A Legal Setback for the IRS

Court ruling may limit agency’s say on role of outside fund raisers

A recent legal setback for the Internal Revenue Service in a case involving a controversial fund-raising company is drawing both praise and criticism — though its impact remains unclear.

ALSO SEE:

Excerpts From Ruling on Charity’s Loss of Tax Exemption

Earlier this month, the U.S. Court of Appeals for the Seventh Circuit, in Chicago, ruled that the Internal Revenue Service was wrong to revoke the tax-exempt status of a small Indianapolis health charity, the United Cancer Council, for a key reason it did. The service had argued that the charity’s fund-raising consultant, the Watson and Hughey Company, was an “insider” that had improperly seized control of the charity.

The ruling in the eight-year-old case, which was watched closely by charities, reversed an earlier decision by the U.S. Tax Court that had backed up the I.R.S.

From 1984 to 1989, the cancer council raised $28.8-million through the fund-raising appeals of the Watson and Hughey Company. After paying Watson and Hughey for fund-raising costs of $26.5-million, the charity had net proceeds of $2.3-million to spend for services to patients and research. The charity filed for bankruptcy in 1990.

Despite the latest ruling, the cancer council’s charity status remains in jeopardy. The appeals court ordered the Tax Court to assess the validity of a second reason that the revenue service gave for revoking the charity’s exemption: that the terms of the fund-raising contract meant, in effect, that the charity’s board of directors ran the organization for “the private benefit” of Watson and Hughey, a Virginia company that later changed its name to Direct Response Consulting Services.

Some observers hailed the appellate court’s ruling as a wide-reaching victory against excessive government regulation, because it places limits on how far the I.R.S. can go in finding fault with the relationship between a charity and its fund-raising consultant. But other observers worried that the revenue service could lose an important enforcement tool.

Dan Moore, speaking in his role as chairman of a committee on charity accountability of the National Association of State Charity Officials, said the appellate court’s decision underscores the need for “strong regulation” by states of charities and professional fund raisers.

“Solicitations for police, fire fighters, missing kids, dying kids, cancer — these are not unpopular causes,” said Mr. Moore, who is charities registrar in the New Mexico Attorney General’s Office. “These are some of the favorite campaigns of charities out there that use professional fund raisers that also have high fund-raising costs.” Mr. Moore added: “The issue is: Is philanthropy being served, or is the private interest of these fund raisers being served?”

Despite such concerns, James J. McGovern, former top charity regulator at the revenue service, said that the opinion is not as big a setback to the I.R.S. as might first appear. That’s because a relatively new federal law permits the revenue service to go after perceived abuses involving non-profit organizations and fund raisers in a different way than it approached the United Cancer Council case, said Mr. McGovern, who now works for the accounting firm KPMG.

The cancer-council case arose years before the federal government enacted a 1996 law that gave the revenue service an enforcement weapon short of revoking a charity’s tax exemption. The statute allows the revenue service to fine people or companies, called “disqualified persons,” who receive overly generous financial benefits — such as high salaries and “sweetheart” contracts — through their involvement with non-profit groups.

Mr. McGovern said the new law does not limit the definition of a disqualified person to an insider who controls a charity, which was the issue at the heart of the appellate court’s ruling. Rather, he noted, the statute describes a disqualified person as one who has the “ability to exercise substantial influence” over the affairs of a charity.

Proposed regulations recently released by the I.R.S. to explain how the agency wants to enforce the law make clear that the government is prepared to fine fund raisers as well as charity officials, Mr. McGovern said.

“The law and regulations use a very broad brush as to who might be a disqualified person” and might wield substantial influence over a charity, said Mr. McGovern. “And that could reach a fund raiser such as the one with the contract with United Cancer Council.”

But other legal experts said they thought the appellate court’s decision could eventually force the I.R.S. to back off from the way it plans to enforce parts of the new law.

“The Seventh Circuit decision will resonate for some time, as it strikes directly at many current I.R.S. positions, well beyond the simple ‘insider’ issue at the core of the case,” said Barnaby Zall, a lawyer in Rockville, Md.

