EXEMPT HEALTH CARE ORGANIZATION ACTIVITIES FAILED TO SERVE PUBLIC INTEREST.

UIL Number(s) 0501.03-11

                                             Date: * * *

1. Whether M provided health care in a charitable manner pursuant to section 501(c)(3) of the Internal Revenue Code.

2. Whether M engaged in activities that served a private rather than a public interest and resulted in inurement of earnings to the benefit of private shareholders or individuals.

3. If M engaged in activities that served a private rather than a public interest, what is the effective date for the revocation of its tax exempt status?

4. M sold all of its assets related to the provision of health care in October of 1992. Is the income from that sale subject to the tax imposed by section 511 of the Code?

5. Whether M will be granted relief pursuant to section 7805(b) of the Code.

FACTS

M, formerly known as N (the "Hospital"), was recognized as an organization described in section 501(c)(3) of the Code in a determination letter dated August 11, 1965. In a notice dated October 10, 1970, the Hospital was notified that it was not a private foundation as defined in section 509(a). It operated a * * * hospital from August 1961 through February 1984.

On January 16, 1984, the Hospital requested a ruling regarding the proposed sale of certain of its assets to an unrelated third party. The Hospital stated that after the sale of the assets it would change its operations from that of a full service acute care hospital to that of a provider of health care through certain alternative delivery systems.

On February 2, 1984, based on the Hospital's representations that it would operate exclusively for exempt purposes, the Internal Revenue Service issued a favorable ruling. The ruling held that: (1) the proposed sale of assets would not adversely affect the Hospital's exempt status under section 501(c)(3) of the Code; (2) the proceeds from the proposed sale of assets would not result in unrelated business income tax under section 512; and, (3) upon consummation of the proposed sale of the assets and the institution of the proposed activities described in the ruling, the Hospital would continue to be treated as an organization described in sections 501(c)(3), 509(a)(1) and 170(b)(1)(A)(iii) of the Code.

After receiving the 1984 ruling, the Hospital closed on the sales agreement with the unrelated third party. The Hospital received approximately $57 million from the sale.

On February 24, 1984, the Hospital filed restated articles of incorporation and changed its name from N to M.

M is one of six entities within a system of exempt and taxable entities. The parent in the system ("Parent") has been recognized as an organization described in sections 501(c)(3) and 509(a)(3) of the Code. The Parent controls its two tax exempt and three taxable subsidiaries by stock ownership or board appointment. M and an organization described in section 501(c)(2) are the two tax exempt entities controlled by the Parent. The taxable entities consist of an off-shore captive insurance company ("Insurance Company"), a management company, and an entity which serves as a general partner in joint ventures with physicians and other investors.

Listed below are the officers, directors, and members of M and the Parent:

 1993                          M                   Parent

On June 6, 1986, M entered into a Purchase and Sale agreement (the "Sale Agreement") with a professional association owned, directly or indirectly, by five physicians (the "Physicians") regarding the purchase of a particular medical practice (the "Practice"). Under the terms of the Sale Agreement, M agreed to purchase all patient records, including but not limited to, patient medical charts, accompanying x-rays, and patient lists; goodwill; and the going concern value of the Practice for the sum of $6 million.

M retained the services of an appraiser (the "Appraiser") to assess the value of the Practice. The appraiser estimated the fair market value of the Practice to be $6,800,000.

Documents accompanying the Sale Agreement indicate that the total tangible assets of the Seller were $170,093 for the period ended April 30, 1986. The Practice incurred losses in its 1984 and 1985 tax years.

An industry economist employed by the Internal Revenue Service appraised the value of the Practice and found it to be worth $2 million at the time of the sale. Reviewing the appraisal commissioned by M, the economist states that the Appraiser's selection of the Capitalized Income Method to value the Practice is appropriate, but the application of that method to the Practice is seriously flawed by the use of an incorrect capitalization rate and the elimination of normal expenses inappropriately determined by the Appraiser to be discretionary.

In response to our letter dated May 27, 1993, regarding the price paid for the Practice, B states that with regard to the purchase of the Practice, the Appraiser may have been "too optimistic."

In a letter to the Service dated August 31, 1993, B discusses the purchase of the Practice. He states that while there may be a difference of opinion as to the correct application of valuation methodology, "there is no evidence of intentional overpayment . . ."

