Nos. 98-2181, 98-2190
INTERNAL REVENUE SERVICE,
ON APPEAL FROM THE
UNITED STATES TAX COURT
BRIEF IN SUPPORT OF PETITIONER-APPELLANT BY:
TABLE OF CONTENTS:
A. STATEMENT OF INTEREST OF THE AMICI CURIAE
B. ISSUES PRESENTED
C. STATEMENT OF FACTS
D. SUMMARY OF ARGUMENT
A. STATEMENT OF INTEREST OF THE AMICI
The Tax Court's ruling places the Amici, as well as the entire fundraising industry, in a state of uncertainty with regard to their relationships with their tax-exempt clientele. Prior to the Tax Court's ruling, contractual arrangements similar to those between UCC and W&H were commonplace in the industry. The Tax Court's decision wrongly permits the Internal Revenue Service (hereinafter "IRS") to penalize fundraising agencies and tax-exempt organizations for entering into freely negotiated contracts based on the IRS' after-the-fact determination that the results of the fundraising efforts did not justify the compensation paid to the fundraising agency. Negotiating arm's length contracts which are dictated by market prices will no longer provide a safe harbor to fundraising agencies from IRS claims that the compensation received for fundraising services was "excessive."
Further, the IRS has announced that it plans to use the Tax Court's decision as a model for the implementation of new "excess benefit" penalties contained in recently enacted legislation, popularly known as The Taxpayer Bill of Rights 2, P.L. No. 168, 104th Cong., 2d Sess. (1996), 110 Stat. 1452. Applying the Tax Court's holding to this legislation could open the door for the IRS to hold fundraising agencies personally liable for payment of an excise tax based on the IRS' after-the-fact determination that "excessive" compensation was paid. The Tax Court's decision is statutorily and constitutionally infirm, and harms fundraising agencies and nonprofit organizations by allowing the IRS to freely and retroactively substitute its judgment of what a reasonable deal is for that of parties who dealt with one another at arm's length and in good faith.
2. Whether, if the Court does determine that W&H is an "insider", any of UCC's net earnings inured to the benefit of W&H.
3. Whether the IRS' interpretation and enforcement of the inurement provisions impermissibly infringe upon the First Amendment right to conduct charitable solicitations.
In 1983, UCC experienced a budget crisis when some of its affiliate member agencies indicated their intent to withdraw from UCC. As a result, UCC's board of directors conducted a search for a fundraising agency that could help UCC raise additional funds pursuant to an arrangement whereby UCC, because of its financial position, would not have to contribute any initial capital or take on the financial risk involved in the fundraising effort. UCC's board of directors consisted of approximately 30 persons, including the Honorable Charles Schwartz, a sitting United States District Court Judge in Louisiana, the Honorable J. Quint Salmon, a sitting Senior Judge of the Court of Common Pleas of the Commonwealth of Pennsylvania, a bank president, as well as several other lawyers, physicians, dentists and nurses. R 37-38, 45-47, 49-50, 558, 1122, 1427, 1538-1539, UCC Opening Brief p. 24.
This search resulted in negotiations and eventual execution of a direct mail fundraising contract with W&H, a for-profit fund raising agency. The contract was negotiated by UCC's contract negotiating committee, which consisted of the aforementioned Judge Salmon; Michael Hyman, Executive Director of UCC and a former development officer at the American Heart Association who had experience in a variety of fundraising activities; Ben Bowen, Esq., a practicing attorney who served on UCC's board; and Dean Heasley, UCC's President of the Board and a bank president experienced in financial, contractual and escrow matters. Mailer's Amicus Brief p. 19, 20, and UCC Opening Brief p. 25. UCC thoroughly investigated W&H, checked W&H's list of references and contacted former clients of W&H. In addition, UCC obtained legal advice during the contract negotiations. Mailers' Amicus Brief p. 25. The contract, which was entered into on June 11, 1984, and amended April 9, 1987, included a number of revisions negotiated by UCC, R 45-47, 372, 512-513, 1088-1089, 1734.
