles/percentage.html
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F. SUMMARY
Paying fundraisers based on a commission can potentially create problems for not for
profit organizations regarding their tax exempt status. Many non-profit organizations wish to pay
their fundraisers this way because it is the only way they can afford to pay for the fund raising
services. In order for an organization to keep its exempt statues, none of its earning may come
into the use of any person having a personal and private interest in the activities of the
organization. Nonprofit organizations have to enter into commission based agreements with
fundraisers while avoiding the appearance of private inurement.
The IRS has expanded the definition of persons with a personal and private interest to
include employees or other individuals with a close working relationship to the organization.
The IRS does allow for the inurement of benefits which are incidental to the organization.
Commission based payment agreements do not, on their face, preclude tax exempt status.
Negotiations of these contracts should be at arm's length. The compensation agreements,
especially with organization insiders, must be reasonable. In order to assure that this
reasonableness factor is not breached organizations should set an upper limit on compensation.
Agreements with 15 to 20 percent commissions have been upheld as not being private inurement.
The association of fundraising professionals as well as other professional fundraising
organizations believe that commission based payments to fundraisers are unethical. The reasons
for this position as cited by the AFP include keeping the interests of the donors first, avoiding the
fostering of inappropriate behavior that may come along with commission based agreements, and
a belief that this type of compensation may discourage volunteer work. While the AFP finds this
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unethical it is not illegal and it is not a requirement that fundraisers be a part of the AFP or any
other national fundraising organizations.
When working under a commission based agreement the fundraiser should
disclose the percentage he gets to potential donors. Proponents of these agreements point to the
excitement they generate in employees, the motivation they create, and the fact that it is the best
way to reward hard work. Nonprofit organizations see a high turnover rate in fundraisers and
commission based agreements will allow fundraisers to earn more money and thus create
longevity. Studies show the performance also increases when people have a financial stake in
what they are doing.
Each individual non profit organization and fundraiser must weigh the positives
and negatives of these decisions. If they determine this is the best agreement for them they must
make sure to avoid the appearance of private inurement by following the guidelines laid out
above.
III. CONCLUSION
Tax exempt organizations are among the most influential organizations in our country
and greatly affect United States public policy. Many types of organizations can be tax exempt
from organizations that exist for religious, charitable, scientific or educational purposes to those
that exist for promoting social welfare, arts organizations, labor unions, golf clubs, and
fraternities.25 The influence and diversity of these organizations is proof as to their importance
in American society.
25 Cafardi and Cherry, Tax Exempt Organizations, 2d Edition, (2008)
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A. THE AGREEMENT
Many nonprofit organizations are smaller organizations with little capital to spend.
Fundraising is an integral part of the operations of most nonprofit organizations. In order to be
successful, non-profit organizations need successful fundraising efforts. In order for these efforts
to be successful, many nonprofit organizations need to be able to attract an experienced and
qualified fundraiser. To attract these fundraisers nonprofit organizations need to be able to pay
them competitively. For many nonprofit organizations with small budgets the only way to do
this is to enter into commission based payment agreements. If fundraisers enter into these types
of agreements the fundraisers will not be allowed membership in the American Fundraising
Professionals organization and will also be barred from other professional fundraising
organizations. If the nonprofit organization decides to enter into commission based agreements
they must be careful to structure the agreement to avoid the appearance of private inurement. One
of the conditions to qualifying for tax-exempt status is that no portion of the net earnings inure to
the benefit of any private individual or shareholder. Inure means to come into the use of and any
private individual shareholder has been broadened to include any employee or other individual
with a close working relationship with the organization. The Service has defined benefit to mean
any benefit that is more than incidental to the organization. When entering into commission
based agreements, non-profit organizations must be very cautious as to how they structure the
agreement. Commission-based payment arrangements can be structured properly to avoid the
appearance of private inurement. The organizations must make sure negotiations with their
fundraisers are done at arm's length. This simply means that the parties should be independently
represented and be negotiating for the best deal. The commission percentage should be limited.
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The courts have held that up to 20% is reasonable for outsiders and up to 10% for insiders. In
addition to an upper percentage level the agreement should also have an upper limit in terms of
total compensation. The compensation must be based reasonable and based on services for
which percentage based compensation is appropriate. An initial portion of the compensation
paid to fundraisers should also go to reimburse them for their expenses. A suggested
compensation agreement may involve payment on three levels. First, a reimbursement of
expenses. Second, an initial salary for services. And finally payment based on a percentage of
funds raised above a certain level. As discussed above the commission percent should probably
be no more than 20 percent and the total compensation should be capped to ensure
reasonableness.
B. FUTURE OF THE LAW
Nonprofit organizations make up an important portion of and play an integral roll in our
society. It is important that we protect these organizations and enable them to stay afloat. For
many nonprofit organizations, the only way to do this is through fundraising and commission
based pay arrangements likely provide an opportunity for more successful fundraising. While it
is important to protect non-profit organizations it is also necessary to keep a watchful eye over
them to ensure that they are not gaining an unfair advantage or abusing the system.
I would suggest that the federal government set up a department with the specific purpose
of regulating nonprofit organization and fundraiser relations. The government could require all
charities and fundraisers used by charities to register. The government could charge a $50
registration fee, as Oklahoma does. I would suggest that this organization lay out guidelines
under which commission based pay arrangements may operate. First, any fundraiser working on
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commission based pay should be required to disclose that fact to donors. Second, set an upper
limit on what percentage may be paid to fundraisers. Third, adopt the reasonableness definition
for compensation used elsewhere in the Internal Revenue Code to provide guidance for setting an
upper bound on compensation. These provisions should allow for any reimbursement of
expenses to be excluded from the calculations of total pay. Forth, the agreements should be
required to be negotiated at arm’s length to provide a further safeguard against the ability to
abuse the system. The Internal Revenue Service could issue a regulation announcing these
standards.
There should also be a reporting requirement which would allow the government to
assure that fundraisers were not abusing the system. One way to achieve this would be to require
the non-profit organizations to report any fundraiser used and to report specific details of the
fundraisers who were paid a set amount. Guidance could be taken from the Oklahoma Statutes
where the limit is set at greater than $10,000. This amount could be a dollar amount, it could be
set as a set percentage of fund raised, or it could be set as a percent of expenses. Whichever
option is taken should set a uniform lower limit which requires non profit organizations to report
fundraisers who exceeded the limit. This information could then be cross-checked to assure that
it was reported properly by the fundraiser, disclosed properly to donors, and that the fundraiser
was no an insider receiving an improper benefit.
The Internal Revenue Service could regulate this area of the law. The Internal Revenue
Service has the ability to take away an organization’s tax-exempt status. The Internal Revenue
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Service could promulgate regulations setting forth the above rules and announce that any
organization not abiding by those rules will have its exempt status taken away.
C. FINAL REMARKS
If nonprofit organizations will follow the guidelines laid out above they should be
able to structure commission based pay agreements to their benefit. This will allow them to be
competitive in compensating fundraisers and allow for more successful fundraising. All of this
should result in more successful non profit organizations which is to the benefit of society.
The government can play its roll in setting up an organization to assist and regulate these
organizations. In doing so the government will be able to give the organizations guidelines to
allow for their success. At the same time the government will be able to more easily ensure that
the system is not being abused.
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