When is it OK to Pay for Members' Legal Costs?
By: Mark E. Truesdell
Q: Can an association pay a member's legal costs?
A: Yes, if doing so is for the common good of the association's members.
The relevant legal concern is the prohibition against private inurement. Trade and professional societies that are tax exempt under section 501(c)(6) of the Internal Revenue Code must be both organized and operating for the common interests of a given occupation, profession, or industry. Conversely, the exempt organization is not to be organized and operated for the private benefit of its members individually. This prohibition is called the Private Inurement Rule. It's stated in section 501(c)(6): "no part of the net earnings" of an exempt organization may "inure to the benefit of any private shareholder or individual."
Private vs. General Benefit
Why is private inurement prohibited? This prohibition is intuitive: The purpose of most for-profit, tax-paying businesses is to provide an individual service or product meeting the individual needs of a paying customer. Why would the IRS grant a tax exemption to a company that competes with for-profit companies in the commercial marketplace?
The IRS and courts consistently find that services provided by 501(c)(6) associations that look too much like commercial services provided by for-profit companies have crossed the line into the commercial marketplace in violation of the private inurement prohibition.
The market for legal services is one such commercial market. A 501(c)(6) association should not pay for legal services that benefit any one or more individual members as opposed to the common good of all members. So where does that "common good versus private inurement" line fall?
When is paying for legal costs OK? In 1967, the IRS approved an association paying litigation costs that benefited all members of the association evenly. Revenue Ruling 67-175 involved a regional farmers' organization that hired a law firm to represent its members in a lawsuit to enjoin a local factory from emitting noxious air pollutants that were damaging crops in the area. The IRS approved the association subsidy of its members' litigation costs, concluding that pursuit of the injunction did indeed improve the business conditions of the association members generally.
In 1969, the IRS approved payment of legal costs by a national football league to negotiate a two-year nationwide television contract covering all of the league's games. The IRS agreed that one of the league's exempt purposes was to enhance athletic competition by advancing the economic equality of all member teams. Previously, each team negotiated its own television contract, which favored teams located in richer television markets. To eliminate this disparity, the member teams authorized the league to negotiate a nationwide television contract to cover all its games, with royalties shared equally among the teams. The IRS ruled that this approach advanced the common business interest of the league's members; hence, the payment of legal costs by the league was not private inurement benefitting any one member.
In 1990, the IRS approved a medical society paying legal costs of its lawsuit against a defendant accused of illegal price fixing that injured the association's members. Many of the members had already paid substantial special assessments to finance the lawsuit, and the case resulted in a substantial settlement in favor of the association. The association repaid the members who had paid in their special assessments, and it even paid many of those members' lost incomes suffered during the protracted litigation. The IRS ruled that neither type of payment to the members was private inurement, because the litigation was directed toward the improvement of general business conditions in that profession.
In the proper situation, an association can achieve some common good for its members by financing a lawsuit. Funding litigation that benefits the entire industry can achieve a result for members that most members could not afford on their own. But, you must be careful about the private inurement prohibition. If you ever face a proposal involving the payment of costs for legal work for an individual member or members, call your attorney. By coloring inside the lines, you might be able to advance a true associationwide exempt interest without threatening your association's tax-exempt status.
Mark E. Truesdell is a partner at Beving, Swanson & Forrest P.C. in Des Moines, Iowa. Email: firstname.lastname@example.org