United Cancer Council, Inc. v. C.I.R., s. 98-2181

• Decision Date: 10 February 1999
• Docket Number: 98-2190,Nos. 98-2181,s. 98-2181
• Citation: 165 F.3d 1173
• Parties: -812, 99-1 USTC P 50,248 UNITED CANCER COUNCIL, INC., Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 1173

165 F.3d 1173

83 A.F.T.R.2d 99-812, 99-1 USTC P 50,248

UNITED CANCER COUNCIL, INC., Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Nos. 98-2181, 98-2190.

United States Court of Appeals, Seventh Circuit.

Argued Jan. 6, 1999.

Decided Feb. 10, 1999.

Andrew L. Frey (argued), Mayer, Brown, & Platt, Leonard J. Henzke, Jr., Powell, Goldstein, Frazer & Murphy, MacKenzie, Canter, III, Copilevitz & Canter, Washington, DC, for Petitioner-Appellant.

Charles Bricken, Kenneth L. Greene (argued), Dept. of Justice, Tax Div., Appellate Section, Washington, DC, for Respondent-Appellee.

F. Hayden Codding, Codding & Codding, Fairfax, VA, for amicus curiae Bruce W. Eberle & Associates, Inc., Stephen Winchell & Associates, Inc., American Target Advertising, Inc., Squire & Heartfield Direct, Inc., Stephen Clouse & Associates, Inc., Stuart/Grey, Response Development Corp., DM Group, Response Dynamics, Inc. and Richard Norman Co.

Roger E. Warin, Steptoe & Johnson, Washington, DC, for amicus curiae National Federation of Nonprofits.

Kirkpatrick Dilling, Dilling & Dilling, Northbrook, IL, for amicus curiae International Association of Cancer Victims and Friends, Inc., Cancer Control Society, Roger Wyburn-Mason and Jack M. Glount Foundation for the Eradication of Rheumatoid Disease, Inc., Heart Support of America, Inc.

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. §§ 501(c)(3) (exemption); 170(c)(2)(B), (C) (receipt of donations); 26 C.F.R. § 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 at 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, 94 S.Ct. 2038, 40 L.Ed.2d 496 (1974); Rev. Proc. 82-39, § 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 WL 49678 (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 WL 3604 (1979), aff'd, 647 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...