The contract vested UCC with unfettered control to decide the content, quantity, recipient and time of mailing for each direct mail solicitation proposed by W&H. No direct mail fundraising solicitations could be mailed, or were mailed, without UCC's prior approval. The record showed that UCC regularly exercised its control in a variety of ways, including refusing to mail certain solicitations W&H proposed, or by changing the content of proposed solicitations. As noted in the Opinion, by exercising this right, UCC at times exposed W&H to severe losses. R 1135, 1660-1662.
Under the contract, W&H advanced the initial costs of the mailings and could be reimbursed only to the extent of the funds raised by the mailings. If the mailings failed to raise sufficient funds to cover the costs involved in mailing (see contract attached as Exhibit A), W&H was responsible for the outstanding debt. This arrangement is known in the direct mail industry as a "no-risk" contract. It has been widely used by fundraising agencies, especially by those with clients who were small or start-up tax-exempt organizations that could not afford or did not want to take on the substantial financial risk involved in direct mail campaigns. W&H also agreed to give UCC an immediate advance, or "draw", against UCC's projected future earnings from the contract.
The contract specified the compensation to be paid W&H for its services: a per piece production fee of 5¢ for each letter mailed to "prospect" names, (i.e., names of people who had not responded or contributed to UCC in the past), and 10¢ for each letter mailed to "housefile" names, (i.e., names of people who had made previous contributions to UCC). In exchange for W&H's assuming the risk of loss if fundraising costs exceeded the amount of donations received, the contract provided that UCC and W&H jointly owned the list of donor names generated by W&H's efforts (hereinafter the "housefile"). UCC could use the housefile for its own projects, and W&H was entitled to rent and to exchange the names generated by its efforts. This was a typical arrangement in "no risk" contracts.
Also typical of other "no risk" agreements was the contract's requirement that contributions received in response to the direct mail solicitations were deposited into an escrow account maintained by an independent third party escrow agent. Washington Intelligence Bureau, Inc. (hereinafter "WIB") acted as the independent third party escrow agent for the donations UCC received under the contract. All costs relating to the direct mail solicitations under the contract were paid from funds in the escrow account. UCC approved disbursements from the escrow account, including the payments of W&H's fees.
An essential element of UCC's tax-exempt mission was the dissemination of educational information about cancer to the general public. UCC used the direct mail solicitations created under the contract to achieve this goal. Every direct mail solicitation sent under the contract contained educational information about cancer. UCC considered this a vital part of its mailings, and constantly strove to increase the amount of educational content included in the mailings. Information on cancer and methods to detect the disease were included in the mailings.
The contract ended by its terms on May 30, 1989, and was not renewed by UCC. Total contributions under the contract were approximately $28.7 million. Op. p. 10. Of that amount, UCC applied over $12.2 million to its program services, including the dissemination of educational information in its direct mail solicitations. UCC also netted approximately $2.25 million in cash. Op. p. 106. Moreover, at the end of the contract UCC received a donor list of more than 1.1 million names, which it could use to generate funds, to expand its membership, and to send educational mailings.
Before, during and after the contract, W&H and UCC were completely independent entities. No employee, officer or director of UCC or any of its member agencies ever held any position with W&H. No employee, officer or director of W&H ever held any position with UCC or its member agencies. UCC Opening Brief p. 59.
When UCC's contract with W&H ended, UCC had almost half a million dollars in the bank, as well as the donor list of more than 1.1 million names. Mailers' Amicus Brief p. 64. UCC then retained the L.W. Robbins Company (hereinafter, "Robbins") to provide it with direct mail fundraising services. UCC Opening Brief p.97. Unlike its contract with W&H, UCC's contract with Robbins was not a "no-risk" contract. Instead, UCC was responsible for all fundraising costs incurred under its contract with Robbins. The direct mail solicitations UCC conducted under its contract with Robbins failed to generate revenues sufficient to cover the costs. UCC Opening Brief p. 99. Faced with significant fundraising expenses incurred under its contract with Robbins that exceeded its financial resources, UCC filed for bankruptcy under Chapter 7 of the United States Bankruptcy Code on June 1, 1990.
