Tax Ct. Dkt. No. 2008-91X
1997 U.S. Tax Ct. LEXIS 70; 109 T.C. No. 17

December 2, 1997, Filed

The prohibition against inurement, on which the Tax Court relied in upholding the revocation of UCC's tax-exempt status, prevents insiders of an exempt organization (such as members, officers, directors, or trustees) from capitalizing on their position to engage in self-dealing. Because of the potential for abuse by insiders, inurement analysis is strict; any inurement of net earnings to an insider, however slight, subjects the organization to revocation of its tax-exempt status. By contrast, when an exempt organization deals with outsiders (such as unrelated third-party vendors), a bad bargain does not automatically place the organization's exempt status in jeopardy. Rather, revocation requires a showing that the private benefit to the vendor is so excessive that, viewed in relation to the overall activities of the organization, it can no longer be said to be operating primarily for legitimate tax-exempt purposes.

By applying inurement analysis to a contract negotiated at arm's length with a third-party vendor, the IRS is seeking a dramatic expansion of power. If the courts can be induced to authorize abandonment of the bright line the law currently draws between outsiders and insiders, the power of the IRS over every facet of the activities of tax-exempt organizations will be virtually plenary. This expanded power invites undesirable, even unconstitutional, government oversight of charities' fundraising activities and other aspects of their operations. As we now endeavor to show, the government's brief wholly fails to justify this outcome.



A. Because W&H Was Not An Insider Of UCC When The Contract Was Negotiated, Its Receipt Of Compensation Under The Contract Could Not Constitute Inurement
The IRS's theory is that W&H became an insider by virtue of the rights accorded it under the contract, that the compensation agreed to in the contract was excessive, and that the payment of that compensation therefore constituted prohibited inurement. But the twin props of this argument &emdash; that payments to an independent, outside service provider can constitute inurement, and that payments made under an arm's-length contract between the organization and a party that is an outsider at the time of contracting can constitute inurement &emdash; are both unprecedented and unsound.

1.) An independent vendor of goods or services does not become an insider of a charitable organization by entering into a contract negotiated at arm's length.
a.) We pointed out (Br. 33-34 & n.7) that the Tax Court's ruling cannot be squared with the statutory text, which prohibits inurement of net earnings to the benefit of "any private shareholder or individual." The ordinary meaning of "individual" is "a single human being considered apart from a society or community." AMERICAN HERITAGE COLLEGE DICTIONARY 692 (3d ed. 1993). W&H is a partnership, not a "single human being." While the term "individual" could in theory be defined to include abstract legal entities, like the term "person," the fact is that the Code uses "individual" to refer to natural persons. This is clear from the statutory definition of "person," which differentiates "an individual" from legal entities such as corporations and partnerships. See I.R.C. § 7701(a)(1). Accordingly, as a partnership that is not a shareholder of UCC, W&H is not subject to the prohibition on inurement.

The IRS responds first (Br. 33) that UCC waived its right to have its tax-exempt status governed by the plain meaning of the statutory language, citing Yorger v. Pittsburgh Corning Corp., 733 F.2d 1215, 1220 (7th Cir. 1984), which actually held that no waiver had occurred because the party had not "wholly neglected the issue" before the district court, even though its articulation of the issue was "less than paradigmatic." Id. at 1221. UCC argued in the Tax Court that W&H was not an entity to which inurement analysis should apply but did not specifically advert to the statutory language in so doing. UCC Post-Trial Br. 218-221. The Tax Court, however, did actually address the issue in its opinion (App. A42 n.25). Against this background, and considering that the issue is a purely legal one that has been fully briefed by the parties, it should be resolved here. See, e.g., Amcast Indus. Corp. v. Detrex Corp., 2 F.3d 746, 749-750 (7th Cir. 1993); Diersen v. Chicago Car Exchange, 110 F.3d 481, 485 (7th Cir.), cert. denied, 118 S. Ct. 178 (1997).

On the merits, the IRS relies (Br. 33) on its regulation applying inurement analysis to "persons" (26 C.F.R. § 1-501(a)-1(c)), a term which, as noted, is defined to include partnerships. But, of course, the IRS is not at liberty to expand the scope of the statutory prohibition by regulation.

