By Roy Whitehead, Jr., Pam Spikes, and Joan Pritchard
In Brief
'Inurement' Means an Insider Benefited
The U.S. Court of Appeals of the seventh circuit recently overturned a Tax Court decision that supported an IRS action revoking the tax exemption of a charity. The grounds on which the IRS pursued the revocation was a private inurement to a fund-raiser that collected almost $29 million from the public and turned over just $2.3 million to the charity.
The court of appeals looked at the definitions in IRC section 501(c)(3) and the issue of control and reached a different conclusion. The opinion of the court of appeals gives the logic for the decision and a great deal of guidance for those seeking to understand what private inurement is all about.
The IRS and the Tax Court recently tried to expand the definition of "inurement" to include arms-length contracts that the IRS considered disadvantageous to a charity. The IRS was shocked and dismayed because the charity's contract with its fund-raiser netted the charity only $2.3 million out of the $28.8 million raised. The IRS's attempt to characterize the business judgment of the charity's board as a private inurement was sternly rebuked by the U.S. Court of Appeals in United Cancer Council v. Comm'r [No. 98-2181 (7th Cir. Feb. 10, 1999)].
The United Cancer Council (UCC) was a charity that sought to encourage preventive and ameliorative approaches to cancer, as distinguished from searching for a cure, which has been the emphasis of the older and better known American Cancer Society. The IRS revoked UCC's charitable exemption, and the Tax Court upheld the revocation on two grounds. First, that the charity was not operated exclusively for charitable purposes, but rather was operated for the private benefit of Watson & Hughley Company (W&H), the fund-raising company that represented UCC. Second, that because the fund-raising contract was too generous, part of the charity's net earnings had inured to the benefit of a private shareholder or individual, namely W&H. IRC section 501(c)(3) provides for a tax exemption if the charitable organization is "organized and operates exclusively for ... charitable ... purposes" and if "no part of the net earnings of the organization inures to the benefit of a private shareholder or individual." Consequently, private inurement is absolutely prohibited in an exempt organization. The Tax Court upheld the IRS's second ground for revoking UCC's exemption, private inurement, because the exclusive fund-raising contract was deemed too favorable to W&H. The Tax Court did not rule on the private benefit issue, the first ground advanced by the IRS.
The Facts
In 1984, UCC was a tiny organization. It had an annual operating budget of only $35,000, and it was on the brink of bankruptcy because several of its larger member societies had defected to its rival, the American Cancer Society. A committee of the board picked W&H, a specialist in charity fund-raising, as the best prospect for raising the funds essential to UCC's survival. Because of UCC's perilous financial condition, it wanted W&H to front all the expenses of the fund-raising campaign. W&H agreed, but it demanded in return that it be made UCC's exclusive fund-raiser during the five-year term of the contract; that it be given co-ownership of the list of prospective donors generated by its fund-raising efforts; and that UCC be forbidden, both during the term of the contract and after it expired, to sell or lease the list, although UCC would be free to solicit repeat donations.
Over the five-year term of the contract, W&H mailed 80 million letters soliciting contributions to UCC. Each letter contained advice about preventing cancer, as well as a pitch for donations; 70% of the letters also offered the recipient a chance to win a sweepstakes prize. The text of all the letters was reviewed and approved by UCC. As a result of the mailings, UCC raised $28.8 million. Its expenses--the cost borne by W&H for postage, printing, and mailing the letters and costs reimbursed by UCC according to the terms of the contract--were $26.5 million. The balance, $2.3 million, was spent by UCC for services to cancer patients and research for the prevention and treatment of cancer.
Although UCC considered its experience with W&H successful, it did not renew the contract when it expired under its terms in 1989. Instead, it hired another fund-raising organization. The results were disastrous. The following year, UCC declared bankruptcy, and within months, the IRS revoked its tax exemption retroactive to the date on which UCC signed the original contract with W&H. The effect--and perhaps the primary motivation--was to make the IRS the major creditor of UCC in the bankruptcy proceedings. The retroactive revocation did not, however, affect the charitable deduction that donors to UCC had taken on their income tax returns.
