In the
United
States Court of Appeals
for the
Seventh Circuit
Nos. 98-2181 and 98-2190
United Cancer Council, Inc.,
Petitioner-Appellant,
v.
Commissioner of Internal Revenue,
Respondent-Appellee
Appeals from the United States Tax
Court.
Argued January 6, 1999--Decided February 10, 1999
Before Posner, Chief Judge and Coffey and Kanne,
Circuit Judges.
Posner, Chief Judge. The United Cancer Council is
a charity that seeks, through affiliated local cancer
societies, to encourage preventive and ameliorative
approaches to cancer, as distinct from searching for a cure,
which has been the emphasis of the older and better-known
American Cancer Society, of which UCC is a splinter. The
Internal Revenue Service revoked UCC's charitable exemption
and the Tax Court upheld the revocation, precipitating this
appeal.
So far as relates to this case, a charity, in order to be
entitled to the charitable exemption from federal income
tax, and to be eligible to receive tax-exempt donations,
must be "organized and operated exclusively for
[charitable] purposes" and "no part of the net
earnings of [the charity may] inure[ ] to
the benefit of any private shareholder or individual." 26
U.S.C. sec.sec. 501(c)(3) (exemption); 170(c)(2)(B), (C)
(receipt of donations); 26 C.F.R. sec.sec. 1.501(a)-1(c),
1.501(c)(3)-1(d)(1)(i), (ii). The IRS claims that UCC (which
is defunct) was not operated exclusively for charitable
purposes, but rather was operated for, or also for, the
private benefit of the fundraising company that UCC had
hired, Watson & Hughey Company (W&H). The Service
also claims that part of the charity's net earnings had
inured to the benefit of a private shareholder or
individual--W&H again. The Tax Court upheld the
Service's second ground for revoking UCC's
exemption--inurement--and did not reach the first ground,
private benefit. The only issue before us is whether the
court clearly erred, Fund for the Study of Economic Growth
& Tax Reform v. IRS, 161 F.3d 755, 758-59 (D.C. Cir.
1998); Church of Scientology v. Commissioner, 823 F.2d 1310,
1317 (9th Cir. 1987); see also Walgreen Co. v. Commissioner,
68 F.3d 1006, 1009-10 (7th Cir. 1995); Williams v.
Commissioner, 1 F.3d 502, 505 (7th Cir. 1993), in finding
that a part of UCC's net earnings inured to the benefit of a
private shareholder or individual.
It is important to understand what the IRS does not
contend. It does not contend that any part of UCC's earnings
found its way into the pockets of any members of the
charity's board; the board members, who were medical
professionals, lawyers, judges, and bankers, served without
compensation. It does not contend that any members of the
board were owners, managers, or employees of W&H, or
relatives or even friends of any of W&H's owners,
managers, or employees. It does not contend that the
fundraiser was involved either directly or indirectly in the
creation of UCC, or selected UCC's charitable goals. It
concedes that the contract between charity and fundraiser
was negotiated on an arm's length basis. But it contends
that the contract was so advantageous to W&H and so
disadvantageous to UCC that the charity must be deemed to
have surrendered the control of its operations and earnings
to the noncharitable enterprise that it had hired to raise
money for it.
The facts are undisputed. 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 raising funds for charities,
as the best prospect for raising the funds essential for
UCC's survival. Another committee of the board was created
to negotiate the contract. Because of UCC's perilous
financial condition, the committee wanted W&H to "front"
all the expenses of the fundraising campaign, though it
would be reimbursed by UCC as soon as the campaign generated
sufficient donations to cover those expenses. W&H
agreed. But it demanded in return that it be made UCC's
exclusive fundraiser during the five-year term of the
contract, that it be given co-ownership of the list of
prospective donors generated by its fundraising efforts, and
that UCC be forbidden, both during the term of the contract
and after it expired, to sell or lease the list, although it
would be free to use it to solicit repeat donations. There
was no restriction on W&H's use of the list. UCC agreed
to these terms and the contract went into effect.
