American Bar Endowment v. U.S.

• Decision Date: 10 May 1985
• Docket Number: Nos. 84-988,84-1000,s. 84-988
• Citation: 761 F.2d 1573
• Parties: -5005, 53 USLW 2581, 85-1 USTC P 9382 AMERICAN BAR ENDOWMENT, Appellee, v. The UNITED STATES, Appellant. Frederic D. TURNER, et ux., Arthur Sherwood, et ux., et al., Appellants, v. The UNITED STATES, Appellee. Appeal
• Court: U.S. Court of Appeals — Federal Circuit

Page 1573

761 F.2d 1573

56 A.F.T.R.2d 85-5005, 53 USLW 2581, 85-1

USTC P 9382

AMERICAN BAR ENDOWMENT, Appellee, v. The UNITED STATES, Appellant.

Frederic D. TURNER, et ux., Arthur Sherwood, et ux., et al.,

Appellants, v. The UNITED STATES, Appellee.

Appeal Nos. 84-988, 84-1000.

United States Court of Appeals Federal Circuit.

May 10, 1985.

Robert S. Pomerance, Tax Div., Dept. of Justice, of Washington, D.C., for appellant U.S. With him on the brief were B. John Williams, Jr., Acting Asst. Atty. Gen., Gary R. Allen and Robert A. Bernstein.

Francis M. Gregory, Jr., Sutherland, Asbill & Brennan, of Washington, D.C., for appellee. With him on the brief were Randolph W. Thrower, Sheila J. Carpenter and Barbara J. Groves.

Before FRIEDMAN, DAVIS, and BENNETT, Circuit Judges.

DAVIS, Circuit Judge.

These are consolidated appeals from the decision of the United States Claims Court, Kozinski, C.J., in American Bar Endowment v. United States, 4 Cl.Ct. 404 (1984). In No. 84-988, the Government appeals from that portion of the ruling which held that appellee American Bar Endowment (the Endowment) earns no unrelated business taxable income from a fund-raising program in which the Endowment obtains a group insurance policy for its members and keeps (by assignment) the refunded dividends which accrue. In No. 84-1000, participating members of the Endowment (the individual taxpayers) appeal from the Claims Court's decision that they may not deduct the premium dividends (which they assign to the Endowment) as charitable contributions. In No. 84-988, we affirm; in No. 84-1000, we reverse and remand for further proceedings in accordance with this opinion.

I. Background

The American Bar Endowment is a charitable organization the purpose of which is to support educational projects and research in the legal field. The Endowment is the principal source of funds for the American Bar Foundation, a research organization under the aegis of the American Bar Association (ABA). Although all members of the ABA are automatically members of the Endowment, the two organizations are separate legal entities. Because the Endowment is devoted to furthering educational projects, the Internal Revenue Service (IRS) has determined that it is exempt from taxation under 26 U.S.C. Sec. 501(c)(3) (1982). ¹

In the early 1950's the Endowment established the insurance plan which is the crux of these cases. In the now-pertinent particulars the plan is similar to any insurance program in which a central organization holds a group policy for which the organization's members pay a portion of the premium reflecting the amount of coverage they desire. In order to participate in the Endowment's plan, however, a member must assign to the Endowment all dividends to which he or she might be entitled. These dividends represent the difference between the premiums paid by the participants and the actual cost of coverage to the insurance company in terms of claims settlement, administrative expenses, and profits. Cf. Penn Mutual Life Ins. Co. v. Lederer, 252 U.S. 523, 525, 40 S.Ct. 397, 398, 64 L.Ed. 698 (1920) ("It is the essence of mutual insurance that the excess in the premium over the actual cost as later ascertained shall be returned to the policyholder.") Members who refuse to assign their right to the dividends are, according to the terms of the plan, not entitled to participate. The terms of the assignment are plainly set forth above the signature line in the contract between the participant and the Endowment.

During the period at issue here (tax years 1979-1981), the Endowment purchased policies from two insurance companies: New York Life Insurance Co. (a life insurance policy) and Mutual of Omaha Insurance Co. (other policies, e.g., major medical and disability income insurance). The Endowment purchased the policies through a broker, James Group Service Inc. The insurance companies paid the broker a small percentage of the premiums as a commission.