Nor is there merit to the argument (IRS Br. 34), made here for the first time, that UCC's earnings may have impermissibly inured to the benefit of Messrs. Watson and Hughey, the principals of W&H (who at least are "individual[s]"). There simply is no evidence regarding either the compensation realized by them that is traceable to the UCC contract or the degree of control either personally exercised over UCC. And because the inurement theory was not the basis for the Commissioner's action, but rather a post-hoc rationalization presented in the Tax Court, the IRS bore the burden of proving at trial that UCC's net earnings inured to the benefit of Watson or Hughey as individuals if it wished to rely on such a claim. See Tax Court Rule 217(c)(2)(B). There being neither evidence nor a finding of personal inurement to Watson or Hughey, that cannot be the basis for revocation.

b.) The Tax Court's decision is the first to suggest that inurement analysis could apply when an exempt organization contracts at arm's length with an unrelated third-party vendor. The IRS argues at length, but unpersuasively, in support of its departure from the prior understanding of the inurement doctrine.

First, it questions (Br. 28 n.7) whether the UCC/W&H contract was truly an arm's-length agreement, relying solely on the observation that "at the time it entered into the Contract, UCC was near insolvency." Ibid. But UCC's financial difficulties in 1984 do not supply an otherwise lacking organizational connection to an unrelated third-party vendor. UCC's financial condition may have affected its bargaining leverage, but it certainly did not render it less than arm's length from W&H. To the contrary, as fully set forth in our opening brief (at 7-9), the process of selection of and negotiation with W&H reflected the very model of an arm's-length transaction. The Tax Court expressly recognized the arm's- length character of the contract (App. A44), and the IRS has offered no basis for overturning that finding, under the clearly erroneous standard or otherwise.

The IRS next questions the conclusions that may be drawn from numerous cases stating the principle that inurement analysis is inapplicable to contracts negotiated at arm's length with third-party vendors, asserting (Br. 31) that "[n]one of the cases relied on by UCC in this regard purport to establish" a bright-line rule and that those cases were merely fact-bound determinations made by courts "given the factual record before them." The cases, however, speak in terms of the general rule that they establish. See, e.g., American Campaign Academy v. Commissioner, 92 T.C. 1053, 1068 (1989) ("this Court has explicitly excluded unrelated third parties from the ambit of the term 'private shareholder or individual' in the earnings inurement context"); Goldsboro Art League, Inc. v. Commissioner, 75 T.C. 337, 345 (1980) ("the proscription against private inurement to the benefit of any shareholder or individual does not apply to unrelated third parties"); People of God Community v. Commissioner, 75 T.C. 127, 133 (1980) ("[t]he term 'private shareholder or individual' refers to persons who have a personal and private interest in the payor organization. * * * The term does not refer to unrelated third parties."); Sound Health Assoc. v. Commissioner, 71 T.C. 158, 186-187 (1978) (IRS's desire to "equate an 'insider' with potentially the whole community would so gut the insider test as to transmogrify it from a test of some precision in distinguishing private benefit to a test of such general application as to be useless.").

The IRS protests (Br. 31) that the rule should not control the outcome here because "[n]one of the cases * * * involved a contractual relationship, such as is present here, where an exempt organization, on the brink of insolvency, yielded substantial control over its finances to the previously unrelated party." But while this may be a valid consideration in determining whether the contract was indeed the product of arm's-length bargaining, once it is established that there was a genuine effort on the part of the exempt organization to strike the best bargain it could, the organization's financial circumstances provide no logical basis for discarding the general principle set forth as settled law in the cited decisions.

Indeed, the IRS's concern was the gravamen of Broadway Theatre League v. United States, 293 F. Supp. 346 (W.D. Va. 1968) (discussed at UCC Br. 35-37), where an exempt organization in its first year of operation yielded substantial control over its very existence to a previously unrelated booking agent. There, as here, the IRS argued that the organization should be deprived of its tax-exempt status because "the provisions of the contract envision such a control that it may be concluded that the [exempt organization] was organized and operated for the benefit of the [unrelated contractor].'" Id. at 353. The Broadway Theatre League court rejected the argument as "misdirected" (293 F. Supp. at 354), concluding that the terms of the contract nevertheless could not constitute inurement.