The I.R.S. could choose to appeal the appellate court’s ruling to the Supreme Court, though it is unclear whether it will do so. Marc Owens, director of the revenue service’s Exempt Organizations Division, said the I.R.S. has no immediate comment on the court’s ruling.

Some observers said they expect that the I.R.S. could win a new battle in Tax Court over whether the cancer charity was run for the benefit of Watson and Hughey. Others, however, said the Tax Court would find it difficult to conclude that the board of directors — whose membership included judges, lawyers, and bankers — violated its duty.

“A court is unlikely to find that a group of professionals who entered into arm’s-length negotiations on behalf of a starving non-profit did not appreciate the economics of what they were doing and consider the implications,” said Mark B. Weinberg, legal counsel of the Free Speech Defense and Education Fund, a McLean, Va., non-profit organization that helped pay for the appeal by the United Cancer Council.

Said Andrew L. Frey, a lawyer for United Cancer Council: “There are very strong arguments as to why this was not an abandonment by United Cancer Council of its educational, scientific, and charitable purposes.”

The case stretches back to 1984, when the United Cancer Council, a tiny group with an annual operating budget of $35,000, chose Watson and Hughey as its best hope for raising the money necessary for its survival.

Under the contract, the charity had Watson and Hughey “front” the expenses of the fund-raising campaign, although the company was reimbursed by the charity as donations came in. In return, the contract designated Watson and Hughey as the charity’s exclusive fund raiser during the contract’s five-year term; gave the company co-ownership of the list of prospective donors generated by the campaign; and forbade the charity, both during the term of the contract and after, to sell or lease the list, although the organization would be free to use it to solicit repeat donations. There was no restriction on Watson and Hughey’s use of the list.

In December 1997, Tax Court Judge Herbert L. Chabot endorsed one of the I.R.S.’s chief reasons for pulling the exemption: that part of the net earnings of the cancer council had improperly “inured to the benefit” of an “insider” — Watson and Hughey.

The judge said that the company was an insider because its contract gave the company too much say over the charity’s finances and fund raising, even though company officials were not charity board members or officials.

But three judges of the appellate court disagreed. Their opinion, written by Chief Judge Richard A. Posner, said that the inurement provision of federal law “is designed to prevent the siphoning of charitable receipts to insiders of the charity, not to empower the I.R.S. to monitor the terms of arm’s-length contracts made by charitable organizations with the firms that supply them with essential inputs, whether premises, paper, computers, legal advice, or fund-raising services.”

The appellate court said it found nothing to support the I.R.S.’s theory, and the Tax Court’s finding, that Watson and Hughey “seized control” of the United Cancer Council and, “by doing so, became an insider, triggering the inurement provision” of federal law and “destroying” the charity’s tax exemption.

In fact, the court said that such use of the concept of control “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 fund raiser, 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.”

That kind of thinking would lead, the court said, to uncertainty about a charity’s ability to retain its tax exemption — and receive tax-deductible contributions — and would be a deterrent to people contemplating a donation to a new or small charity.

It is precisely that type of charity, the court added, that is “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.”

The appellate court’s decision was greeted with a strong response from lawyers familiar with the case.

MacKenzie Canter III, a Washington lawyer who represents the United Cancer Council, said the ruling was “a common-sense decision that says if you do not have an insider, if you have negotiations at arm’s length, you don’t apply the inurement analysis. It’s about that simple.”

But Thomas A. Troyer, a Washington lawyer, said the decision was unfortunate.

“Where you have somebody with an economic hammer over a little organization that has no bargaining power at all, you ought to be able to treat them as an insider,” said Mr. Troyer. “I just cringe at the specter of private parties, particularly for-profit fund raisers, sucking away tax-deductible charitable contributions because they have the total economic power to control a very weak charity that has an appealing name.”

The full text of the appellate court’s decision can be found on the World-Wide Web site of the Chicago-Kent College of Law: http://www.kentlaw.edu/7circuit/1999/feb/98-2181.html.