Edited Transcript of the January 2000 ABA Tax Section Exempt Organizations Committee Meeting

[1] MR. FERGUSON: Welcome to the Exempt Organizations Committee session, which will wind up at 3:30 Pacific Standard Time (PST); for you folks that are still on East Coast time, get your eyelids popped open and we will do the best we can. I'm Bob Ferguson and to my left is Victoria Bjorklund. We are both from New York. That's something you will have put up with for the next year-and-a- half. But we will do what we can to avoid a repetition when the time comes.

[2] I'd like to spend a little time catching up on what the committee has been doing this year, outside of its meetings. We had a request for comments from the Joint Committee on Taxation and, subsequently, from the Treasury, on materials having to do with section 6104 and return confidentiality and disclosure. We put in a set of comments which comprise the last half of the letter from Paul Sax, who is head of the Tax Section, to the Joint Committee and subsequently to the Treasury. The substance of the comments were, first, to disclose PLRs that went to exemption issues -- or to find out how we could get the Service to construe 6104 and 6110 to allow that disclosure. Next, we raised, but did not offer comments on issues such as whether or not to disclose closing agreements, whether or not to disclose exceptions to the lobbying rules that an organization was claiming -- whether or not that had to go on a return -- and whether or not to disclose donors' and sponsors' identities. Finally, we discussed the problems raised by the absence of contemporary communication between state AGs and the IRS, which will indeed be a subject of one of the panels this morning.

[3] I would like to thank, for the work that went into that submission, Celia Roady and Marion Fremont-Smith who came up with some wonderful stuff that Tom Chomicz then put together in a form that was reproduced without change in Paul Sax's letter. Subsequent to that, we got a request from the Joint Committee to have a couple of people from our committee who are knowledgeable in the area go over and talk to the people on the JCT who were concerned about this, and Celia and Milt Cerny were kind enough to do that and within a couple of hours after they left I got a call from Morey Ward saying how helpful and really valuable their input had been.

[4] At the request of the Tax Section we submitted our suggestions for priority guidance for the year 2000. Those included the finalization of the 4958 regs -- that would come as no surprise to most in this room; the republication in proposed form of 4958-5 regs, which we understand or at least believe is going to be the form that they come out in; additional guidance on issue advocacy and political intervention as it applies to section 501(c)(4) and 527 organizations; getting out a revenue ruling on section 507 that we got in draft form into the Service about three years ago; and publishing an announcement framing the Internet issues that they would like comments on. We are planning to respond to that notice, when and if it ever comes out, very quickly. You may have seen an article on Internet issues that appeared in the last issue of EOTR by Chris Nooney, and that will provide the jumping off point for the response to what we think the announcement's going to be seeking. Chris Nooney and Todd Mayo, who's the other co-chair of the Internet Subcommittee, will be working on it. But, obviously comments by any of the rest of you who are interested in that very complex and very important area will be welcome.

[5] We also asked that there be some clarification and, more importantly, simplification of international grant-making rules for private foundations. We also asked that there be some publication or guidance on what the post-litigation posture of the IRS will be with respect to affinity cards and mailing lists arrangements. Assuming that the appeals really are over, we'd like to know what the new rules are that the IRS thinks we should be playing by are, and we thought it would be useful if that could be published. Personally, I'm not overly sanguine that that will be popping right out of the next issue of the Internal Revenue Bulletin, but we'll see.

[6] Finally, some more guidance outlining in a bit more reliable way what the rules are on donor advised funds and how they get classified in the private foundation publicly supported context. We submitted these on time to the Tax Section as briefly as we could. There wasn't a spare syllable in the presentation. What happened to it thereafter looked like extreme liposuction and it came back, with a request that we go over it and make sure that it still made sense. We tried to reinflate, putting exempt organization collagens back into it and hopefully the form of the submission will still be comprehensible.

