Nonprofit key members' use of apartment.

The Service has increased enforcement against nonprofit organizations, particularly charities. In fact, a large portion of the Pension Protection Act of 2006 contained rules for charities. Thus, what are the ramifications of the following situation?

Facts

A large nonprofit organization's chief executive officer (CEO) has resided for years (along with his wife, who is a "significant employee" of the entity), in a town very close to the organization's headquarters. The CEO decides to move out-of-state, making it difficult for him to continue in his position. A board discussion ensues; in employment agreements, the entity affirms that it is willing to continue the CEO's and spouse's employment, if they (1) physically work at headquarters at least one week per month and (2) fulfill all other demands of their positions.

The board later discusses the entity's employee travel-expense reimbursement policies. It proposes to replace the current practice of putting visiting out-of-town, on-business employees in a hotel, with an ostensibly cheaper "corporate apartment" arrangement. The CEO, who will become a major user of the apartment, offers to donate furniture and furnishings, thus reducing the cost of outfitting the unit, and also offers to loan art to decorate it.

The chief financial officer (CFO) and his staff complete an economic analysis and discover that a suitably situated, moderately priced two-bedroom corporate apartment, rented from an unrelated party, would run about $1,500 per month, plus utilities. Given that the CFO'S staff, on average, has been reimbursing lodging costs at about $120 per staff-night for the local hotel, they conclude that about 14 staff-nights would break even with the apartment rent and utilities. The staff finds that, historically, there have been about seven nights of reimbursed hotel use per month. This, when combined with the CEO's intended use (i.e., another seven nights per month), yields 14. All of the business travel is assumed to be ordinary and necessary and the accountable plan rules are assumed to be met.

Issues

This situation raises a number of issues, including whether:

* In light of the IRS's publicized recent "nonprofit scandals," this arrangement will pass muster;

* The expected budget for the proposed apartment is fair and not excessive; and

* Any staff member who stays in the apartment beyond a business-related period should be charged for such use.

Conclusions

Generally, the above proposal would be acceptable, even for the CEO and spouse, and any other key staff members. The expected budget for the proposed apartment appears to be fair and not excessive, to the extent that all costs of maintaining the apartment are considered and total less than the reasonable lodging costs the organization currently pays (except for differences that can be otherwise justified, such as simplified administration, etc.). However, to the extent that any staff member stays in the apartment beyond a business-related period, he or she would need to pay for such use, if the circumstances surrounding the stay are personal, and not merely incidental to the business stay. However, staff members who are "insiders" (generally, key decisionmakers) should be extra-scrupulous in vacating the premises when the business purpose has ended.

Law

In distinguishing a nonprofit organization from a for-profit entity, Sec. 501(c)(3) proscribes private inurement---an undue benefit to any individual or other person having a close relationship to the organization. There is a particular focus on "insiders" (i.e., those in a position to exercise a significant degree of control over the organization, such as founders, directors, officers, key employees and their families and controlled entities); see Sec. 4958(f).

Definition: Inurement is broadly defined. GCM 38459 stated that private inurement "is likely to arise where the financial benefit represents a transfer of the organization's financial resources to an individual solely by virtue of the individual's relationship with the organization, and without regard to accomplishing exempt purposes."

However, Letter Ruling 9130002 stated that"[t]here is no absolute prohibition against an exempt section 501(c)(3) organization dealing with its" insiders. (Private foundations, in contrast, do face an absolute prohibition on "self-dealing" under Sec. 4941.) Inurement can roughly be gauged against a litmus test of reasonableness that compares how similar organizations, for-profit or nonprofit, when acting prudently, transact their affairs under similar circumstances.

Ordinary and necessary: Generally, this inurement test focuses on whether an expenditure is ordinary and necessary, and is more or less currently governed by Sec. 162. This means that the surrounding circumstances and prudent business practice will determine reasonableness.

By allowing staff to stay in a corporate-paid apartment for free, a nonprofit is deemed to be providing use of facilities at below-market rent, which constitutes a benefit. Whether this benefit (or any other) is undue (i.e., inurement) depends on the reasonableness of the benefit and the circumstances surrounding it.

The provision of facilities at below-market rent may or may not be a form of compensation. When characterized as compensation, it would become part of the total compensation of such staff and would be compared to a reasonable amount of compensation, ultimately manifesting (if at all) in excessive compensation. In such case, the value of the provision of such facilities would have to be included in taxable income for any applicable staff members.

However, the provision of facilities at below-market rent would not be characterized as compensation if the surrounding circumstances suggest otherwise. In particular, the maintenance of a corporate apartment may be a more judicious approach to an organization's finances than reimbursement of staff lodging at other quarters, such as hotels. The proper measure of a judicious approach would occur when the lodging costs saved exceed the total cost of maintaining the apartment. A properly documented (substantiated) business-purpose travel and lodging activity, whether reimbursed or occurring at a corporate apartment, would have the same result--it would not affect the staff's personal income tax situation (i.e., it is not taxable compensation to them).

Results

Under the information provided, the leasing of a corporate apartment that results in organizational savings would be both judicious and result in no inurement.

Caveat: When calculating the lodging costs saved, it is important to properly analyze how much of the travel and lodging should be borne by the organization (i.e., only the part ordinary and necessary to its operation). The mere fact of a contract requiring a stay-over would not automatically categorize a cost as ordinary and necessary, especially for those viewed as having control over the formulation and approval of contracts (as in the case of the CEO and spouse). Rather, as previously noted, business prudence in the surrounding circumstances determines the ordinary and necessary nature of the expense. The entity's payment of an employee expense that is not ordinary and necessary confers a personal benefit. Any personal stayover should result in a fair consideration being paid by the staff member to the organization (e.g., the $120/night hotel rate (or any other, more comparable rate for a nightly corporate apartment)). The published IRS maximum lodging reimbursement rates have no bearing on the rate to charge employees for personal use of a corporate apartment.

Insiders: Specific issues need to be addressed for insiders. Given that inurement focuses on whether one or more individuals are abusing power for personal benefits, it is advisable that when business ends, staff members who are insiders (such as the CEO and spouse), depart the corporate apartment.

Strategy

Due to the IRS's increasingly rigid approach in this regard (e.g., the establishment of the Tax Exempt Compensation Enforcement Project; see IR 2004-106), and the Sec. 4958 excess-benefit-transaction rules in particular, it is also advisable that there be a formal board resolution to undertake such a proposal, stating its intention to treat as compensation the unreimbursed value (e.g., $120/day) of any non-incidental personal use of the corporate apartment. Although the above analysis is couched in terms of "inurement," which is one of four types of outlawed insider personal-benefit transactions, the analysis holds true for the other three types (private-benefit doctrine, excess-benefit transactions and self-dealing) as well.

Under the Sec. 4958 excess-benefit rules, penalties of 25%-200% of an excess benefit could be imposed on a staff member, as well as a 10% penalty on each member of the entity's management deemed to have knowledge of the arrangement resulting in the benefit. If an organization is considered to be a habitual offender, it risks losing its exempt charter altogether.

FROM DAN WISE, CPA, GORFINE, SCHILLER & GARDYN, P.A., OWINGS MILLS, MD)