On November 2, 1990, the IRS revoked UCC's tax-exempt status retroactive to June 11, 1984 -- the date it entered into the contract with W&H -- and issued a notice of deficiency for income taxes for the years 1986 and 1987. Pursuant to 26 U.S.C. §7428, UCC filed a declaratory judgment action with the Tax Court on January 30, 1991, seeking to set aside the IRS' revocation. A trial was held in the Tax Court during parts of 1992 and 1993 before the Honorable Herbert L. Chabot. On January 30, 1998, the Tax Court entered its decision (dated December 2, 1997) upholding IRS' retroactive revocation of UCC's tax-exempt status. The Tax Court held that the IRS had met its burden of proving that UCC was not operated exclusively for tax-exempt purposes, because UCC's net earnings "inured to the benefit of private shareholders or individuals", i.e., W&H. On April 24, 1998, UCC noticed this appeal from the Tax Court's decision.
The Tax Court erred by holding that the net earnings of UCC inured to W&H. Net earnings are, by definition, the proceeds which were netted by UCC. Only portions of UCC's gross earnings were paid to W&H for expenses and compensation as provided in the contract. The list of donors, having no monetary value at the onset of the contract, was jointly owned and developed by UCC and W&H and was not part of the net assets. Finally, the compensation paid to W&H was within the average range for fundraising contracts with small nonprofits such as UCC.
Charitable solicitations are protected speech and are afforded the highest level of First Amendment protection. The IRS' new interpretation of the inurement provisions in I.R.C. § 501(c)(3) violates the First Amendment and will have a chilling effect on nonprofits and fundraising agencies who wish to conduct charitable appeals. Nonprofits are now put in the perilous position of risking their tax-exempt status by entering into a contract negotiated at arms length. Fundraising agencies may risk IRS sanctions by executing and performing under such a contract. If the decision is not reversed, the ability of certain nonprofits to engage in protected First Amendment activity will be jeopardized.
Here, the Tax Court found that UCC and W&H were at all times independent entities with no overlapping directors, officers, or employees. Indeed, the Tax Court expressly acknowledged that W&H officers and employees neither served as officers or directors of UCC, nor even had a "voice in the selection of any director or officer of [UCC]." Op. p. 91. The Tax Court further recognized that the UCC/W&H contract was a product of arm's length negotiations and included changes requested by UCC. Op. p. 93. Having made these findings, the Tax Court should have concluded its analysis and ruled that the IRS could not meet its burden of proving improper inurement of UCC's net earnings to W&H. The Tax Court, however, erroneously went on to hold that W&H was an "insider." Because the previously accepted elements of being an "insider" (e.g., ability to choose the tax-exempt organization's officers and directors, or not dealing at arm's length) were absent, the Tax Court employed what it termed a "practical standpoint" analysis in order to conclude that W&H was an "insider" of UCC. Id. The Tax Court concluded that W&H was an "insider" vis-a-vis UCC based on its determination that W&H had substantial control over UCC's fundraising and finances. Id. It analogized W&H's relationship to UCC as akin "to that of a founder and major contributor to a new organization." Id. at 92. The Tax Court's analysis is seriously flawed.
Fundraising agencies such as W&H (and Amici) operate at arm's length like many other businesses and consultants. When working with a nonprofit on a direct mail campaign, the tax-exempt organization decides what is mailed, when it is mailed and how much is mailed. Thus, as is typical in the direct mail fundraising industry, the contract between W&H and UCC vested control over all fundraising activities in UCC. Section 3 of the contract expressly states that:
All material, to include copy, list selection and proposed quantity to be mailed, prepared and recommended by W&H shall be subject to the approval of UCC and no such material shall be mailed or made available to the public without such approval.
The record is replete with instances in which UCC exercised this control. For example, UCC refused to mail certain solicitations proposed by W&H, and UCC edited the content of other solicitations before authorizing them to be mailed. Op. p. 52, R 1135, 1660-1662. Furthermore, UCC's Board of Directors created a special screening committee whose sole function was to review all direct mail materials that W&H proposed. In short, UCC was vigorous in exercising its control over its own fundraising activities.