The Endowment took sole responsibility for arranging the terms of the insurance, including the premiums and terms of coverage. Because the Endowment sought to maximize dividends, it had an incentive to set the premiums as high as possible without discouraging participation. The Endowment therefore set the premium at a level competitive with other insurance on the market; what the Endowment hoped is that it would benefit from the high dividends it could recoup as a result of the generally favorable morbidity and mortality experience of the attorney participants. This strategy has been extraordinarily successful. In the twenty-eight years from its inception to the time of this suit, the plan has grown from 12,000 to 55,000 participants. During this period the Endowment has recouped $81.9 million in dividends, of which it has distributed $63 million for educational projects. Currently, the Endowment employs approximately 40 people to administer the insurance plan.

Each year in which the Endowment receives a dividend on a group policy, which is more often than not, the Endowment notifies the participants as to the percentage of the total premium paid on that policy which it subsequently recouped as a dividend. These percentages are often as high as 30-40 percent, and sometimes 50 percent or over. Along with the notice, the Endowment advises participants that, in its opinion, that portion of the individual participant's payment which the Endowment received as part of the dividend is a tax deductible charitable contribution for the participant. As the prospect of litigation arose, the Endowment has included in the annual notice a caveat to the effect that the IRS does not necessarily share its views.

These cases present two issues for our resolution. First, do the dividends which the Endowment receives from the insurance companies fall within the provisions concerning the taxation of the unrelated business income of otherwise tax-exempt organizations (such as the Endowment)? Second, are the participants in the Endowment's insurance plans entitled to deduct from their gross income that portion of their insurance payments which the Endowment recoups in dividends? We deal with these questions in the context of the separate appeals to which they pertain.

II.

The Government's Appeal--Taxability of the Endowment

A.

Congress has placed several provisions in the tax laws which grant beneficial treatment to charitable contributions. Of central importance are the tax forgiveness provisions in sections 170 and 501. Section 170(a), with exceptions and limitations not relevant here, authorizes taxpayers to deduct the value of charitable contributions from their gross income, thus allowing charitable donors to avoid taxation on that amount. Section 501(a) correspondingly exempts charitable organizations from taxation on the donations they receive. Under this arrangement, donations to charity are never taxed, either in the donor's hands or in the charity's pocket.

In the Revenue Act of 1950, Pub.L. No. 81-814, 64 Stat. 947, Congress modified this scheme to insure that a charitable organization does not engage in a commercial enterprise and thus take unfair advantage of its tax-exempt status to the detriment of competing businesses subject to taxation. The statute created an unrelated business income tax (unrelated business tax) on the income that a charitable organization receives from a trade or business unrelated to its charitable purpose. ² See sections 511(a)(1), 512(a)(1). The term "unrelated trade or business" (for the purposes of this tax) means

any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance of such organization of its ... purpose or function constituting the basis for its exemption under section 501.

Section 513(a). In the Tax Reform Act of 1969, Pub.L. No. 91-172, 83 Stat. 542, Congress clarified the meaning of "trade or business": "For the purposes of this section, the term 'trade or business' includes any activity which is carried on for the production of income from the sale of goods or the performance of services." Section 513(c).

The regulations interpreting section 513 set forth a three-part test for determining whether a charitable organization's activity generates income subject to the unrelated business tax:

[G]ross income of an exempt organization subject to the tax imposed by section 511 is includible in the computation of unrelated business taxable income if: (1) It is income from trade or business; (2) such trade or business is regularly carried on by the organization; and (3) the conduct of such trade or business is not substantially related (other than through the production of funds) to the organization's performance of its exempt functions.

Treas.Reg. Sec. 1.513.1(a), 26 C.F.R. Sec. 1.513-1(a) (1984). By stipulation of the parties, only part (1) of this test--whether the Endowment carries on a trade or business by conducting the insurance plan--is at issue in the case regarding the Endowment's tax liability.

B.

In a technical advice memorandum dated July 3, 1980, the IRS informed the Endowment that, in the IRS' opinion, the insurance plan is an "unrelated trade or business" within the meaning of the statutory provisions imposing the unrelated business tax, and that the dividends constitute taxable income. The IRS reasoned that the Endowment sells its services as a group policyholder, without which its members could not enjoy the benefits of the plan's group rates. See G.C.M. 38940 (April 15, 1982), reprinted in [1982-1983 Transfer Binder] IRS Positions Rep. p 1127 (for a full exposition of the IRS' reasoning). Based on this conclusion, the IRS conducted an audit and assessed a deficiency against the Endowment for the tax years 1979 and 1980, plus interest on the 1980 payment. ³ This was paid. The Endowment also paid taxes on the...