[7] The new push from TE/GE and its educational outreach appears, from what we understand, to be directed more at small organizations where the sophistication of the advisors is not what it is for most of the clients of people in this room. In order to assist the Service in that effort, we have set up a subcommittee in this group on small organizations. The co-chairs will be Sarah Paul, who practices in New York and has basically a general practice which includes a number of small and medium size organizations, and Eve Borenstein from Minneapolis who is engaged exclusively in tax, but also worked for small organizations and who would be an ideal person to help out. We're hopeful that the educational push and the guidance efforts will continue to involve this committee to the extent it has in the past, and that's one of the reasons that we formed that subcommittee.

[8] I point out to you that there was recently -- and maybe Marc will be able to help us with this later on -- an announcement that the Chief Counsel and the TE/GE Commissioner's Office are going to be publishing something referred to as information letters, which will be the responses to questions coming from outside which are non- fact specific. I guess it sounds like kind of a informal opinion dialogue. The problem with it is that the announcement says that they will contain general statements of well-defined law. It doesn't sound as though anything cutting edge is probably going to happen here, but, it may reflect a possibility for another avenue of guidance coming out of TE/GE.

[9] Finally, Bob Boisture, Greg Colvin, and Miriam Galston have put together what we hope will be a one-page statement by this committee on the section 501(h) election, which will appear we believe in the next issue of the ABA Tax Section's Newsletter. The statement urges those organizations that engage in lobbying to make the election. Those three have been trying very hard for a long time to get this thing published, and hopefully they will be able to do it with the committee's imprimatur on it.

[10] There have been a few litigations in the cy pres area that Victoria is going to go over briefly.

[11] MS. BJORKLUND: Since we have a program at 10 o'clock involving the interface between the IRS and state attorneys general, I wanted to mention just three cases of note that have occurred since our last meeting.

[12] On October 15, 1999, Surrogate Eve Priminger in New York rendered a decision interpreting for the first time the exercise of the variance power by a community foundation, and she essentially ruled against the New York Community Trust in finding that uncertainty alone was not sufficient basis for exercising the variance power. The facts in this case are bizarre because the actual exercise of the variance power occurred in 1971 and the organization against which the power was exercised claimed that it was not aware of the fact that it was truly exercised against them until the 1990s. So, there are latches and statute of limitations issues but on the question of the criteria, the standard for exercising the variance power, this is the first decided case in the nation. It is being appealed. I think it is an unpublished decision, but if anybody would like a copy, please contact me and I will get a copy to you.

[13] In early December 1999, the New York Supreme Court ruled on a petition brought by the Manhattan Eye, Ear, and Throat Hospital under a statutory provision requiring court approval to dispose of all or substantially all of an organization's assets. The petition was opposed by the New York attorney general, the new head of the Charities Bureau, and the court sided with the attorney general and blocked the disposition of the hospital's assets very late in the process of sale of these assets.

[14] On December 7, 1999, the Hershey Trust brought a petition in Pennsylvania Orphan's Court, and on December 7, 1999, the court ruled against the Hershey Trust and denied the Trust request for cy pres relief to expend $25 million in start-up funds and $25 million annually to fund an institute to study the educational needs of needy children. The needy children are trained in the Hershey School which is run by the Hershey Trust, but the Hershey Trust had so much excess revenue that they had sought a cy pres petition rather than greatly expanding the enrollment in the schools. So, we mention those as cases of interest.

[15] MR. FERGUSON: I would add that for those of you who might be curious, the Manhattan Eye, Ear and Throat opinion is a wonderful example of how to get a state attorney general really angry. It's fascinating to read between the lines, if you haven't looked at it.

[16] Just a couple of things about what we are planning for the near future. As I mentioned earlier, there should be an announcement coming out fairly quickly from Washington, requesting ideas and analysis on Internet issues. The paper that I referred to that Chris Nooney has done is going to be the jumping off place. But when it comes out, for those who are interested or indeed anybody here now who would like to help out, let me know or let Chris know. Just touch base with her so that you can coordinate when the announcement comes out. That's going to be obviously a long-term and a difficult project.