The minutes of the December 1, 1987 meeting of M's board of trustees, establish that A states that there was a conscious overpayment to the Physicians for the Practice in order to gain their patients and credibility.

On June 6, 1986, M entered into a medical services agreement ("Service Agreement") with a partnership (the "Contractor"). The general partners of the Contractor were five professional associations owned by the Physicians.

Under the terms of the Service Agreement, M agreed to provide, at its expense, the facilities, equipment, supplies, services (other than physician services), and general office personnel necessary for the Contractor to properly operate and conduct the business of the Practice. The Contractor agreed to provide physicians' services and overall supervision necessary to operate the Practice. The Contractor agreed to furnish the services of the Physicians on a full-time basis. The Service Agreement defined the term "full-time basis" as performance of services on the same historical basis that the Physicians provided medical services prior to the commencement of the term of the Service Agreement. Under the terms of the Service Agreement, M paid $2 million per year, plus medical malpractice insurance, to the Contractor as compensation for the physician services provided.

The Physicians performed essentially the same duties both prior to and after the sale of the Practice. A comparison of compensation paid to the Physicians prior to and after the sale of the Practice is shown below. Figures for the year 1986 are not shown since the Physicians were employed by the Contractor for only a portion of that year.

                           1983         1984        1985        1987

M paid $17.4 million for various medical assets ("Medical Assets") that it purchased over a period of time beginning in 1986 and ending in 1991. On January 31, 1992, a valuation of the Medical Assets was prepared for M by an accounting firm. The accounting firm determined the fair market value of the Medical Assets to be $7,328,564. The accounting firm did not inspect the Medical Assets. It relied on information furnished by M.

On October 19, 1992, M sold the Medical Assets -- the medical practices it purchased during 1986 and 1987 as well as its interest in six other health care centers -- to O in exchange for a promissory note in the amount of $4.5 million. Thirteen physicians ("Purchasing Physicians") who were employed by M prior to the sale of the Medical Assets hold, indirectly, 70% of the ownership interest in O. AA, A's grandson, holds a one percent interest in O through a corporation in which he is the majority shareholder. The remaining interest in O is held by L and Q.

The promissory note issued to M by O provides for monthly payments of interest to begin on September 30, 1993 and monthly payments of principal to begin on March 31, 1995. On November 30, 1992, M assigned the promissory note to the Parent.

In a letter dated February 14, 1994, B states that the current book value of M and its affiliates is approximately $16 million. He indicates that the principal change since mid-1993 is that the promissory note from O has been written down due to doubtful collectibility.

During 1988, A received $266,667 in salary from M for his duties as M's Chief Executive Officer, President, and Trustee. A indicates that his duties consist of establishing policy for M and ensuring that M complies with "exempt organization regulations." A states that he devoted 70 hours per week, with no vacations, to his duties as Chief Executive Officer, President, and Trustee of M. A random sample of A's business journal entries fails to indicate that he worked on weekends.

A's salary is not determined by an independent compensation committee. In a letter dated February 15, 1994, M represents that A's 1988 compensation was determined as a part of the budgeting process. M indicates that the budget was proposed by its Treasurer, C, and presented to the Finance Committee for review. A, C, F, and J served on the Finance Committee. After reviewing the budget, it was presented to M's governing board for approval.

The examining agent conducted an informal survey regarding annual compensation paid to chief executive officers of large hospitals in the areas during 1988 and 1989. Total compensation per CEO ranged from $110,000 to $262,295. The majority of the CEOs' compensation was in the $236,000 range.

In addition to the above compensation in 1988, A received a lump sum distribution of $1,830,474 from M's executive staff retirement plan ("Retirement Plan"). In that same year, A also received $120,000 from the Insurance Company -- a taxable subsidiary of the Parent. M indicates that this amount represents A's 1988 annual salary of $80,000 for his duties as President and Chief Executive Officer of the Insurance Company, M maintains that the remaining $40,000 represents A's salary from the Insurance Company for the period July 1 through December 31, 1987.

M indicates that A provides claims management, engages in executive decision-making, strategic planning, investment management, sales and client relations. A is also responsible, at least in a general sense, for oversight with respect to the services provided by the manager, the claims administrator, and the Insurance Company's several attorneys.