The contractual relationships that Amici have with their tax-exempt clientele similarly provide that nothing can be mailed without the tax-exempt organizations' prior approval. The Tax Court's failure to accord any significance to UCC's approval authority means that fundraising agencies such as W&H and the Amici can be held to "control" a tax-exempt organization's fundraising, even though they cannot cause anything to be mailed without the tax-exempt organization's prior approval. Because UCC -- and UCC alone -- decided what was mailed, to whom it was mailed, and how much was mailed, the Amici submit there is simply no factual or legal basis to support the Tax Court's finding that W&H "controlled" UCC's fundraising activities.
Nor is the Tax Court's "control" finding supported by the escrow arrangement that was used under the contract. WIB, an independent third party, maintained an escrow account in UCC's name for the collection and disbursement of all funds raised under the contract. This type of escrow arrangement is typical in "no risk" agreements and helps protect fundraising agencies which assume the risk of bearing the fundraising and communications costs. It also protects tax-exempt organizations, not only by assuring accurate payment of its fundraising expenses, but also by prohibiting their fundraising agencies from unilaterally taking control of the donated funds. UCC had the authority to approve all bills before they were paid from the account. Over the entire five-year term of the contract, the Tax Court identified only one instance in which monies were withdrawn from the escrow account maintained by WIB to pay a fundraising related bill without UCC's prior approval, and in that instance, W&H agreed to bear the cost of the bill. Op. 66. Moreover, the IRS conceded that the escrow arrangement "was a true escrow agreement in the sense that WIB acted as a stakeholder for both parties." Commissioner Post-Trial Brief at 185. Finally, the Tax Court's reliance upon W&H's relationship with UCC as being akin "to that of a founder and major contributor to a new organization" is misplaced, and puts the Amici and other fundraising agencies in the untenable position of being unable to make contributions to tax-exempt organizations when every other corporation can freely make such contributions. Amici often enter into fundraising agreements with tax-exempt organizations that have very modest finances. Indeed, the very reason tax-exempt organizations retain fundraising agencies such as Amici (and W&H) is because they lack sufficient funds to carry out their tax-exempt purposes. The Tax Court's conclusion would make Amici and other fundraising agencies an "insider" of every modestly capitalized tax-exempt organization with whom they deal. Having found that the contract was entered into at arm's length, that W&H had no role in choosing UCC's officers and directors, and that UCC had to approve all direct mail solicitations, the Tax Court should have ruled that W&H was not an "insider." Its ruling to the contrary cannot stand.
Compounding the error is the manner in which the Tax Court quantified the benefit UCC received under the contract, i.e., the amount UCC "netted," and how it decided W&H's compensation was "excessive." As noted above, one of UCC's principal exempt purposes was to educate the public about cancer. Op. p. 7. Yet, in determining the benefit UCC derived from the contract, the Tax Court considered only the amount of cash UCC "cleared." Op. p. 106. The Tax Court ignored completely the $12.2 million that UCC allocated to its program mission via the educational information contained in each of its direct mail solicitations. Op. p. 110 (stating it did not consider the allocation issue). Amici submit that it was clearly erroneous for the Tax Court to refuse to give any consideration to the $12.2 million UCC allocated to its program of public education in determining the benefit UCC received under the contract. It is unreasonable to consider UCC's mission to provide educational messages about cancer to have zero value! Such communications containing helpful information is the primary goal for many charities.
The United States Supreme Court has held that charitable solicitations contain intrinsic value beyond the basic appeals for funds. In Village of Schaumburg v. Citizens for a Better Environment, 444 U.S. 620, 632 (1980), the Court determined that:
Prior authorities clearly establish that charitable appeals for funds involve a variety of speech interests &endash; communication of information, the dissemination and propagation of views and ideas, and the advocacy of causes &endash; that are within the protection of the First Amendment. Soliciting financial support is undoubtedly subject to reasonable regulation but the latter must be undertaken with due regard for the reality that solicitation is characteristically intertwined with informative and perhaps persuasive speech seeking support for particular causes or for particular views on economic, political, or social issues, and for the reality that without solicitation the flow of such information and advocacy would likely cease.
