Recent developments affecting 501(c) (3) organizations.

• Author: Hagan, James Andrew

Section 501(c)(3) organizations face ever increasing scrutiny from the government when entering into transactions with private individuals and entities. There have been three significant changes in the law which substantially affect how these types of transactions may be structured. First, the Tax Court has ruled in United Cancer Council, Inc. v. Commissioner, 109 T.C. No. 17 (1997), that the use of a professional fundraiser merited revocation of United Cancer Council's tax-exempt status. Second, in a ruling that should have implications beyond the health care arena, the Service issued Revenue Ruling 98-15(1) which changes the Service's position with regard to transactions in which tax-exempt hospitals contribute their entire facility(ies) to joint ventures with for profit partners. Finally, on July 30, 1996, Congress enacted "intermediate sanctions" legislation which became effective September 13, 1995, and penalizes individuals who benefit from private inurement violations. This article analyzes each of these developments and explains how they impact 501(c)(3) organizations.(2)

Private Inurement -- Definition of "Insider"

A recent Tax Court case has expanded the types of situations in which a tax-exempt organization may lose its exemption. In United Cancer Council, the Tax Court agreed with the IRS that an "insider" is anyone who has the opportunity to influence or manipulate an organization's activities for the benefit of a private party. As a result of this decision, tax-exempt organizations may risk their exempt status when they transfer control of revenue-generating operations to an independent third party. In order to understand the significance of whether someone is an insider, a brief discussion of private inurement is necessary.

Section 501(c)(3) of the Internal Revenue Code(3) provides that in order for an organization to qualify as a tax-exempt charity, no part of its net earnings or assets may inure to the benefit of any private shareholder or individual. This is the basis of the so-called private inurement doctrine. Any private inurement, regardless of the amount of benefit conferred, results in revocation of an organization's exempt status.(4)

There are two critical elements of private inurement: 1) "inurement" of earnings or assets which 2) benefit a "private shareholder or individual." Whether "inurement" of earnings or assets occurs is a broad question of fact. The issue usually arises when the organization's financial resources are transferred to an individual solely as a result of the individual's relationship with the organization and without regard to accomplishing exempt purposes.(5)

"Private shareholders or individuals" are often referred to as "insiders." The Treasury Regulations define insiders as persons who have a "personal and private interest" in the tax-exempt organization.(6) Founders or controlling members of an exempt organization (i.e., officers or directors) are generally viewed as insiders because they have the potential to benefit from an organization's receipts and assets. In addition to individuals such as officers and directors, the Service has held that the term "insiders" also includes anyone able to exert influence on the organization to engage in a private inurement transaction.

The IRS historically has not interpreted the term insiders to include independent third parties.(7) However, in United Cancer Council, which was decided on December 2, 1997, the Tax Court expanded the definition of insiders when it revoked the 501(c)(3) status of United Cancer Council, Inc. (UCC). In that ruling the Tax Court held that a third party, a contingent-fee advertising company, was an insider for purposes of the private inurement doctrine.(8)

From its inception in 1963 until 1984, UCC was primarily funded by membership dues. Due to financial hardship in 1984, UCC entered into a five-year fund-raising contract with Watson & Huey Co., a professional fund-raiser (W&H). During the contract period, UCC received a total of about $2.25 million in net fund raising revenue. Over the same period, W&H received in excess of $4 million in fees directly from UCC and another $4 million indirectly through a division of W&H for use of mailing lists.

The IRS revoked UCC's exempt status in 1990, asserting that the organization's net earnings inured to the benefit of a private shareholder or individual, W&H. UCC contested the revocation by filing a petition with the Tax Court claiming there was no private inurement because W&H was not an...