A study of the Insurance Company's loss reserves and rates dated October 22, 1991, conducted by an accounting firm, indicates that in the four years since the Insurance Company began operating, 30 claims were filed. M is the Insurance Company's only client.

M represents that during 1988 the Insurance Company contracted with an independent firm to act as its manager. The manager acted as M's principal representative responsible for compliance with regulatory matters under the insurance laws of the country in which M operates. In addition, the manager handled the policies, maintained M's books and records, managed the accounts payable and receivable, and provided general management consulting to M. The Insurance Company also contracted with an independent third party to provide claims administration services. A local law firm has at all times provided corporate record services for the Insurance Company. Various other attorneys have been retained from time to time for particular matters. For a brief period, M paid retainers to legal and tax counsel.

During 1988, C received an annual salary of $213,308 from M with regard to his duties as M's Executive Vice President and Treasurer. C also received a salary of $60,000 from the Insurance Company during 1988.

In addition to the salaries paid to A and C by M, M paid $78,876 in premiums for whole life insurance policies with regard to A and C.

The law firm in which B is a partner received $451,831 in legal fees from M during 1988. In that same time period, B's spouse received $445 from the Insurance Company for graphic arts services. B was an officer of both M and the Parent in 1988.

In 1988, M paid D, one of its trustees, $48,000 in medical consulting fees. He received the same amount in 1985, 1986 and 1987. There was no contract or other agreement between D and M regarding the provision of the medical consulting services for this four year period. During 1988, D also received a lump sum distribution of $755,049 from M's pension plan.

M's books and records indicate that during the period which began October 1, 1987 and ended September 30, 1988, the following expenses, totaling $25,245.98, were paid by M:

      11/27/87 $1,108 airline tickets for A's spouse

With regard to M's purchase of airline tickets to Bermuda for the spouses of A and B, M indicates that the tickets were purchased simply as a matter of convenience. M believes that the cost of the spouses' tickets was reimbursed to M either by check or offset against subsequent expense accounts. M is unable to provide documentation evidencing reimbursement.

M represents that it purchased the remaining items (except for the liquor and food) as gifts or awards to its employees. M failed to submit documents to substantiate its claims.

During its 1988 tax year, M expended over $8,000 for liquor from a local liquor store. The invoices indicate that the liquor was delivered but does not indicate the delivery address. M represents that the liquor was used at various receptions it sponsored as a part of its marketing practice. M was able to furnish one announcement which referred to cocktails being served -- a reception concerning the use of its vision screening van.

With respect to the $9,563.30 M expended to cover food and liquor charged at a local country club by A and C. M represents that A and C were entertaining business clients.

In 1988, M purchased professional and patient liability insurance from the Insurance Company under a master policy program that covered the period beginning July 1, 1988 and ending June 30, 1989. With respect to the premium allocated to each physician covered, the Insurance Company attached an administrative surcharge that amounted to approximately 10 percent of the related premium. With respect to the premium allocated to M managerial staff, the Insurance Company attached an administrative surcharge that amounted to 473 percent of the related premium. The administrative surcharge amounted to $173,139. The applicable premium was $36,577.

P is a limited partnership. P was formed to own and operate an adult congregate living facility ("Facility"). Between 1985 and 1989, two of M's trustees and officers, A and C, and M's Associate Director of Operations, K, held a financial interest in P. C was the general partner in P and A and K were limited partners. M was neither a general nor a limited partner in P.

Financial data indicates that on December 30, 1985, the law firm in which B is a partner received a payment of $12,761 from P for legal services provided.

During 1984 and 1985, M incurred expenses totaling $64,313.66 that were related to the formation of P. After P filed its Certificate and Agreement of Limited Partnership with the State of Florida in November of 1985, the expenses were recorded as interest- free, unsecured loans to P on M's books. From April of 1987 to November of 1987, M incurred additional expenses on behalf of P totaling $26,332.16. These additional expenditures were recorded on the books of M as interest-free, unsecured loans.

In an interview with the examining agent, A represented that M paid expenses on behalf of P because of sloppy bookkeeping. In an affidavit dated December 24, 1992, C states that M incurred the expenses because it was interested in establishing the Facility. C represents that each of the expenditures later recorded as loans to P were made by M for the purpose of investigating whether M would establish, operate or otherwise be involved in a Facility. C states that it was ultimately determined that M would not pursue the Facility concept.

