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A Fundraiser Is Not an Insider

Recently, the Seventh Circuit issued its opinion in United Cancer Council, 2/10/99, which reversed the Tax Court and held that a fundraising company was not an "insider" for purposes of the Sec. 501(c)(3) private inurement rules. The case was remanded to the Tax Court to settle the still-unresolved question of whether the fundraising contract resulted in improper private benefit to the fundraiser, leaving practitioners still uncertain as to how the case will eventually be resolved.

In 1984, the United Cancer Council (UCC) entered into an exclusive five-year contract with a fundraising company to raise funds through a direct-mail campaign. At the time of the execution of the contract, UCC was on the verge of bankruptcy and had a minimal operating budget. UCC's board of directors engaged the fundraising company to raise the funds necessary for its survival. From 1984 to 1989, the fundraising company helped UCC conduct a nationwide direct-mail fundraising campaign. UCC received about $2.3 million in net fundraising revenue under the contract. The fundraising company received more than $4 million in fees from UCC and derived substantial income from exploiting co-ownership rights in UCC's mailing list, which had been granted to the fundraiser under the contract.

When the IRS revoked a favorable ruling letter retroactively to 1984, UCC initiated Tax Court proceedings to determine if it qualified as an exempt organization and as an eligible charitable donee. The Tax Court found that the fundraiser was an "insider" who exercised substantial influence and control over the organization due to the terms of the contract (i.e., the fundraiser was able to manipulate and control the exempt organization).

The Seventh Circuit reversed and remanded the Tax Court's decision, holding that there was no diversion of charitable revenues to an insider. The appeals court rejected the Service's argument that the arm's-length fundraising contract was so advantageous to the fundraiser and so disadvantageous to UCC that the charity essentially had surrendered control of its operations and earnings to a private third party. Although the court questioned UCC's judgment in entering into the contract, it found the contract to be negotiated at arm's length and stated that the charity "drove (so far as the record shows) the best bargain that it could, but it was not a good bargain." The appeals court further wrote that private inurement "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 essential inputs, whether premises, paper, computers, legal advice, or fundraising services." The court went further to describe the Service as being "ignorant" of contract law; it could "find nothing in the facts to support the IRS's theory and the Tax Court's finding that [the fundraiser] seized control of UCC and by doing so became an insider, triggering the inurement provision and destroying the exemption." The court concluded that there was neither diversion of revenues to an insider nor was there self-dealing, disloyalty or breach of fiduciary obligation.

The Seventh Circuit opinion shows sympathy for small and struggling charities that may be forced to rely on fundraisers for their survival (especially in their early years). As a matter of fact, the court stated that the Service's charge of inurement in this type of case threatened to upset charities in general. Many times, for example, new or small charities solicit donations in an effort to grow, and use fundraisers predominately for this solicitation. Addressing this situation, the appeals court rejected the IRS's argument that the fundraiser was the equivalent of a "founder," stating that this argument would deny charitable tax exemption to small charities that potentially would not have access to the capabilities of a fundraiser.

The Seventh's Circuit's ruling will continue to have a significant impact on the exempt organization community. The decision has come at a time when the Service is attempting to finalize the intermediate sanction regulations dealing with the imposition of excise taxes on insiders and others who improperly benefit from their relationships with exempt organizations.

Further, charities often have multiple long-term contracts with third parties, including fundraisers. For example, tax-exempt hospitals often have contract management arrangements of more than a year with physician practices. Does the Seventh Circuit's decision in United Cancer Council reject the theory that insider status can be created by such long-term contracts? Obviously, the facts and circumstances of the specific situation, along with the specific provisions of the contract, need to be analyzed before any conclusions can be reached. Overall, however, the decision by the Seventh Circuit should be viewed as a well-received initial resolution of an issue that is sure to get further attention. With the case remanded to the Tax Court, however, the issue of private benefit (i.e., whether the fundraiser received reasonable compensation for its efforts on behalf of the UCC) will surely be explored and analyzed in more detail.

From Richard Bliha, CPA, South Bend, IN, and James B. Champer, CPA, Elkhart, IN

©1999 AICPA