The IRS suggests (Br. 32) that Broadway Theatre League "simply did not purport to establish any hard and fast rule" and points to certain factual differences, most notably that the UCC/W&H contract had a five-year term, whereas the term in Broadway Theatre League was one year. Ibid. But the IRS's obsession with minutia cannot detract from the force of the logic in Broadway Theatre League. Even the most cursory examination of the opinion reveals that the court's decision was motivated not by a close analysis of the specific terms of the contract but rather by giving common-sense effect to the plain meaning of the relevant statutory language:

The prohibition in Section 501(c)(3) against any benefit inuring to private shareholders or individuals clearly and without question refers to the organization contemplated in the first sentence of the statute and not to any disassociated organization such as the legal services, secretarial services, or from what we have decided, an organization like [the booking agent] who has a bona fide contractual relationship with an exempt organization.

293 F. Supp. at 355.

All that the IRS can muster in its support is (1) a report of the New York State Bar Association's Tax Section, issued after the trial in this case had begun, stating that organization's view of what the law of insider status "should" be; and (2) a secondary source citing that report "with approval." See IRS Br. 29 (citing N.Y. State Bar Assn. Tax Section, Report on Exempt Organization Inurement Issues in the Context of Gen. Couns. Mem. 39862, at 14 (Nov. 11, 1992); HILL & KIRSCHTEN, FEDERAL AND STATE TAXATION OF EXEMPT ORGANIZATIONS ¶ 2.03[3][c] (1994)). But the opinions of a few commentators reacting to the IRS's attempt to expand its power hardly furnish a basis for subverting the longstanding and heretofore unanimous rule of law limiting inurement to true insiders.

By seeking to expand the accepted notion of "insiders" of an exempt organization to include all unrelated third-party service contractors (see G.C.M. 39670 (Oct. 14, 1987)), the IRS would arrogate to itself almost unlimited power to revoke the exempt status of organizations with which it is displeased or which it deems unpopular. It would need only to find (in hindsight) that an organization paid even a small amount too much to the unrelated contractor. There need be no deliberate misconduct or even negligence on the part of those who run the affairs of an exempt organization. See IRS Br. 45 ("The private inurement proscription is like a strict liability standard. It does not matter whether UCC's directors used their best efforts to keep UCC afloat.").

Departure from the previous bright-line distinction between traditional insiders and third-party contractors would also place grave burdens on exempt organizations. Currently, knowing that any monies paid to insiders will be subject to a searching inurement analysis, exempt organizations are prepared to take the time-consuming and often costly steps to acquire data to ensure the reasonableness of any compensation paid to insiders. But the expansive concept of inurement espoused here will exponentially increase those burdens by encompassing virtually every transaction involving the outflow of gross earnings. Courts have recognized precisely this concern in rejecting the IRS's open-ended view of inurement: "It is not possible to read such into the intention of Congress in passing Sec. 501. If such were the law, it would not be possible to have an exempt organization under the law. Certainly such was not the intention of Congress * * *." Science & Research Found., Inc. v. United States, 181 F. Supp. 526, 529 (S.D. Ill. 1960), quoted in Broadway Theatre League, 293 F. Supp. at 354. Finally, Congress's explicit limitation of inurement in I.R.C. § 501(c)(3) to the "net earnings" of an organization conclusively indicates that expenses incurred in good faith pursuant to contracts negotiated at arm's length are not covered.

In sum, the Tax Court erred as a matter of law in subjecting the UCC/W&H contract &emdash; which it expressly and correctly found to have been negotiated at arm's length &emdash; to an inurement analysis. In doing so, the Tax Court departed from well-established law, grounded in sound policy and fidelity to the language of the statute.