M has failed to furnish documentation, such as minutes of its meetings, to substantiate that it actually considered establishing a Facility.

On June 19, 1985, C signed a letter of agreement with an architecture and planning group regarding the architectural design for the Facility. C signed as "Trustee for a Partnership to be formed". On August 6, 1985, M paid the charges related to the architectural design. The request for payment was approved by C. It is apparent that on June 19, 1985, the work was undertaken on behalf of the yet to be formed P. M continued to pay expenses on behalf of P through November of 1987.

P repaid the initial loans, which totalled $64,313.66, without interest. On March 31, 1989, A entered into an indemnification agreement with a limited partnership and a corporation (collectively referred to as "Corporation"). Corporation holds a financial interest in P. The indemnification agreement acknowledges the outstanding amount due to M, $26,332.16, and acknowledges that the amount is to be repaid with 10% interest. In addition, the indemnification agreement holds P and/or Corporation responsible for repayment of the loan. Prior to the indemnification agreement, there was no acknowledgment of interest with regard to the loans. The entire balance of the loan is still outstanding.

On March 31, 1989, A assigned his interest in P to the corporation mentioned above. A's capital account was valued at $92,117 on P's books. As consideration for A's transfer, P agreed to pay A an amount equal to 50% of the net revenue and net profit from certain real property valued at $1,574,125 on P's books.

On April 28, 1983, M adopted its Retirement Plan to reward selected senior executives. It was determined at that time that A, B, C, D, J, K and two other individuals would be participants in the Retirement Plan.

Initially, the Retirement Plan provided "upon the retirement of an executive or, if later, his or her normal retirement date, or upon the disability of an executive, the executive shall be entitled to receive his annual retirement benefit each year for a period of ten years." The Retirement Plan also provided that upon the death of an executive prior to his normal retirement date, the executive's designated beneficiary shall be entitled to receive the executive's annual retirement benefit each year for a period of ten years.

The Retirement Plan, as amended through December 17, 1985, provided "A participating Executive shall be entitled to benefits hereunder only upon retirement or death or disability prior to retirement."

On March 19, 1987, the Retirement Plan was amended to provide that a participating executive who would be entitled to receive retirement benefits but for the continuation of such executive's employment, may elect "constructive retirement". In other words, the executive shall be deemed to have retired for purposes of the commencement of retirement benefits only. An additional amendment to the Retirement Plan authorized the payment of the retirement benefit in one lump sum equal to the present value of the annuity otherwise payable under the Retirement Plan for ten years.

In a board meeting held on January 19, 1988, the constructive retirement of both A and D retroactive to September 30, 1987 was voted on and approved. Four board members were present -- A, D, F and G. A and D abstained from voting. Lump sum distributions of $1,830,474 and $755,049 were approved for A and D, respectively. Both A and D continued to work for M. There were no substantial changes in their duties or hours.

In its protest to the request for technical advice, M contends that any adverse action taken by the Service should be without retroactive effect since M believes it can rely on the ruling it received dated February 2, 1984. Thus, M requests relief pursuant to section 7805(b) of the Code.

LAW

Section 501(a) of the code exempts organizations described in section 501(c) from federal income taxation.

Section 501(c)(3) of the code describes, in pertinent part, corporations organized and operated exclusively for charitable purposes no part of the net earnings of which inures to the benefit of any private shareholder or individual.

Section 1.501(c)(3)-1(a) of the Income Tax Regulations provides that, in order to be exempt as an organization described in section 501(c)(3), an organization must be both organized and operated exclusively for one or more exempt purposes. If an organization fails to meet either the organizational test or the operational test, it is not exempt.

Section 1.501(c)(3)-1(c)(1) of the regulations provides that an organization will be regarded as operated exclusively for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of such exempt purposes specified in section 501(c)(3). An organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.

Section 1.501(c)(3)-1(c)(2) of the regulations provides that an organization is not operated exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals as defined in section 1.501(a)-1(c).

Section 1.501(a)-1(c) of the regulations provides that the terms "private shareholder or individual" in section 501 refer to persons having an personal and private interest in the activities of the organization.

