IRS Overruled
A FEDERAL APPEALS COURT has reversed the Internal Revenue Service’s revocation of a charity’s tax-exempt status because of the arrangement it had with its direct mail fundraiser.
Fundraising experts disagree about what the fallout will be from the decision, depending on how they view the fundraiser’s contract with the charity and the IRS’ actions. But one thing seems clear-the court had no real problem with a charity assigning its mailing list to an outside agency for that agency to profit from. And whatever the outcome, it is eight years too late to help the charity.
On Feb. 10, the U.S. Court of Appeals for the Seventh Circuit reversed the tax court’s decision in United Cancer Council Inc. vs. Commissioner, which had upheld the IRS’ ruling. The IRS had said that United Cancer’s outside fundraiser had benefited improperly from running the nonprofit’s donor activities.
Near insolvency in 1984, United Cancer, an umbrella group based in Indianapolis, signed an exclusive five-year contract with Watson & Hughey Co., now called Direct Response Consulting Services and headquartered in McLean, VA. In return for paying the charity’s expenses up front, the fundraising agency was granted co-ownership of the donor list. United Cancer was forbidden to rent it but there was no restriction on Watson & Hughey’s use of it.
Between 1984 and 1989, Watson & Hughey raised $28.8 million in donations, but only $2.3 million went to the charity. According to the court decision, its expenses for postage, printing and mailing were $26.5 million.
After the contract expired, United Cancer hired another fundraiser and went bankrupt. In 1990 the IRS revoked its tax-exempt status retroactive to the date the Watson & Hughey contract was signed.
In its proceeding, the IRS said United Cancer’s deal with Watson & Hughey violated federal law against “inurement,” which pertains to the improper benefit of parties inside a charity. The tax agency argued that the contract was so beneficial to Watson & Hughey that it was an “insider.”
The IRS also said that the mailing list assignment contributed to the bottom line of a for-profit company, which is illegal under tax-exempt guidelines.
The appeals court admitted the arrangement was more favorable to Watson & Hughey than are most fundraising contracts, but did not make Watson & Hughey an “insider.”
The appeals panel said that the IRS’ argument in the case made “the tax status of charitable organizations and their donors a matter of the whim of the IRS.”
“There’s a myth that whatever a charity doesn’t get goes to the fundraiser, but a lot of it goes to expenses,” said Richard O. Wolf, general counsel for Direct Response Consulting Services, which is not a party to the case. “United Cancer had $35,000 before the contract, and at the end of it had $2 million in cash and a list of donors. The idea that Watson & Hughey drove them to bankruptcy is wrong.”
An IRS spokesperson said the agency doesn’t comment on tax court cases.
The appeal was financed by the Free Speech Defense and Education Fund, a McLean, VA, group that seeks to ease regulation of fundraisers.
The appeals court sent the case back to the tax court to consider a ground separate from inurement-that the charity was run for the “private benefit” of Watson & Hughey. The court suggested that the large fundraising expenses, which were irrelevant to the inurement question, might play a larger role in the “private benefit” accusation.
Andrew Fry, of Mayer Brown & Platt, the Washington, DC attorney who won the appeal, said the “fact that the tax court judge did not adopt the private benefit theory shows that he had serious doubts about it. Otherwise he would not have adopted the novel theory of inurement.”
Max Hart, fundraising director for Disabled American Veterans, Cincinnati, said he was surprised at the ruling because the Watson & Hughey contract was so tough, including the co-ownership of the list.
“If you don’t control your list, you don’t control your destiny,” he said. “I took great issue with that. Some good, reputable agencies, even though they didn’t agree with [Watson & Hughey’s] practices, still had concern about the government, namely the IRS, stepping into their business and dictating how their contracts should be structured. Obviously, some of those folks will breathe easy.”
National Federation of Nonprofits executive director Lee Cassidy had a rosier view, and said that many in the nonprofit community were not surprised the original decisions had been overturned. “It’s a victory for smaller government, but most importantly it affects the way the IRS will be able to prosecute intermediate sanctions,” he said, referring to measures the tax agency takes that fall short of revoking a charity’s tax exemption. “The IRS has said they’re not going to tell us what improper dealing is, but they know it when they see it-it depends on facts and circumstances. The judge in this case said that’s no standard at all. It’s a big case.”