2.) Even if a third-party vendor could become an insider through an arm's-length contract, the Tax Court clearly erred in finding inurement here.
The IRS maintains (Br. 26) that it is "well-settled" that the inurement proscription "is directed at persons who exercise control over the organization's operations." The IRS cites Camps Newfound/Owatonna, Inc. v. Town of Harrison, 117 S. Ct. 1590, 1603 (1997), which states that insiders include individuals "such as members, officers, directors, or trustees." Thus, according to the IRS (Br. 27), W&H was an insider of UCC because it "obtained sufficient control over UCC to make it an 'insider' of that organization." Of course, the contract did not make W&H a "member[], officer[], director[], or trustee[]" of UCC, and, as discussed above, there are powerful reasons for distinguishing between such entities and independent service-providers, even if the latter do exercise some degree of "control" over the exempt organization's affairs.

But even if, arguendo, the IRS were correct that a contractor such as W&H can in theory become an insider subject to the strict prohibition against inurement, this supposition does not, for two reasons, lead to the conclusion the IRS seeks. First, the IRS fails to explain why, even if W&H became an insider by virtue of the contract, payment terms negotiated at arm's length before it achieved that status should be subject to the inurement prohibition. After all, W&H by definition could not have diverted UCC's assets to its own private use at the time the contract was negotiated, because it was not then an insider under any theory. Second, the IRS ignores the point that a principal cannot divest itself of control of its own affairs by hiring an agent to whom it confers delegated authority in a narrow area and whom it carefully supervises. The Tax Court clearly erred in finding that W&H obtained sufficient control over UCC that it was able to divert UCC's net earnings to its own coffers.

a.) The proscription on inurement targets insiders of exempt organizations because only insiders are likely to be able to divert an organization's net earnings to their personal benefit. Even the IRS recognizes (Br. 30) that "[t]he bottom line is that the inurement prohibition serves to prevent anyone in a position to do so from inappropriately acquiring or using a charity's assets (such as donations) for private use." The natural corollary of this principle, however, is that inurement must derive from the ability to exploit an insider position, not from arrangements arrived at when the evil to be guarded against was absent.

Here, even under the IRS's theory, W&H became an insider only pursuant to the powers it acquired under the contract. See IRS Br. 30. But even if W&H &emdash; which was indisputably an outsider on June 10, 1984 &emdash; became an insider on June 11, 1984 by virtue of the "control" it acquired by becoming UCC's direct-mail advisor, it could not have abused its insider status to divert funds for its private use because the terms of its compensation were fixed at a time when W&H was clearly an outsider. Because over the five-year life of the contract all payments to W&H were made in accordance with the terms negotiated when it was an outsider, W&H could not have violated the inurement provision by abusing any "control" it obtained pursuant to the contract.

The IRS emphasizes (Br. 30) that the contract committed UCC and W&H to interact over the entire term of the agreement. But the IRS cannot show that W&H received one penny of compensation over and above what it was promised in the contract. The fact that UCC and W&H had agreed in the contract on the compensation to be provided W&H in a wide range of potential future events did not confer on W&H the power to divert UCC's net earnings for its own use. For example, the IRS cites (Br. 30) W&H's ability under the contract to use its division Washington Lists as a vendor to rent lists to UCC &emdash; a right expressly provided by the contract. See App. A56. Whatever dissatisfaction the IRS has with that arrangement does not implicate the ability of an insider to divert assets to his or her own use; it merely reflects the IRS's post-hoc belief that the contract was a bad deal for UCC. But the Internal Revenue Code does not permit the forfeiture of tax-exempt status because an organization made what seems, in retrospect, to have been a bad deal. The Code requires that harsh result only where the deal is so bad that it results in a private benefit wholly out of proportion to the organization's exempt activity. See UCC Br. 30-32. The Tax Court expressly declined to find on this record that an impermissible private benefit had taken place. See App. A50.

The IRS seeks to avoid this logic by arguing (Br. 30) that the control exercised by W&H in implementing the contract &emdash; for example, by sometimes choosing Washington Lists rather than other sources for list rentals &emdash; allowed W&H to influence its own compensation in ways that, even if within the terms of the contract, were not necessarily predetermined by it. But even if this were a legitimate basis for finding the kind of insider control that the inurement prohibition is designed to protect against, it cannot avail the IRS here, because there has been not the slightest showing that any such discretionary actions (which, contrary to the IRS's contention, were never within W&H's exclusive control) involved excessive compensation. Thus, there is no finding that the charges made for lists provided by Washington Lists were in any way excessive, or that W&H used its control to force inappropriate mailings. Accordingly, whatever the theoretical merits of this line of argument, it cannot justify affirmance.