Section 1.501(c)(3)-1(d)(1)(ii) of the regulations provides that an exempt organization must serve a public rather than a private interest. The organization must demonstrate that it is not organized or operated to benefit private interests such as "designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests."

Thus, if an organization is operated to benefit private interests rather than for public purposes, or is operated so that there is prohibited inurement of earnings to the benefit of private shareholders or individuals, it may not retain its exempt status.

In Better Business Bureau v. United States, 326 U.S. 279 (1945), the Supreme Court held that the presence of a single noncharitable purpose, if substantial in nature, will preclude exemption under section 501(c)(3) of the Code regardless of the number or importance of the charitable purposes.

John Marshall Law School and John Marshall University v. United States, 81-2 USTC 9514 (Ct. Cl. 1981), involved a private, unaccredited, law school and college that were operated by two brothers, Theo and Martin Fenster, and members of their families. The Service revoked the exemption of both organizations on the ground that part of the net earnings of the organizations inured to the benefit of private shareholders or individuals. The organizations filed a declaratory judgment action in the Court of Claims.

The court recognized that an organization described in section 501(c)(3) is permitted to incur ordinary and necessary expenses in the course of its operations without losing its tax-exempt status. However, the court found that a series of interest-free, unsecured loans made by the organization to the Fensters, the granting of noncompetitive scholarships to the Fenster children, and the payment of nonbusiness related expenses for travel, health spa membership, and entertainment resulted in the inurement of the earnings of the organization to the Fenster brothers and their families. Thus, the Service's revocation of the organizations' exemptions was upheld.

Founding Church of Scientology v. United States, 412 F.2d 1197 (Ct. Cl. 1969), cert. den., 397 U.S. 1009 (1970), involved an organization that attempted to demonstrate, after the fact, that a number of undocumented transactions were typical business arrangements. The organization argued that it had paid its founder for expenses incurred in connection with his services, made reimbursements to him for expenditures on its behalf, and made some payments to him as repayments on a loan. The organization was unable to produce evidence of contractual agreements for services, documents evidencing indebtedness, or any explanation regarding the purposes for which expenses had been incurred. Accordingly, since the plaintiff failed to meet its burden of proof, the court found that a part of the corporate net earnings inured to the benefit of private individuals.

RATIONALE

An organization described in section 501(c)(3) of the Code is not prohibited from dealing with its directors or officers in conducting its economic affairs. However, transactions between a charitable organization and a private individual in which the individual appears to receive a disproportionate share of the benefits of the exchange relative to the charity served presents an inurement issue. Some typical transactions in which inurement may be present include compensation arrangements, sales of property, rental arrangements, and contracts to provide goods or services to the organization. Generally, if the transaction is indistinguishable from an ordinary prudent business practice in comparable circumstances, a fair exchange of benefits is presumed and inurement will not be found.

A has served as an M Trustee for over 22 years. B has been an officer of M for over 10 years. C was an officer of M for over 10 years. These individuals held their respective positions in 1984, 1985, 1986, 1987, and 1988. During 1988, D, H, J, and BB served as trustees, officers and/or members of M. K was a senior executive with respect to M. In addition to his duties with respect to M, J served as A's accountant for his personal matters during 1988 and 1989 and thus had a personal relationship with A outside of his work at M. The individuals noted in this paragraph have held various positions with M, the Parent, and/or the other entities within the system over a number of years. During 1988, A, B, C, D, H, J, K and BB held positions of authority with respect to M. The Participating Physicians were employed by M and controlled the flow of patients to its medical practices. L was an officer of M during 1992 and 1993. Thus, A, B, C, D, H, J, K, BB, the Participating Physicians (during the period they were employed by M), and L are persons who have a personal and private interest in the activities of M within the meaning of section 1.501(a)-1(c) of the regulations and are subject to the inurement proscription.

During 1988, salaries for executives and consulting fees for services such as those paid to A, B, C, D, and J were suggested by the Finance Committee. A, C, F and J comprised the four member Finance Committee. The figures put forth by the Finance Committee were subject to approval by the trustees of M. The trustees, A, D, B, F & G, were elected by M's members. During 1988, two of the six members were closely related to A. The third member was B's spouse. D was the fourth member.

