UNITED
CANCER COUNCIL, INC.,
Petitioner
v.
COMMISSIONER
OF INTERNAL REVENUE,
Respondent
Tax Ct. Dkt. No.
2008-91X
UNITED STATES TAX COURT
1997 U.S. Tax
Ct. LEXIS 70; 109 T.C. No. 17
December 2, 1997,
Filed
REPLY BRIEF FOR UNITED CANCER COUNCIL,
INC.
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.
I. NONE OF UCC'S NET EARNINGS INURED TO THE BENEFIT OF A
PRIVATE SHAREHOLDER OR INDIVIDUAL
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.
II. THE IRS ABUSED ITS DISCRETION IN REVOKING UCC'S
TAX-EXEMPT STATUS RETROACTIVELY TO THE DATE OF THE W&H
CONTRACT
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.
CONCLUSION
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
MAYER, BROWN & PLATT
2000 Pennsylvania Ave., NW
Washington, D.C. 20006
(202) 463-2000
Leonard J. Henzke, Jr.
GINSBURG, FELDMAN AND BRESS
1250 Connecticut Ave., N.W.
Washington, D.C. 20036
(202) 637-9000
MacKenzie Canter, III
COPILEVITZ & CANTER
Three Lafayette Centre, Ste. 330
1155 21st Street, N.W.
Washington, D.C. 20036
(202) 861-0740
November 25, 1998
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