In sum, because the IRS has not shown that W&H obtained any compensation as an insider that it had not been promised as an outsider, it has not met its burden of proving that UCC's net earnings improperly inured to the benefit of W&H.

b.) The IRS does not dispute that any "control" W&H exercised over UCC was confined to the limited arena of direct-mail fundraising. See UCC Br. 39-40. Thus, for example, it is clear that W&H had no input whatever as to how UCC pursued its public health objectives or how it used its net earnings under the contract. The IRS bases its conclusion that W&H was an insider of UCC on its assertion (Br. 27) that "W&H effectively obtained exclusive control over UCC's fundraising activities and substantial control over UCC's finances." The record does not support that claim.

Preliminarily, we note that even as to fundraising, W&H's domain was not exclusive. Charitable organizations utilize a number of different fundraising mechanisms, including personal appeals for funds; door-to-door solicitations; applications for grants from the government, foundations, and commercial corporations; planned giving programs (e.g., deferred capital gifts in trust); the sponsorship of lotteries, sweepstakes, dinners, plays, parties, and other special events; telemarketing campaigns; selling products related to the organization's exempt purpose; and direct-mail campaigns. See Ex. 1516, at 6. The contract designated W&H as UCC's "sole and exclusive consultant and advisor" only with respect to UCC's "conduct of its direct mail solicitations of contributions." App. A55, § 1. While UCC in fact did rely on direct-mail solicitations as its primary source of funds during the W&H contract, UCC remained at liberty under the contract to pursue any other form of fundraising (by itself or with another fundraiser) either in conjunction with or in lieu of direct-mail solicitations.

In any event, the IRS's assertion that W&H obtained "control" over UCC's fundraising activities and finances begs the question of what degree of control is necessary to transform a third-party vendor and consultant into an insider of an exempt organization. Presumably, such a party would need to obtain sufficient control to enable it to divert net earnings from the exempt organization for its own private use. The record does not indicate that W&H ever achieved that degree of control over UCC. Rather, it shows that &emdash; even within the narrow area in which W&H had its expertise (i.e., direct-mail campaigns) &emdash; W&H obtained only the "control" that a principal provides to a relatively trusted agent.

The contract expressly provided that every aspect of the fundraising campaign (including editing of copy, list selection, timing and volume of mailings, etc.) was subject to the ultimate approval and control of UCC. App. A56, § 3. Indeed, the IRS does not dispute this. See IRS Br. 7 ("Pursuant to the Contract, W&H was responsible for implementing all aspects of the direct mail solicitations, subject to UCC's approval.") (emphasis added). A third-party contractor cannot become an insider by virtue of executing delegated authority that is entirely subject to the approval of the exempt organization. See Broadway Theatre League, 293 F. Supp. at 354. And it is untenable to suggest that UCC's board adopted a hands-off attitude to the direct-mail campaign, for the record unambiguously demonstrates that UCC exercised its contractual right to modify or reject W&H proposals with respect to nearly two-thirds of all packages, rejecting 15% outright. App. A312- A313.

d.) The IRS makes three factual arguments concerning the control W&H employed under the contract. First, it argues (Br. 27) that "W&H retained control of the amount of the advances" it made to UCC. But that hardly shows that W&H had an insider's control over UCC. It is wholly unsurprising that W&H would insist upon and be given some degree of control over the advances, given the fact it had no right to recover these sums if the campaign failed to perform according to expectations. Perhaps the IRS seeks to convey the impression that by controlling the amount of non-recourse advances W&H somehow controlled the ultimate amount of compensation UCC received from the campaign, but that is completely contrary to the record. UCC's entitlement to funds raised from mailings was dictated by the provisions of the contract; it was guaranteed to receive at least 50% of the receipts from all housefile mailings. See A57, § 9.