In addition to controlling the election of trustees in 1988, A, B, C, D and J served as officers of M. Thus, during 1988, A, B, C, D and J essentially controlled M.

During 1988, A received $266,667 in salary from M. M claims that during 1988, A devoted 70 hours per week, with no vacations, to the performance of his duties with respect to M. A continues to receive annual compensation from M in approximately the same amount although M has admitted that it currently engages in very few activities.

In addition to the salary A received from M during 1988, he received $120,000 from the Insurance Company. M now claims that $40,000 of the $120,000 was compensation for duties performed during the last half of 1987 and that A received only $80,000 for services performed during 1988.

Not only did A receive compensation of $266,667 from M and at least $80,000 from the Insurance Company during 1988, he also received a lump sum payment from M's Retirement Plan in the amount of $1,830,474 despite the fact that he continued to work for M with no reduction in duties or hours.

During 1988, C received $213,308 from M for his duties as its Executive Vice President and Treasurer. C, as Treasurer of the Insurance Company, also received a salary of $60,000 from that entity in 1988.

There is nothing in the file to indicate that A or C have expertise in the insurance or actuarial field that would qualify them to provide various services to the Insurance Company.

In addition, a study of the Insurance Company's loss reserves and rates dated October 22, 1991, conducted by an accounting firm, indicates that in the four years since the Insurance Company began operating, only 30 claims were filed. M is the Insurance Company's only client.

Further, the documents in the administrative file indicate that the Insurance Company had entered into contracts with various entities to provide services similar to those M indicates A and C provided.

Through the overpayment for insurance coverage, M allowed its funds to be diverted to the Insurance Company. The Insurance Company then passed a portion of those funds on to A and C under the guise of salaries. Thus, M and the Insurance Company allowed the funds of M to inure to the benefit of A and C.

In addition to the amounts received by A and C described above, M paid $78,000 in life insurance premiums on behalf of A and C during 1988.

The law firm in which B is a partner received $451,831 in legal fees from M during 1988. During that same year, B's spouse received $445 from the Insurance Company for graphic arts services.

M paid D $48,000 in medical consulting fees during 1988. There was no contract or other written agreement between M and D concerning the duties he was expected to perform as medical consultant to M. In addition to the consulting fee, D received a lump sum payment from M's Retirement Plan in the amount of $755,049 during 1988. After the payment, D continued to work for M with no reduction in duties or hours.

J received $73,835 in consulting fees from M during 1988. During 1989, J received $155,000 in consulting fees from M.

M adopted its Retirement Plan in 1983. The purpose of the Retirement Plan was clearly stated -- to reward selected senior executives UPON RETIREMENT THROUGH THE PAYMENT OF A RETIREMENT BENEFIT OVER A TEN YEAR PERIOD (emphasis added).

Two amendments to the Retirement Plan made in 1987 altered the original purpose of the plan by providing that participating executives may elect "constructive retirement" whereby the electing executive is deemed to have retired for purposes of the commencement of retirement benefits only and by authorizing the payment of the retirement benefit in a lump sum.

In 1988, M's board approved the constructive retirement of both A and D retroactive to September 30, 1987. The amendments to the Retirement Plan and the approval of the constructive retirement of A and D were made solely to benefit those two individuals by entitling them to collect retirement benefits while continuing to work for and be compensated by M. Thus, through the payment of the lump sum distributions, M's funds inured to the benefit of A and D.

M paid $25,245.98 to cover various expenses during 1988 that do not appear to further its exempt purpose. It paid $5,107 in airfare on behalf of A's wife and $1,192 in airfare to * * * on behalf of the wives of A and B. M expended $9,563.30 to cover food and liquor charged at a local country club by A and C. It paid for $8,275.55 worth of liquor charged at a local liquor store. In addition, M paid $1,108.13 for items such as china, glassware, perfume, etc. M has failed to submit documents to evidence that any of these expenditures furthered its exempt purpose. The payment of these nonexempt expenses resulted in inurement to A, B and C.

Between 1984 and 1987, M made unsecured, interest free loans to P, the partnership in which A, C, and K held a financial interest.

In an interview with the examining agent, A represented that M paid expenses on behalf of P because of sloppy bookkeeping. In an affidavit dated December 24, 1992, C states that M incurred the expenses because it was interested in establishing the Facility.

