The Federalist Society’s Private Inurement Problem
Does IRC 4958, imposing an excise tax on excess benefit transactions, override IRC 501(c)(3)’s prohibition against private inurement? By that I mean, does 4958 cover all that is prohibited by 501(c)(3). I don’t think so and I think some of the comments in a Politico report analyzing potential private inurement in the Federalist Society misses this point. By the way, our man Phil is quoted in the article correctly pointing out that an insider’s operation of his charity in explicit or implicit association with his for-profit entity is definitely problematic. Here is the gist of Politico’s investigation:
A POLITICO investigation based on dozens of financial, property and public records dating from 2000 to 2021 found that Leo’s lifestyle took a lavish turn beginning in 2016, the year he was tapped as an unpaid adviser to incoming President Donald Trump on Supreme Court justices. It’s the same period during which he erected a for-profit ecosystem around his longtime nonprofit empire that is shielded from taxes. Leo was executive vice president of The Federalist Society at the time. The for-profit and nonprofit entities share more than just Leo’s involvement: The same longtime ally managing the books for two of his new leading nonprofits, Neil Corkery, is also chief financial officer of Leo’s for-profit company, POLITICO confirmed in IRS filings. One of those nonprofits paid the for-profit $33.8 million over two years.
Later, the report suggests that this might be fine so long as everything bought from or sold to Leo’s for-profit is at fair market value. For the record, let’s clarify that all private inurement constitutes private benefit. The opposite is not true because private benefit can occur without the participation of an insider. To the extent an insider — a disqualified person under IRC 4958(c)(1)(A) — enriches himself by non-fair market value returns, there is an act of private inurement and excess benefit. And those transactions suggest, if not prove, that the organization is operating for private benefit — in this case the insider’s private benefit. That explanation does not address the normative concern arising when an insider purchases all, or nearly all the organization’s mission inputs exclusively from the insider’s for-profit entity. Even when the inputs are purchased at fair market value, the exclusive franchise granted by the organization to the insider’s for-profit creates an intolerable conflict. Or at least it ought to, so that protective rules should be implemented. The grant of the franchise is less obviously a private inurement or excess benefit transaction if all inputs are purchased at fair market value. Still the insider has preferred access to the organization’s secondary but invariable ability to provide revenues to suppliers.
The insider’s monopolization of the charity’s necessary buying raises two problems we should not simply accept in organizations operating with public subsidy. First, there is the market value of the exclusive franchise appropriated to the insider’s closely related for-profit entity, and thus the insider. The franchise itself is valuable so it should not matter that each transaction pursuant to the franchise is at fair market value. Second, conveying an exclusive franchise to an insider is better analyzed as private inurement than private benefit. Private benefit implies the organization was just a lousy market player and a vendor– like the charitable fundraiser in United Cancer Council — took advantage of the organization’s lack of market skill to pay less or get paid more than what it would have paid if both parties were equally informed. Private inurement implies the same thing but adds a more likely reason for the smelly transaction — the insider’s conflict of interest resulting in personal enrichment. I would allow the transaction, though, if it is proven that the exclusive franchise saved the organization money or increased its charitable impact. For example, the insider appropriates an exclusive franchise but charges below market rates in each transaction. In that case, the [private] benefit to the insider dissipates because the insider exhibits a donative intent in appropriating the exclusive franchise. The insider donates whatever advantage back to the organization through discounts on each transaction.
In fact, the discount might even be necessary to exclude the transaction from the definition of excess benefit. If the franchise itself is a valuable asset, transferring it to an insider for no consideration (such as discounted prices per transaction) violates IRC 4958(c)(1)(A)’s requirement that the organization receive fair market value. But if the insider’s for-profit is selling without a discount pursuant to an exclusive supplier franchise, the transaction should be analyzed as private inurement because the insider’s status affords more opportunity for abuse, and warrants higher scrutiny and a stronger in terrorem effect than is afforded under the private benefit doctrine.
darryll jones