The IRS next maintains (Br. 27; citing Tr. 1901-1907) that "W&H continued its control over UCC by its ability to limit, if it so desired, the number of mailings made." Again, the IRS simply disregards the economic realities that dictate such an arrangement. The testimony indicates (Tr. 1904-1905) that W&H would generally expend in excess of $100,000 on each mailing. No for-profit venture would choose to suffer repeated losses of that magnitude once it became clear that a campaign was not working. Significantly, UCC enjoyed a reciprocal right to shut down the direct-mail campaign &emdash; it could simply refuse to authorize further mailings. W&H's right to discontinue losing mailings gave it no more control over UCC than UCC's right to discontinue mailings gave it over W&H.

Finally, the IRS finds control in the fact that "WIB [the escrow agent] paid money out of the escrow account only in response to requests from W&H." IRS Br. 28 (citing Tr. 2126-2127, 2131). The testimony actually indicates that although as an administrative matter invoices originated from W&H, WIB would not issue payment unless UCC had approved the invoice. See Tr. 2126-2127, 2131. Moreover, UCC retained its ability to stop payment on any check (including checks to W&H) if it withheld approval or felt that the vendor should not be paid. Tr. 2130. Thus, far from demonstrating W&H's tyrannical control over UCC's finances, the testimony actually establishes the unremarkable proposition that both signatories to an escrow account had to agree before disbursements could be made.

The IRS did not satisfy its burden of demonstrating that W&H obtained and exercised sufficient control over UCC to permit it to divert UCC's net earnings to its own private use. Instead, the record confirms that W&H was compensated pursuant to the terms of the contract it had negotiated at arm's length with UCC. The Tax Court's conclusion that W&H was an insider of UCC was clearly erroneous, and its decisions must be reversed.


B. The Compensation Provided W&H Under The Contract Was Reasonable

1.) A contract negotiated at arm's length with an unrelated vendor provides reasonable compensation as a matter of law.
The IRS fails to identify any specific circumstances sufficient to counteract the presumption that compensation set by a contract negotiated at arm's length is reasonable. See UCC Br. 43-44. It merely states (Br. 41) that "whether or not such a presumption exists, the record amply supports the Tax Court's factual finding that the Contract at issue here provided for unreasonable compensation." We respond next to the IRS's arguments defending the Tax Court's conclusion that W&H's compensation under the contract was excessive. Our point here, however, is that the court's unwillingness to give full effect to the presumption that the arm's-length UCC/W&H contract provided reasonable compensation fatally tainted its analysis &emdash; a flaw that alone compels reversal.

2.) The Tax Court clearly erred in finding W&H's compensation under the contract "excessive.”
The Tax Court's conclusion that W&H's compensation under the contract was excessive rested largely on an impermissible post-hoc analysis of the results achieved by the fundraising efforts. Cf. 26 C.F.R. § 1.162-7(b)(3) (circumstances determining reasonableness should be evaluated on the date the contract was made, not on the date the contract was challenged). Implicitly recognizing the flaws in this approach (which include serious First Amendment problems and an indefensible refusal to give any consideration to the educational benefits of the mailings), the IRS makes little effort to defend it. Instead, it bases its excessiveness argument primarily on a comparison (Br. 35-39) of the compensation provided under the contract with that agreed to in other direct-mail fundraising agreements.

Before turning to that contention, we note that if a results-oriented analysis is indeed improper, the IRS's focus on contract comparisons, even if it were sound on its own terms, could not salvage the judgment. The Tax Court's decision is simply too pervaded by a focus on what it considered to be the poor results demonstrated by comparing net cash earnings with total contributions. Given that, this Court should not employ a deferential standard to uphold the judgment on the basis of the arguably legitimate rationale that is intertwined with the improper one. Rather, it should remand to the Tax Court to redetermine the question free from consideration of the fundraising results.

In any event, the IRS's analysis based on the contract terms does not support the assertion that the UCC/W&H contract afforded W&H excessive compensation. The IRS propounds its contention through a confusing discussion of selected samples of fundraising contracts appended to the report of one of UCC's experts. A complete summary of the terms of those contracts is contained in the record (see Ex. 1516, App. E), and it in fact conclusively supports the testimony of UCC's expert that the compensation provided to W&H was reasonable and typical in light of the risks it assumed. See Ex. 1516, at 15-16.

