Excerpts From Ruling on Charity’s Loss of Tax Exemption

Following are excerpts from a ruling by the the U.S. Court of Appeals for the Seventh Circuit in a case known as United Cancer Council v. Commissioner of Internal Revenue. The decision, written by Chief Judge Richard A. Posner, said the U.S. Tax Court was wrong to endorse the service’s explanation for revoking the tax-exempt status of the cancer charity. The I.R.S. had argued that the organization’s fund-raising consulting company had seized control of the charity. The appellate court said the Tax Court should now consider the validity of the service’s second reason for revoking the cancer council’s tax-exempt status: that the terms of the fund-raising contract meant, in effect, that the charity’s board of directors ran the organization for the “the private benefit” of the consulting company.

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The [Internal Revenue] Service’s point that has the most intuitive appeal is the high ratio of fund-raising expenses, all of which went to Watson and Hughey [the fund-raising company, now known as Direct Response Consulting Company] because it was the United Cancer Council’s only fund raiser during the term of the contract, to net charitable proceeds. Of the $28-odd million that came in, $26-plus million went right back out, to W & H.

These figures are deceptive, because U.C.C. got a charitable “bang” from the mailings themselves, which contained educational materials (somewhat meager, to be sure) in direct support of the charity’s central charitable goal. A charity whose entire goal was to publish educational materials would spend all or most of its revenues on publishing, but this would be in support rather than in derogation of its charitable purposes.

Even if this point is ignored, the ratio of expenses to net charitable receipts is unrelated to the issue of inurement. For one thing, it is a ratio of apples to oranges: the gross expenses of the fund raiser to the net receipts of the charity. For all that appears, while U.C.C. derived a net benefit from the contract equal to the difference between donations and expenses plus the educational value of the mailings, W & H derived only a modest profit; for we know what U.C.C. paid it, but not what its expenses were. The record does contain a table showing that W & H incurred postage and printing expenses of $12.5-million, but there is nothing on its total expenses.

To the extent that the ratio of net charitable proceeds to the cost to the charity of generating those proceeds has any relevance, it is to a different issue, one not presented by this appeal, which is whether charities should be denied a tax exemption if their operating expenses are a very high percentage of the total charitable donations that they receive. To see that it’s a different issue, just imagine that U.C.C. had spent $26-million to raise $28-million but that the $26-million had been scattered among a host of suppliers rather than concentrated on one. There would be no issue of inurement, because the Service would have no basis for singling out one of these suppliers as being in “control” of U.C.C. (or the suppliers as a group, unless they were acting in concert). But there might still be a concern either that the charity was mismanaged or that charitable enterprises that generate so little net contribution to their charitable goals do not deserve the encouragement that a tax exemption provides. Recall that most of U.C.C.’s fund-raising appeals offered the recipient of the appeal a chance to win a sweepstake, a form of charitable appeal that, we are told, is frowned upon. There may even be a question of how reputable W & H is (or was). … But these points go to U.C.C.’s sound judgment, not to whether W & H succeeded in wresting control over U.C.C. from the charity’s board.

U.C.C.’s low net yield is no doubt related to the terms of the fund-raising contract, which were more favorable to the fund raiser than the average such contract. But so far as appears, they were favorable to W & H not because U.C.C.’s board was disloyal and mysteriously wanted to shower charity on a fund raiser with which it had no affiliation or overlapping membership or common ownership or control, but because U.C.C. was desperate.

The charity drove (so far as the record shows) the best bargain that it could, but it was not a good bargain. Maybe desperate charities should be encouraged to fold rather than to embark on expensive campaigns to raise funds. But that too is a separate issue from inurement. W & H did not, by reason of being able to drive a hard bargain, become an insider of U.C.C. If W & H was calling the shots, why did U.C.C. refuse to renew the contract when it expired, and instead switch to another fund raiser?

We can find nothing in the facts to support the I.R.S’s theory and the Tax Court’s finding that W & H seized control of U.C.C. and by doing so became an insider, triggering the inurement provision and destroying the exemption. There is nothing that corporate or agency law would recognize as control. A creditor of U.C.C. could not seek the satisfaction of his claim from W & H on the ground that the charity was merely a cat’s paw or alter ego of W & H. … The Service and the Tax Court are using “control” in a special sense not used elsewhere, so far as we can determine, in the law, including federal tax law. It is a sense which, as the amicus curiae briefs filed in support of U.C.C. point out, threatens to unsettle the charitable sector by empowering the I.R.S. to yank a charity’s tax exemption simply because the Service thinks its contract with its major fund raiser too one-sided in favor of the fundraiser, even though the charity has not been found to have violated any duty of faithful and careful management that the law of non-profit corporations may have laid upon it. The resulting uncertainty about the charity’s ability to retain its tax exemption — and receive tax-exempt donations — would be a particular deterrent to anyone contemplating a donation, loan, or other financial contribution to a new or small charity. That is the type most likely to be found by the I.R.S. to have surrendered control over its destiny to a fund raiser or other supplier, because it is the type of charity that is most likely to have to pay a high price for fund-raising services. …

It is hard enough for new, small, weak, or marginal charities to survive, because they are likely to have a high expense ratio, and many potential donors will be put off by that. The Tax Court’s decision if sustained would make the survival of such charities even more dubious, by enveloping them in doubt about their tax exemption.

We were not reassured when the government’s lawyer, in response to a question from the bench as to what standard he was advocating to guide decision in this area, said that it was the “facts and circumstances” of each case. That is no standard at all, and makes the tax status of charitable organizations and their donors a matter of the whim of the I.R.S.

There was no diversion of charitable revenues to an insider here, nothing that smacks of self-dealing, disloyalty, breach of fiduciary obligation, or other misconduct of the type aimed at by a provision of law that forbids a charity to divert its earnings to members of the board or other insiders.

But what there may have been was imprudence on the part of U.C.C.’s board of directors in hiring W & H and negotiating the contract that it did. Maybe the only prudent course in the circumstances that confronted U.C.C. in 1984 was to dissolve. Charitable organizations are plagued by incentive problems. Nobody owns the right to the profits and therefore no one has the spur to efficient performance that the lure of profits creates. Donors are like corporate shareholders in the sense of being the principal source of the charity’s funds, but they do not have a profit incentive to monitor the care with which the charity’s funds are used. Maybe the lack of a profit motive made U.C.C.’s board too lax. Maybe the board did not negotiate as favorable a contract with W & H as the board of a profit-making firm would have done. And maybe tax law has a role to play in assuring the prudent management of charities.

Remember the I.R.S.’s alternative basis for yanking U.C.C.’s exemption? It is that as a result of the contract’s terms, U.C.C. was not really operated exclusively for charitable purposes, but rather for the private benefit of W & H as well. Suppose that U.C.C. was so irresponsibly managed that it paid W & H twice as much for fund-raising services as W & H would have been happy to accept for those services, so that of U.C.C.’s $26-million in fund-raising expense $13-million was the equivalent of a gift to the fund raiser.

Then it could be argued that U.C.C. was in fact being operated to a significant degree for the private benefit of W & H, though not because it was the latter’s creature. That then would be a route for using tax law to deal with the problem of improvident or extravagant expenditures by a charitable organization that do not, however, inure to the benefit of insiders.