Greenberg Traurig Alert

Appeals Court Rejects IRS Inurement Argument;
IRS Approves 'Gainsharing' Programs

March 1999
By Harry J. Friedman, Greenberg Traurig, Miami Office

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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 UCC’s 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 Court’s 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 Circuit’s 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 Circuit’s 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 IRS’s 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 physician’s 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 conclusion’s 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 programs.

©1999 Greenberg Traurig