The IRS's Position
The IRS took particular note of the part of IRC section 501(c)(3) having to do with private inurement: "No part of the net earnings of the charity may inure to the benefit of any private shareholder or individual." The IRS claimed that part of the charity's net earnings had inured to the benefit of W&H which, under the circumstances, should have been characterized as a private shareholder or individual. The Tax Court agreed and upheld the IRS's revocation of UCC's tax exemption on the private inurement theory.
The Appeal
In United Cancer Council, the appeals court commenced its review with a discussion of the terms involved. The court said that "any private shareholder or individual" in the inurement clause of IRC section 501(c)(3) has always been interpreted to mean an insider of the charity (Orange County Agricultural Society v. Comm'r, 893 F.2d 529). A charity is not to siphon its earnings to its founder, the members of its board, the families, or anyone else that can fairly be described as an insider, that is, an equivalent of an owner or manager. The test is functional. It looks to the reality of control rather than to the insider's place in a formal table of organization.
Previous Tax Court cases held that the key factor in deciding whether a tax-exempt entity retains its exemption is the extent of operational control over the charitable assets by the tax-exempt participant [See Housing Pioneers v. Comm'r, 65 T.C.M. (CCH) 2191 (1993) amended 58 F.3d 401 (1995) and "Revenue Ruling 98-15: Operational Control Saves the Exemption," The CPA Journal, Nov. 1998]. The insider who exercises control could be a "mere employee or even a nominal outsider, such as a physician with hospital privileges in a charitable hospital" (Rev. Rul. 98-15).
In writing that it is important to understand what the IRS did not contend, Chief Judge Richard A. Posner quickly signaled the court's concern with the IRS and Tax Court position on private inurement. The IRS did not contend that any part of UCC's earnings found its way into the pockets of any member of the charity's board; the board members, who were medical professionals, lawyers, judges, and bankers, served without compensation. The IRS did not contend that any member of the board was an owner, manager, or employee of W&H, or a relative or even a friend of any of W&H's owners, managers, or employees. And the IRS did not contend that the fund-raiser was involved either directly or indirectly in the creation of UCC or that it selected or managed UCC's charitable goals. The IRS conceded that the contract between the charity and the fund-raiser was negotiated at arm's length. But it did contend that the contract was so advantageous to W&H and so disadvantageous to UCC that the charity must be deemed to have surrendered control of its operations and earnings to the noncharitable enterprise hired to raise money for it.
The Tax Court's classification of W&H as an insider of UCC was based on the fund-raising contract. Such contracts are common. Fund-raising has become a specialized professional activity, and many charities hire specialists. If UCC's contract with the fund-raiser made the latter an insider, triggering the inurement clause of IRC section 501(c)(3) and destroying the charity's tax exemption, the consequences for the charity sector would be enormous. The IRS does not take the position that every such contract has that effect.
What troubled the IRS were the terms and circumstances of UCC's contract. It argued that, because at the contract's inception the charity had no money to speak of and all the expenses of the fund-raising campaign were borne by W&H, the latter was like a founder, or rather re-founder, of the charity. The IRS pointed out with concern that 90% of the contributions received by UCC during the term of the contract were paid to W&H to defray the cost of the campaign. It argued that W&H was the real recipient of the charitable contributions, and it contended that, because W&H was UCC's only fund-raiser, the charity was at its mercy during the five-year term of the exclusive contract. This relationship, said the IRS, effectively gave W&H operational control over the charity and made it an insider.
Judge Posner wrote that, singly and together, these points bore no relationship to the inurement provision. The inurement provisions were designed to prevent the siphoning of charitable receipts to insiders of the charity, not to empower the IRS to monitor and second-guess the terms of arms-length contracts made by charitable organizations. The IRS's first point was that W&H defrayed such a large fraction of the charity's total expenses in the early stage of the contract that it was the equivalent of a founder of the organization. Carried to its logical extreme, this argument would deny the charitable tax exemptions to any new or small charity that wanted to grow by soliciting donations, since it would have to get the cash to pay for initial solicitations from some outside source, often a fund-raising organization. The court couldn't see what this had to do with inurement.
Judge Posner pointed out that if UCC had hired 10 fund-raisers, the IRS couldn't have argued that any one of them was so large a recipient of the charity's expenditures that it must be deemed to have controlled the charity. Yet in terms of the inurement clause, it makes no difference how many fund-raisers the charity employs. W&H obtained an exclusive contract and, thus, was the sole fund-raiser--not because it sought control of UCC, but because it was taking a risk. Importantly, UCC did not receive a repeated infusion of capital from W&H; all the advances W&H made to start the fund-raising campaign were repaid.