Although M claims that the expenditures related to the Facility furthered its exempt purpose, M has not furnished documentation, such as minutes of its meetings where establishing the Facility was discussed, to substantiate the claim that it initially sought to establish the Facility.

Further, the June 19, 1985 letter of agreement signed by C as "Trustee for a Partnership to be formed" clearly establishes that the work was undertaken on behalf of the yet to be formed P. M continued to pay expenses incurred by, or on behalf of, P through November of 1987. Accordingly, the unsecured, interest free loans made to P resulted in inurement to A, C and K.

M paid $6 million with respect to its purchase of the practice. The Service has determined that the fair market value of the Practice at the time of the purchase was $2 million. The documentation submitted by M to support its conclusion that the $6 million purchase price did not exceed fair market value appears to be flawed and is not reliable.

The history of the Physicians' compensation prior to the Contractor's entering into the Service Agreement with M is relevant for purposes of determining whether reasonable compensation was paid by M since the Physicians were performing essentially the same duties both before and after the existence of the Service Agreement.

M paid the five Physicians aggregate annual compensation of $2,000,000. The industry norm for five physicians practicing in the same specialty has been established by M's Appraiser at $1,325,000. In the years prior to the purchase of the Practice, the Physicians' aggregate compensation conformed to the industry norm. M paid the Physicians, in the aggregate, compensation that exceeds the industry norm by approximately 50%. Thus, the Service Agreement resulted in excessive compensation being paid by M to the Physicians.

Although M paid $17.4 million for the various practices it purchased in 1986 and 1987, on October 19, 1992, M sold all of the medical practices it owned as well as its interest in six other health care centers (collectively referred to as "Medical Assets") to O in exchange for a promissory note in the amount of $4.5 million. The thirteen Participating physicians who were employed by M at the time of the sale of the Medical Assets hold, indirectly, 70% of the ownership interest in O. AA, A's grandson, holds a one percent interest in O through a corporation in which he is the majority shareholder. The remaining interest in O is held by Q and L.

Just prior to the sale, the Medical Assets were valued at $7,328,564. The $4.5 million promissory note issued to M by O provided for payments of principal to begin on March 31, 1995. In mid-1993, the promissory note was written down due to doubtful collectibility. * * * Thus, the sale of the Medical Assets at a price substantially below fair market value resulted in inurement to L and the Participating Physicians. The reduction of the promissory note from O on M's books and records indicates that M does not intend to vigorously take steps to collect the outstanding debt. This failure suggests additional inurement to L and the Participating Physicians.

Like the activities described in John Marshall Law School and John Marshall University v. United States, the salaries paid to A and C by the Insurance Company; the changes in the Retirement Plan and the payment of a lump sum retirement benefit to A and D during a period during which they would otherwise have been ineligible to receive retirement benefits; the payment of expenses related to food and liquor charged by A and C; the payment of expenses on behalf of the wives of A and B; the provision of unsecured, interest-free loans to P; and, the sale of the Medical Assets at a price substantially below fair market value all served to confer benefits on A, B, C, D, K, L and the Participating Physicians which violate the inurement proscription of section 501(c)(3) of the Code.

In addition to prohibiting private inurement, the Code provides that an exempt organization must be operated for public rather than private benefit. Although inurement is generally applied only to insiders with some authority with respect to an organization, private benefit may accrue to an independent outsider. However, unlike inurement, private benefit must be substantial in order to jeopardize exempt status and even substantial private benefit may be tolerated where it is incidental to the accomplishment of charitable purposes.

Any private benefit arising from a particular activity must be "incidental" in both a qualitative and quantitative sense to the overall public benefit achieved by the activity. To be qualitatively incidental, a private benefit must occur as a necessary concommitant of the activity that benefits the public at large. Such benefits might also be characterized as indirect or unintentional. To be quantitatively incidental, a benefit must be insubstantial when viewed in relation to the public benefit conferred by the activity. The private benefit conferred by an activity or arrangement is balanced only against the public benefit conferred by that activity or arrangement, not the overall good accomplished by the organization.