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 percent of the letters also
offered the recipient a chance to win a sweepstake. The text
of all the letters was reviewed and approved by UCC. As a
result of these mailings, UCC raised an enormous amount of
money (by its standards)--$28.8 million. But its
expenses--that is, the costs borne by W&H for postage,
printing, and mailing the letters soliciting donations,
costs reimbursed by UCC according to the terms of the
contract--were also enormous--$26.5 million. The balance,
$2.3 million, the net proceeds of the direct-mail campaign,
was spent by UCC for services to cancer patients and on
research for the prevention and treatment of cancer. The
charity was permitted by the relevant accounting conventions
to classify $12.2 million of its fundraising expenses as
educational expenditures because of the cancer information
contained in the fundraising letters.
Although UCC considered its experience with W&H
successful, it did not renew the contract when it expired by
its terms in 1989. Instead, it hired another fundraising
organization--with disastrous results. The following year,
UCC declared bankruptcy, and within months the IRS revoked
its tax exemption retroactively to the date on which UCC had
signed the contract with W&H. The effect was to make the
IRS a major creditor of UCC in the bankruptcy proceeding.
The retroactive revocation did not, however, affect the
charitable deduction that donors to UCC since 1984 had taken
on their income tax returns. See Bob Jones University v.
Simon, 416 U.S. 725, 728- 29 (1974); Rev. Proc. 82-39, sec.
3.01, 1982-1 Cum. Bull. 759, 1982 WL 196338 (July 6, 1982).
The term "any private shareholder or individual" in the
inurement clause of section 501(c)(3) of the Internal
Revenue Code has been interpreted to mean an insider of the
charity. Orange County Agricultural Society, Inc. v.
Commissioner, 893 F.2d 529, 534 (2d Cir. 1990); Church of
Scientology v. Commissioner, supra, 823 F.2d at 1316-19;
Church by Mail, Inc. v. Commissioner, 765 F.2d 1387, 1392
(9th Cir. 1985); American Campaign Academy v. Commissioner,
92 T.C. 1053, 1066 (1989). A charity is not to siphon its
earnings to its founder, or the members of its board, or
their families, or anyone else fairly to be described as an
insider, that is, as the 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. The insider could be a "mere" employee-- or
even a nominal outsider, such as a physician with hospital
privileges in a charitable hospital, Harding Hospital, Inc.
v. United States, 505 F.2d 1068, 1078 (6th Cir. 1974); John
E. Burke, "Hospital-Physician Joint Ventures," GCM 39862,
1991 WL 776308 (IRS Dec. 2, 1991), a licensor, Est of Hawaii
v. Commissioner, 71 T.C. 1067, 1078-81 (1979), aff'd, 687
F.2d 170 (9th Cir. 1981) (realistically, a case involving a
founder's siphoning of charitable donations), or for that
matter a fundraiser, National Foundation, Inc. v. United
States, 13 Cl. Ct. 486, 494-95 (1987)--though the court in
that case rejected the argument that the fundraiser
controlled the charity.
The Tax Court's classification of W&H as an insider
of UCC was based on the fundraising contract. Such contracts
are common. Fundraising has become a specialized
professional activity and many charities hire specialists in
it. If the charity's contract with the fundraiser makes the
latter an insider, triggering the inurement clause of
section 501(c)(3) and so destroying the charity's tax
exemption, the charity sector of the economy is in trouble.
The IRS does not take the position that every such contract
has this effect. What troubles it are the particular terms
and circumstances of UCC's contract. It argues that since at
the inception of the contract the charity had no money to
speak of, and since, therefore, at least at the beginning,
all the expenses of the fundraising campaign were borne by
W&H, the latter was like a founder, or rather refounder
(UCC was created in 1963), of the charity. The IRS points
out that 90 percent of the contributions received by UCC
during the term of the contract were paid to W&H to
defray the cost of the fundraising campaign that brought in
those contributions, and so argues that W&H was the real
recipient of the contributions. It argues that because
W&H was UCC's only fundraiser, the charity was totally
at W&H's mercy during the five-year term of the
contract-- giving W&H effective control over the
charity. UCC even surrendered the right to rent out the list
of names of donors that the fundraising campaign generated.