UCC clearly used its charitable appeals to further its mission of providing "informative speech" to the public regarding cancer and its detection. In light of the Schaumburg decision, the Tax Court clearly erred in giving no consideration to the costs expended by UCC in communicating this message to the public.
The Tax Court's determination that W&H's compensation was "excessive" is just as flawed. Although the Tax Court did concede that the per piece mailing fees W&H charged, which was the primary component of W&H's compensation, was within the range of fees charged by other fundraising agencies, it was critical of the fact that W&H's fees were not reduced as the amount of mail volume increased. Op. p. 100. But the record showed that some fundraising contracts had graduated fees and some did not. Even if that were not so and W&H was the only fundraising agency which did not have graduated fees, that would not make the fees excessive, particularly in light of the fact that W&H and UCC dealt at arm's length in negotiating W&H's compensation under the contract. There was no prior legal authority supporting the Tax Court's decision in this regard.
The Tax Court also included monies W&H received from using the list of donor names generated by its fundraising efforts as an element of "excessive" compensation. Op. p. 106. Whatever monies W&H received from such use, however, came from payments by third parties who paid for using those names. As such, none of those monies came from UCC's net earnings, and therefore, cannot constitute inurement. Curiously, the Tax Court finds elsewhere in its opinion that the list of donor names produced through W&H's services was practically worthless. Op. at 106. ("W&H's services were a 'practical failure' in this regard") Accepting that finding as true, there could be no "excessive" compensation associated with using the list.
At bottom, the Tax Court engages in nothing more than Monday morning quarterbacking in concluding that W&H's compensation was excessive. The Tax Court was "convince[d] that the initial risk that W&H bore did not justify so high a level of compensation." Op. p. 106. Such a conclusion, however, was reached by a court, in hindsight, long after the contract had been performed. In all fairness, such a conclusion cannot be justified based upon the facts known in 1984. The level of risk could not be fully known at the time the contract was negotiated and entered into. The Tax Court had the luxury of coming to a decision in 1998. When the contract was signed some 14 years earlier, however, W&H had no knowledge or guarantee that donations to UCC would be adequate to cover all the expenses for which it agreed to be at risk. UCC essentially had no existing list of donors (less than 100 names) to whom it could send direct mail solicitations. It had not previously done mass direct mail solicitations, so there was no track record to help gauge how the public might respond to appeals for donations. Moreover, UCC had earned the enmity of ACS, the largest and most entrenched player in the competition for charitable donations for cancer related causes. R 43-44. UCC was further handicapped by the fact that it was not permitted to solicit in areas covered by its local affiliates
These were the risk variables confronting UCC and W&H in 1984 when they negotiated their contract. W&H bore the risk of failure and received only as much compensation as UCC agreed to by an arm's length contract. Amici know firsthand that every direct mail fundraising effort runs the risk of failure. Indeed, the record shows just how risky direct mail fundraising can be. Whereas W&H had success in raising money for UCC, UCC's subsequent fundraising agency, Robbins, was not successful and UCC was forced into bankruptcy as a result of the failed mailings. Direct mail fundraising is not a science. Success and failure can happen for reasons beyond the control of fundraising agencies or their clients. Medical discoveries, wars and political upheavals are examples of numerous reasons such efforts can fail. The Tax Court's ruling, however, means that Amici and other fundraising agencies are now at risk of having their compensation deemed excessive if, after the fact, the IRS determines the results of the direct mail campaign were not adequate. The inurement provision of the IRC cannot be applied in such a retrospective manner.
This principle advanced by the Tax Court could have terrible consequences for more than just fundraising agencies. For example, if an attorney takes on a tax exempt client under a contingent fee arrangement, the attorney could be deemed to risk the tax-exempt status of his or her client if the attorney is successful in the litigation and receives a fee that the Tax Court later finds excessive.
