Greenberg Traurig Alert
Appeals Court Rejects IRS Inurement Argument;
IRS Approves 'Gainsharing' Programs
By Harry J. Friedman, Greenberg
Traurig, Miami Office
View or download the PDF version of this Alert
7th Circuit Defines "Insiders" For Inurement Purposes
The United States Court of Appeals for the Seventh Circuit handed the
IRS a sharp defeat in United Cancer Council v. Commissioner, issued on February
10, 1999. The UCC decision by the Tax Court, issued in late 1997, revoking
exempt status of a charity based on private inurement, was thought to have
significantly influenced the Proposed Regulations issued by the IRS with
respect to Intermediate Sanctions.
UCC was a national organization whose members were local cancer agencies.
UCC was in poor financial condition when it hired Watson and Hughey Company
("W&H") to act as a fundraiser. Under the contract with W&H, a contributor
list developed for the fundraising campaign on behalf of UCC became the
joint property of UCC and W&H. W&H was able to use the list for marketing
itself to other charities. W&H provided UCC with the initial capital to
conduct a fundraising campaign and also provided operating funds to UCC.
Contributions received were placed in an escrow account controlled by W&H.
Of $29 million received in contributions, only approximately $2 million
actually made its way to UCC.
The IRS revoked UCC's exemption arguing that UCC was operated for the
private benefit of W&H and that UCC's net earnings had inured to the benefit
of a private person, W&H. In 1997, the Tax Court upheld the private inurement
argument and the IRS revocation of UCCís exempt status. As noted in the
Court of Appeals decision, the IRS did not contend that any member of UCC's
board of directors received any of UCC's earnings nor that any member of
the board was related to any of W&H's owners or employees. The parties conceded
that the contract was negotiated on an arms-length basis. The Tax Court
found that W&H was an "insider" and had improperly received a portion of
UCC's net earnings, thereby supporting revocation of the exemption. The
terms of the contract, according to the Tax Court, provided W&H with influence
over UCC to the extent that it became an insider.
The 7th Circuit disagreed with the Tax Court's conclusions on private
inurement. Private inurement, according to the 7 th Circuit, is designed
to prevent "the siphoning of charitable receipts to insiders of the charity,
not to empower the IRS to monitor the terms of arms-length contracts made
by charitable organizations. . . ." The Court observed that "insiders" were
persons who are the equivalent of owners or managers. An "insider" could
be a nominal outsider such as a physician with hospital privileges. The
Court concluded that a service provider was not an insider simply because
it entered into an arms-length contract. The private inurement prohibition
was, according to the Court, not intended to provide the IRS with power
to monitor service contracts of charities. An arms-length contract, even
if badly negotiated and one-side in the IRS' eyes, does not constitute a
violation of law that would lead to revocation of exemption.
The Court did remand the case to the Tax Court to examine the other alternative
contention the IRS had made at the Tax Court, that UCC was operating to
a significant degree for the private benefit of W&H.
The IRS issued Proposed Regulations addressing Intermediate Sanctions.
Intermediate Sanctions, enacted in 1996, are penalty excise taxes imposed
on "persons with substantial influence" over a charity who engage in transactions
with that charity if the compensation paid exceeds fair market value for
the services rendered. In addition, the taxes may be imposed in the case
of certain revenue sharing transactions between a charity and a person with
substantial influence. Examples contained in the Proposed Regulations expressly
dealt with fundraisers, reflecting the Tax Courtís UCC decision. One would
expect the IRS to revisit those examples.
The Proposed Regulations presume that the first contract between a private
party and an exempt organization may subject the private party to the excise
tax. The 7 th Circuitís decision appears to preclude a private party from
becoming an insider simply from the negotiation of a service agreement at
arms-length. The decision may enter into question whether a person or organization
can be a subject to Intermediate Sanctions with regard to the first contract
negotiated with the exempt organization. The absence of a "first-bite" rule
in the Intermediate Sanctions may have been related to the Tax Court's decision
in the UCC case, making W&H an insider notwithstanding that it had no prior
relationship with UCC. The final Intermediate Sanction Regulations may contain
an exception for agreements between parties that had no prior relationship.
If such a provision is not included, the 7 th Circuitís position on arms-length
agreements may prevail with regard to the Intermediate Sanctions.
The Court of Appeals decision refuses to treat a service provider as
an insider solely as a result of the charity negotiating an unfavorable
contract because the service provider had stronger bargaining power. In
terms of Intermediate Sanctions, the issue is whether an unfavorable contract
to the charity may alone constitute evidence of substantial influence over
the exempt organization that would make the contracting party subject to
penalties if the compensation were not at fair market value.
Some commentators have suggested that the 7th Circuit interpretation
of who is an insider for purposes of private inurement may have limited
direct future importance since the Intermediate Sanctions regime makes future
revocations less likely. Nevertheless, the threat of revocation remains
a potent weapon in the IRSís arsenal, particularly in the case of organizations
such as hospitals that have tax exempt bonds outstanding.
Hearings are scheduled March 16 and March 17 with regard to the Proposed
Intermediate Sanction Regulations. One would anticipate that these issues
will be hotly debated at those hearings.
IRS Approves Gainsharing Arrangements
The media is reporting that the IRS has issued two private letter rulings
approving gainsharing programs. Practitioners have been concerned that such
arrangements might constitute private inurement to physicians who would
be treated as insiders. In addition, there was concern that such arrangements
would be affected by the application of Intermediate Sanctions as
a result of the revenue sharing consequences of the program.
Under a gainsharing program, physicians are rewarded for providing cost
effective care. Under the program approved in the private letter rulings,
if the physicianís department experienced variable cost savings and certain
quality of care requirements were met, a percentage of the savings were
placed in a pool available to the physicians. The program provided for a
fair market value cap on the amount of any compensation a physician could
earn, determined by an independent appraiser.
The IRS conclusionís were, according to reports, based on the value of
the services provided by the physicians to the hospital. This is consistent
with Proposed Intermediate Sanction Regulations that penalize revenue sharing
arrangements that fail to provide proportional benefits to the exempt organization.
Generally, private letter rulings become public within 60 to 90 days
after they are issued to the taxpayers who request the rulings. Publication
of these rulings will provide a better picture of the limits on gainsharing
©1999 Greenberg Traurig
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