The terms of the contract were more favorable to the
fundraiser than the terms of the average fundraising
contract are.
Singly and together, these points bear no relation that
we can see to the inurement provision. The provision is
designed to prevent the siphoning of charitable receipts to
insiders of the charity, not to empower the IRS 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
fundraising services.
Take the Service's first point, that W&H defrayed
such a large fraction of the charity's total expenses in the
early stages of the contract that it was the equivalent of a
founder. Pushed to its logical extreme, this argument would
deny the charitable tax exemption to any new or small
charity that wanted to grow by soliciting donations, since
it would have to get the cash to pay for the solicitations
from an outside source, logically a fundraising
organization. We can't see what this has to do with
inurement. The argument is connected to another of the
Service's points, that W&H was UCC's only fundraiser
during the period of the contract. If UCC had hired ten
fundraisers, the Service couldn't argue that any 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 purposes of the inurement clause, it makes no
difference how many fundraisers a charity employs. W&H
obtained an exclusive contract, and thus was the sole
fundraiser, not because it sought to control UCC and suck it
dry, but because it was taking a risk; the exclusive
contract lent assurance that if the venture succeeded, UCC
wouldn't hire other fundraisers to reap where W&H had
sown.
And it was only at the beginning of the contract period
that W&H was funding UCC. As donations poured into the
charity's coffers as a result of the success of the
fundraising campaign, the charity began paying for the
subsequent stages of the campaign out of its own revenues.
True, to guarantee recoupment, the contract with W&H
required UCC to place these funds in an escrow account, from
which they could be withdrawn for UCC's charitable purposes
only after W&H recovered the expenses of the fundraising
campaign. But this is a detail; the important point is that
UCC did not receive repeated infusions of capital from
W&H. All the advances that W&H had made to UCC to
fund the fundraising campaign were repaid. Indeed, it is an
essential part of the government's case that W&H
profited from the contract. The other point that the
Service makes about the exclusivity provision in the
contract--that it put the charity at the mercy of the
fundraiser, since if W&H stopped its fundraising efforts
UCC would be barred from hiring another fundraiser until the
contract with W&H expired-- merely demonstrates the
Service's ignorance of contract law. When a firm is granted
an exclusive contract, the law reads into it an obligation
that the firm use its best efforts to promote the contract's
objectives. Wood v. Duff-Gordon, 118 N.E. 214 (N.Y. 1917)
(Cardozo, J.); Advent Systems Ltd. v. Unisys Corp., 925 F.2d
670, 679- 80 (3d Cir. 1991); E. Allan Farnsworth, Contracts
sec. 7.17, pp. 509-11 (3d ed. 1999). If W&H folded its
tent and walked away, it would be in breach of this implied
term of the contract and UCC would be free to terminate the
contract without liability.
The Service also misses the significance of the
contract's asymmetrical treatment of the parties' rights in
the donor list. The charitable- fundraising community
distinguishes between "prospect files" and "housefiles." A
prospect file is a list of people who have not given to the
charity in question but are thought sufficiently likely to
do so to be placed on the list of addressees of a
direct-mail fundraising campaign. If the prospect responds
with a donation, his or her name is transferred to the
housefile, that is, the list of people who have made a
donation to the charity. A housefile is very valuable,
because people who have already donated to a particular
charity are more likely to donate to it again than mere
prospects are likely to donate to it for the first time. The
housefile's value to the charity is thus as a list of people
who are good prospects to respond favorably to future
solicitations. Its value to the fundraiser is quite
different. The fundraiser is not a charity. The value to it
of a housefile that it has created is the possibility of
marketing it (as a prospect file--but as a prospect file in
which all the prospects are charitable donors rather than a
mere cross- section of potential donors) to another charity
that hires it. So it made perfect sense for the contract to
give the fundraiser the exclusive right to use the UCC
housefile that it created in raising money for other
charities, while reserving to UCC the right to use the
housefile to solicit repeat donations to itself.