The other point the IRS made demonstrated a lack of understanding of contract law and exclusive contracts. The IRS contended that the exclusive provision of contract put UCC at the mercy of the fund-raiser, since UCC would be barred from hiring another fund-raiser until the contract expired if W&H stopped the fund-raising efforts. When a party is granted an exclusive contract, the law reads into it an obligation of the party to use its best efforts to promote the contract's objectives [citing jurist Cardozo in Wood v. Duff-Gordon, 118 N.E. 214 (N.Y. 1917)]. If W&H folded its tent and walked away, it would be a breach of this implied term of the contract, and UCC would be free to terminate the contract and find another fund-raiser without liability.
The IRS argument that had the most emotional appeal was the high ratio of fund-raising expenses, all of which went to W&H, to net charitable receipts. These figures are deceptive, however, because UCC in part advanced its charitable purpose from the mailings themselves, which contained educational materials in direct support of the UCC's central charitable goal of fighting cancer. This spending, even if deemed excessive, would be in support of, rather than derogation of, its charitable purposes.
The appellate court pointed out that the ratio of expenses to net charitable receipts (even if unusually high) is unrelated to the issue of inurement. The point of ratio to expenses went to UCC's sound judgment, not whether W&H succeeded in wrestling control over UCC. As far as the facts indicated, the contract was favorable to W&H, not because UCC's board was disloyal, but because UCC was desperate to raise money to survive. The charity drove the best bargain it could, whether or not it was a good bargain. The judge indicated that maybe desperate charities should be encouraged to fold rather than to embark on expensive campaigns to raise funds--but that is a separate issue from inurement. W&H did not, through its position, become an insider of UCC. If W&H had such an insider position, how could UCC refuse to renew the contract when it expired and instead switch (with disastrous results) to another fund-raiser?
The court said it could find nothing in the facts to support the IRS's theory or the Tax Court's findings that W&H seized control of UCC and by doing so became an insider, triggering the inurement provision of IRC section 501(c)(3) and destroying the exemption. There was nothing in the facts that corporate or agency law would recognize as control. It was clear that UCC's board still maintained operational control over the charitable activities of the organization as required by Revenue Ruling 98-15. A UCC creditor could not seek satisfaction of its claim from W&H on the ground that the charity was merely a cat's paw or alter ego of W&H.
The IRS and the Tax Court used "control" in a special sense not used elsewhere. The IRS's approach, if supported, would unsettle the charitable sector by empowering the IRS to withdraw a charity's tax exemption if it believed that its contract with a major fund-raiser was too one-sided in favor of the fund-raiser. This would be so even if the charity had not been found, as in UCC, to violate any duty of faithful and careful management of the charity's purpose.
Finally, the court indicated it was not reassured by the government lawyer's response to questions from the bench about what standard he was advocating to guide the court. The lawyer replied that the "facts and circumstances" of each case should guide the decision. Judge Posner pointed out that without a precedent-establishing standard, the tax status of charitable organizations and their donors would be a matter of IRS whim. The court went on to note that there was no evidence of diversion of charitable revenues to an insider here: Nothing smacked of insider dealing, disloyalty, breach of fiduciary obligation, or other misconduct of the type covered by the provisions of IRC section 501(c)(3). What there may have been was imprudence on the part of the UCC board of directors in hiring W&H and in negotiating the contract--but that is not an inurement.
No Lining of Insider Pockets
The IRS's concern about the enormous amount of money retained by the fund-raiser is understandable. UCC's board may have exercised poor business judgment. What did not survive judicial scrutiny, however, was the IRS's attempt to characterize this as a private inurement. The IRC's inurement provisions are intended to prevent the transfer of charitable assets to insiders or anyone who controls a charitable organization. Control is the key. Even if unwise, the contract between UCC and W&H did not result in the transfer of any of UCC's assets to the pockets of an insider or anyone else who controlled UCC. This long-awaited decision provides much needed guidance and brings refreshing economic reality to the regulation of exempt organizations. *
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