The salaries paid to A and C by the Insurance Company; the payment of $78,000 in life insurance premiums on behalf of A and B; the payment of a lump sum retirement benefit to A and D; the payment of expenses related to food and liquor charged by A and C; the payment of expenses on behalf of the wives of A and B; the provision of unsecured, interest free loans to P; the overpayment for the Practice; the payment of excessive compensation to the Physicians; and, the sale of the Medical Assets at a price considerably below fair market value conferred a direct and intentional benefit on A, AA, B, the wives of A and B, C, D, K, L, the Physicians and the Participating Physicians. These actions did little or nothing to further the exempt purpose of M. Thus, they resulted in substantial private benefit to A, AA, B the wives of A and B, C, D, K, L, the Physicians and the Participating Physicians. The reduction of the promissory note from O on M's books and records indicates that M does not intend to vigorously take steps to collect the outstanding debt. This failure suggested additional private benefit to AA, L and the Participating Physicians.

In addition to the items listed above, during 1988, A, B, C, D and J paid themselves substantial salaries and/or consulting fees, used M's funds to purchase large amounts of liquor and caused M to purchase various gift items that M has been unable to establish were used to further its exempt purpose. The facts clearly demonstrate that during 1988, A, B, C, D and J used their control of M to benefit themselves and their relatives.

Section 1.501(c)(3)-1(d)(1)(ii) of the regulations provides that an organization is not organized or operated exclusively for exempt purposes unless it serves a public rather than a private interest. The regulation places the burden of proof on the organization to demonstrate that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled directly or indirectly by such private interests.

Similar to the organization described in the Founding Church of Scientology v. United States, M has failed to meet the burden of proof placed on it by section 1.501(c)(3)-1(d)(1)(ii) of the regulations. It has not provided documentation to show that its net earnings did not inure to A, B, C, D, K, L and the Participating Physicians. Further, it has failed to provide documentation to evidence that it is not organized or operated for the benefit of private interests.

In June of 1986, M purchased the Practice and entered into the Service Agreement which resulted in a substantial private benefit to the Physicians. Accordingly, revocation of M's tax-exempt status is effective October 1, 1985, the first day of its 1986 taxable year.

The February 2, 1984 ruling, issued to M under its former name, was based on M's representation that it would own and operate various community health clinics. M believes that it can continue to rely on that ruling. In its protest dated November 24, 1992, M requested relief under section 7805(b) of the Code with respect to any adverse action proposed.

Section 12.09 of Revenue Procedure 94-4, 1994-1 I.R.B. 90, provides that a taxpayer ordinarily may rely on a letter ruling received from the Service subject to the conditions and limitations described in that section. Further, it provides that if, during the course of an examination the Key District Director finds that a letter ruling should be modified or revoked, the findings and recommendations of the Key District Director will be forwarded to the National Office for consideration before further action. Generally, a letter found to be in error or not in accord with the current views of the Service may be modified or revoked. If a letter ruling is revoked or modified, the revocation or modification applies to all years open under the statutes, unless the Service uses its discretionary authority under section 7805(b) of the Code to limit the retroactive effect of the revocation or modification.

We are not proposing to modify or revoke the ruling issued to M on February 2, 1984. The ruling, based on the facts presented therein, is correct. With respect to M's request for relief dated November 24, 1992, the Assistant Commissioner (Employee Plans and Exempt Organizations) has refused to grant relief under section 7805(b) of the Code since the proposed activities in the 1984 ruling were not the activities upon which our recommendation to revoke M's tax exempt status is based.

CONCLUSION

1. M did not provide health care in a charitable manner because it operated for the private benefit of its officers, trustees, and physician employees.

2. M engaged in activities that served a private rather than a public interest and resulted in inurement of earnings to the benefit of private shareholders or individuals.

3. Revocation of M's tax exempt status should be effective October 1, 1985, the first day of its 1986 taxable year.

4. The question of whether the income from the sale of M's Medical Assets is subject to the tax imposed by section 511 of the Code is moot since we are recommending revocation of M's tax exempt status effective October 1, 1985.

5. Relief pursuant to section 7805(b) of the Internal Revenue Code with regard to the February 2, 1984 ruling is not granted since the activities that serve as the basis for our adverse position were not the subject of the February 2, 1984 ruling.

M is to be furnished a copy of this technical advice memorandum. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.