The Tax Court concluded (App. A47) and the IRS argues (Br. 35-36) that W&H assumed less risk than the usual fundraiser in a no-risk contract because it retained the ability to terminate UCC's monthly draws and cease making advances for postal expenses if the campaign fared poorly. But the court could not point to a single contract that required a fundraiser continually to pour good money after bad into a failing direct-mail campaign. Rather, the characteristic cited by the court is common to all "no risk" direct-mail contracts and entirely fails to support the suggestion that W&H should have received less compensation than other fundraisers.

In reality, it is clear from the record evidence that W&H assumed more risk than the usual direct-mail advisor, for which it was entitled to reasonable compensation. Pursuant to the contract, W&H undertook (1) to protect UCC from suffering any financial loss if the direct-mail campaign failed to generate net revenues; (2) to advance postage expenses for the direct-mail campaign; and (3) to advance UCC operating funds before any contributions were received. The IRS responds (Br. 41-43) by pointing to specific contracts in the record that assumed one or another of these risks and asserting that those contracts provided less total compensation to the fundraiser. Although the IRS's analysis of the compensation in those contracts leaves much to be desired, more important is the fact that its approach disguises the crucial point. It does not matter if a fundraiser assuming any one of the three risks undertaken by W&H received less compensation than W&H did. What the IRS fails to show (and could not on this record) is that any fundraiser assumed all three of the risks that W&H did and still received less compensation.

Another serious error &emdash; and an especially ironic one in a case about inurement &emdash; is the attempt by both the Tax Court (App. A48) and the IRS (Br. 38) to compare the UCC/W&H contract with contracts between W&H and the American Institute for Cancer Research ("AICR"), a charity co-founded by W&H partners Jerry Watson and Chat Hughey. The IRS asserts that because AICR enjoyed better terms in its contract with W&H than UCC did, W&H must have extracted excessive compensation in the UCC/W&H contract. That argument is seriously flawed. Watson and Hughey (as co-founders) were clearly insiders of AICR in a way that they were not of UCC. While insiders are entitled to enter into contracts with their exempt organizations, extreme care must be taken to ensure that they are not being compensated excessively. Thus, on advice of counsel, W&H accepted compensation from AICR below the market rate in order to avoid potential challenge by the IRS. See Tr. 2680-2681. Thus, the W&H/AICR contracts are not a valid baseline for fair market compensation for fundraisers.

Finally, even were it sound to evaluate the excessive-compensation issue in light of the results of the fundraising effort, as the Tax Court plainly did, its analysis of the results is seriously flawed. UCC adduced evidence that $12.2 million of the expenses of the direct-mail campaign were properly allocated to UCC's educational function. UCC materially furthered its educational mission by being able to disseminate educational material in the 79,600,000 letters mailed during the campaign. Yet the Tax Court inexplicably decided to disregard the allocation issue (App. A50), with the result that it gave no credit whatever to this benefit.

Unable to justify the Tax Court's total disregard of the educational benefits of the direct-mail campaign, the IRS largely confines its discussion of the issue to a footnote (Br. 40 n.5), contending that substantially less than $12.2 million should have been allocated to education. But recognition of even a considerably smaller benefit than UCC's accountants recognized would have changed materially the comparison of UCC's benefits to W&H's compensation. This material legal error makes it unsound to give deferential "clearly erroneous" review to the excessive-compensation finding.

The IRS cannot salvage the Tax Court's blunder by characterizing the educational issue as a "subterfuge." See IRS Br. 44. The IRS speculates that recipients of the Nine Warning Signs of Cancer derived no benefit from that information because they had not requested it. But UCC believed that dissemination of information on how to prevent cancer or receive the most effective early treatment for this universally prevalent disease should not be limited to those who are already sufficiently aware of the risks of cancer to request information. Indeed, one of the primary benefits of the sweepstakes mailings was that they delivered UCC's educational message to a class of people usually ignored by more established cancer charities. See Ex. 1516, at 11. The Tax Court's failure to address the educational issue was thus wholly unjustified.