The Service's point that has the most intuitive appeal is
the high ratio of fundraising expenses, all of which went to
W&H because it was UCC's only fundraiser 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 UCC 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 fundraiser to the net
receipts of the charity. For all that appears, while UCC
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 UCC 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 UCC 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
UCC (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 UCC's fundraising 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). See Commonwealth v. Watson
& Hughey Co., 563 A.2d 1276 (Pa. Commw. 1989). But these
points go to UCC's sound judgment, not to whether W&H
succeeded in wresting control over UCC from the charity's
board.
UCC's low net yield is no doubt related to the terms of
the fundraising contract, which were more favorable to the
fundraiser than the average such contract. But so far as
appears, they were favorable to W&H not because UCC's
board was disloyal and mysteriously wanted to shower charity
on a fundraiser with which it had no affiliation or
overlapping membership or common ownership or control, but
because UCC 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 UCC. If W&H
was calling the shots, why did UCC refuse to renew the
contract when it expired, and instead switch to another
fundraiser?
We can find nothing in the facts to support the IRS's
theory and the Tax Court's finding that W&H seized
control of UCC 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 UCC 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, as in Pepper v.
Litton, 308 U.S. 295, 311-12 (1939), or Freeman v. Complex
Computing Co., 119 F.3d 1044, 1051-53 (2d Cir. 1997). 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 UCC point out,
threatens to unsettle the charitable sector by empowering
the IRS to yank a charity's tax exemption simply because the
Service thinks its contract with its major fundraiser 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 nonprofit
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 IRS
to have surrendered control over its destiny to a fundraiser
or other supplier, because it is the type of charity that is
most likely to have to pay a high price for fundraising
services. "Developments in the Law-- Nonprofit
Corporations," 105 Harv. L. Rev. 1578, 1649-51 (1992). 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
IRS.
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 UCC'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 UCC
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 UCC's board too lax. Maybe the board did not negotiate
as favorable a contract with W&H as the board of a
profitmaking firm would have done. And maybe tax law has a
role to play in assuring the prudent management of
charities. Remember the IRS's alternative basis for yanking
UCC's exemption? It is that as a result of the contract's
terms, UCC was not really operated exclusively for
charitable purposes, but rather for the private benefit of
W&H as well. Suppose that UCC was so irresponsibly
managed that it paid W&H twice as much for fundraising
services as W&H would have been happy to accept for
those services, so that of UCC's $26 million in fundraising
expense $13 million was the equivalent of a gift to the
fundraiser. Then it could be argued that UCC 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.
That in fact is the IRS's alternative ground for revoking
the exemption, the one the Tax Court gave a bye to. It would
have been better had the court resolved that ground as well
as the inurement ground, so that the case could be
definitively resolved in one appeal. But it did not, and so
the case must be remanded to enable the court to consider
it. We shall not prejudge the proceedings on remand. The
usual "private benefit" case is one in which the charity has
dual public and private goals, see, e.g., Better Business
Bureau v. United States, 326 U.S. 279, 283 (1945); Living
Faith, Inc. v. Commissioner, 950 F.2d 365 (7th Cir. 1991);
American Campaign Academy v. Commissioner, supra, 92 T.C. at
1064- 65, and that is not involved here. However, the board
of a charity has a duty of care, just like the board of an
ordinary business corporation, see, e.g., Riss v. Angel, 934
P.2d 669, 680-81 and n. 5 (Wash. 1997); Fairhope Single Tax
Corp. v. Rezner, 527 So.2d 1232, 1236 (Ala. 1987); Frances
T. v. Village Green Owners Ass'n, 723 P.2d 573, 582 n. 13
(Cal. 1986), and a violation of that duty which involved the
dissipation of the charity's assets might (we need not
decide whether it would--we leave that issue to the Tax
Court in the first instance) support a finding that the
charity was conferring a private benefit, even if the
contracting party did not control, or exercise undue
influence over, the charity. This, for all we know, may be
such a case.
Reversed and Remanded.
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