Riley involved a North Carolina statute that defined the "reasonable fee" that a fundraising agency could charge a charity based upon the percentage of contributions collected. In Riley, the Court flatly rejected this approach as an unconstitutional infringement upon freedom of speech:
"Solicitation of charitable contributions is protected speech, and using percentages to decide the legality of the fundraiser's fee is not narrowly tailored to the State's interest in preventing fraud. Riley, 487 U.S. at 789.
Like the North Carolina statute, the IRS' new inurement interpretation purports to serve the purpose of preventing fraud by attempting to ensure that charitable funds are only used for charitable purposes, and not for the benefit of any "private individual or shareholder."
This application of a test based on percentage-based limits is unconstitutional. According to the Riley Court, the state's interest in protecting charities and their donors is not adequately served by percentage-based restrictions. Rather, as the Supreme Court declared:
[T]here are several legitimate reasons why a charity might reject the State's overarching measure of a fundraising drive's legitimacy -- the percentage of gross receipts remitted to the charity. For example, a charity might choose a particular type of fundraising drive, or a particular solicitor, expecting to receive a large sum as measured by total dollars rather than by percentage of dollars remitted. Riley, 487 U.S. at 791-92 (emphasis added).
In fact, the fundraising method chosen by UCC in this case corresponds with the Riley Court's recognition of the costs of various fundraising campaigns. A direct mail campaign typically must require proportionally large initial expenditures with the intent of receiving a large sum of total dollars to cover those expenses and provide net income to the charity. The Supreme Court has acknowledged that certain charities will have to conduct expensive fundraising campaigns in order to generate the donations to raise the funds necessary to support their causes.
The fact that this case involves revocation of tax-exempt status, rather than direct prohibition of solicitation, does not place it outside of First Amendment scrutiny. The denial of tax-exempt status, applied retroactively, as it was here, has the effect of chilling protected speech. Nonprofits and fundraising agencies such as the Amici will be reluctant to enter into agreements where the requirements for tax-exempt status are unclear and when the IRS is using hindsight to challenge arm's length agreements. The Riley court recognized the chilling effect that such an approach would have on Amici:
According to the State of North Carolina, we need not worry over this burden, as standards for determining '[r]easonable fundraising fees will be judicially defined over the years.' Speakers, however, cannot be made to wait for 'years' before being able to speak with a measure of security. In the interim, fundraisers will be faced with the knowledge that every campaign incurring fees in excess of 35 percent...will subject them to potential litigation over the 'reasonableness' of the fee. And, of course, in every such case the fundraiser must bear the cost of litigation and the risk of a mistaken adverse finding by the factfinder, even if the fundraiser and the charity believe that the fee was in fact fair. This scheme must necessarily chill speech in direct contravention of the First Amendment's dictates This chill and uncertainty might well drive professional fundraisers out of North Carolina, or at least encourage them to cease engaging in certain types of fundraising...or representing certain charities (primarily small or unpopular ones), all of which will ultimately 'reduc[e] the quantity of expression.'" Riley, 487 U.S. at 793 (emphasis added).
The Tax Court's approach leaves the fundraising industry in a great state of uncertainty. Those hardest hit by the Tax Court's decision are fundraising agencies such as Amici who deal with small, underfunded tax-exempt organizations. The fundraising agencies will no longer advance their own funds or shoulder the risk of loss for campaigns if they are unable to obtain list rights or other means of compensation to justify the risk. This chills not only fundraising agencies, but will mean fewer tax-exempt organizations will be able to have the opportunity to get their message out to the public. Banks will refuse to loan money to nonprofits for fear that they might not recover their costs; and certainly, they will refuse to accept donor lists as collateral. Printers will be reluctant to print letters on credit for fear that the tax exempt organization might not pay them. Only large, well-endorsed charities will survive the Tax Court's decision. Because of this impact, the Tax Court's ruling restricts speech protected by the First Amendment and, therefore, cannot stand.