3.) The First Amendment prohibits reliance on the ratio of net earnings to contributions in determining whether W&H's compensation was unreasonable.
The Tax Court's conclusion that W&H was excessively compensated focused in substantial part on the high level of fundraising expenses in relation to net earnings as a proxy for reasonableness. We contended (Br. 48-50) that this criterion may not be so used without running afoul of the First Amendment. The IRS appears tacitly to concede our point, making no real effort to defend this aspect of the Tax Court's decision. Instead, it dismisses the cases cited by UCC on the grounds that the Internal Revenue Code "does not set forth a blanket rule that precludes eligibility for tax-exempt status if the organization incurs high fundraising costs" (IRS Br. 46) and that "there is no First Amendment right to a tax exemption" (IRS Br. 47).

Both points are irrelevant. The fact that Section 501(c)(3) is not facially discriminatory does not mean that resort may be had to impermissible considerations in interpreting or enforcing it. And, of course, we are not claiming that the First Amendment affords blanket protection to UCC from revocation of its exempt status on any ground involving fundraising, simply that the particular ground relied on by the Tax Court here is prohibited. Thus, it would not be unconstitutional to base revocation on the making of excessive payments to an insider for fundraising services, measuring excessiveness in light of the nature of the services provided and the fees paid for those services. That, indeed, is the theory espoused by the IRS in defense of the judgment below &emdash; albeit, for the reasons previously discussed, that theory is also erroneous.

The question for this Court, then (assuming it even reaches this point in the decision tree), is what the effect is of the Tax Court's improper reliance on fundraising expense ratios. Contrary to the IRS's apparent position, it may not simply be shrugged off on the basis that an alternative theory exists that is not infected with a constitutional defect. Rather, because the improper reliance on fundraising ratios was so central to the Tax Court's reasoning, the case must be remanded for a new, untainted decision of the excessive compensation issue.


The IRS revoked UCC's tax-exempt status retroactive to June 11, 1984, the date on which UCC entered into its contract with W&H. It made this decision notwithstanding the utter absence of any authority that could have placed UCC on notice that a contract with a third-party vendor could be subject to inurement analysis. Given the dramatic change in the law that the IRS seeks to achieve in this "test case" (App. A391.1), retroactive revocation of UCC's tax-exempt status is indefensible:

It seems particularly inappropriate for the Commissioner, absent express statutory authority, to impose retroactively a tax with respect to years prior to the date on which taxpayers are clearly put on notice of the liability. * * * In view of the complexities of federal taxation, fundamental fairness should prompt the Commissioner to refrain from the retroactive assessment of a tax in the absence of such notice or of clear congressional authorization.

Central Illinois Pub. Serv. Co. v. United States, 435 U.S. 21, 38 (1978) (Powell, J., concurring).

The IRS relies (Br. 50) on Automobile Club of Michigan v. Commissioner, 353 U.S. 180 (1957), but that case is not to the contrary. There, the Commissioner in 1943 announced a revised position on a question of law; that revision should have resulted in the loss of the petitioner's tax-exempt status. Because of an oversight, however, the revocation did not occur until 1945. The Supreme Court affirmed the reasonableness of making the revocation retroactive to 1943, because that outcome merely "dealt with petitioner upon the same basis as other automobile clubs," which had had their exemptions revoked in 1943. Id. at 186. That situation is completely unlike the present case, in which the IRS seeks to impose a radical change in the law retroactively.


For the foregoing reasons, as well as the reasons stated in UCC's opening brief, the Court should reverse the Tax Court's decisions and direct entry of an order that UCC is an organization described in I.R.C. § 501(c)(3) and is an eligible charitable donee under I.R.C. § 170(c)(2).

Respectfully submitted,

James W. Curtis, Jr.
8777 Purdue Road
Suite 124
Indianapolis, IN 46268-3104
(317) 875-0222

Andrew L. Frey
John J. Sullivan
Robert L. Bronston
2000 Pennsylvania Ave., NW
Washington, D.C. 20006
(202) 463-2000

Leonard J. Henzke, Jr.
1250 Connecticut Ave., N.W.
Washington, D.C. 20036
(202) 637-9000

MacKenzie Canter, III
Three Lafayette Centre, Ste. 330
1155 21st Street, N.W.
Washington, D.C. 20036
(202) 861-0740


November 25, 1998