[17] We are putting in on February 7, God willing, the Important Development Summary for the year 1999. I'd just like to mention that judicial decisions are done by Steve Schwartz, proposed regulations by Dick Ruge, and the lion's share, which is the private letter rulings, by Laura Chisholm and Steve Simpson, and we simply cannot acknowledge them sufficiently, gratefully, and enthusiastically for what they do.

[18] [Applause.]

[19] Everybody here who is applauding was thinking "there, but for the grace of God...."

[20] In that regard, I should add that Laura is going to give us, quite shortly, a draft of the summaries of the PLRs and would like input on which ones are important enough to go in the Important Development Summary. Victoria is going to take charge of this project and will be allocating the PLRs to various people in this room and others who may not be here to try to make sure that we get a quick and an accurate response to that request. It's certainly the least we can do for Laura and what she does.

[21] There have been some changes in the speakers today. The reason was we got restructured out of our original agenda. We had a gentleman, who many of you in California are familiar with by the name of Marcelo Gamez who was scheduled to be on three separate panels. He was the Acting Branch Chief, EP/EO. When that became TE/GE he stopped being Acting Branch Chief and got assigned entirely to EP. He sent a procedural obituary of himself to us and told us he would try to find somebody else. We ended up with Vicki Hansen on the first panel. And we have a second government representative on the last panel of the day, which is the burned out hospital panel that Doug Mancino will be chairing. Then we finally ran for cover doing what we knew we'd always be forced to do anyway and enlisted Marc, who was going to be out here anyway and on one panel, to appear on four. So, that's the reason you will being seeing so much of him.

[22] There are CLE credit sheets which you should sign in back. As for the Saturday programs, briefly, there will be no intermediate sanctions workshop, yet again. But, if we get lucky, and if April of the year 2000 is really when we're going to be blessed with 4958 regs, we can expect to have something in the nature of a workshop, at the May meeting, unless all of our comments were accepted without change. We will also be having a CLE program tomorrow afternoon and I'm going to let Victoria Bjorklund, who is one of the participants in that, explain it.

[23] MS. BJORKLUND: I just want to mention our CLE program from 2 o'clock to 5 o'clock tomorrow. It has a very long title. It's called "Advising the Charitably Inclined Client, Selecting a Charitable Recipient, the Care and Feeding of the Donor Created Charitable Organization." This is actually the initiative of the Estate and Gift Tax Committee and they decided to try and find people in their committee to be the speakers. They spoke with Larry Katzenstein and Larry enlisted me and Tom Chomicz. It looks a lot like an exempt organizations CLE program, so we are also co- sponsoring it. I mention it to you if you have colleagues who might be interested in this question.

[24] MR. FERGUSON: We will all look forward to that and undoubtedly be in the conference room and out of the sunshine.

[25] MS. BJORKLUND: If you are out in the sunshine, the materials are in the large handout and will be in the conference room.

[26] MR. FERGUSON: A couple of other words about the May meeting. First, administratively the last newsletter that went out, and had to do with the May meeting, has the proper dates on the front cover, but if you go to the registration form it has last year's dates, April 30 and May 1. Don't mark your calendar from that one. It is May 12 and 13, I believe that these are the correct dates.

[27] At the May meeting, there'll be a whole bunch of new folks from the IRS that we'd like to introduce and hopefully get on panels or least work in. At Miriam's suggestion last night, which is an extremely good one, we're going to try to see if we can put together a reception for the new players so we can all get to know them a little better, perhaps at a cash bar in a little more ambiance- friendly place than the corridor outside the meeting room. But do plan -- and I'll try and get word out on the timing of this early -- to be able to stay a little longer than possible if you would like to (and I would urge you to do so) meet these people and get to know them a little bit better. We are going to working with them for a while and we might as well get to know them.

[28] I guess that's about all there is, except for two things. There is an absence in this room. For the first time in God knows how long, our former chair, Madame Carolyn Osteen has decided to miss it. She's vacationing in a sunny climate and enjoying herself. I promised when I took over this post from her that I would try to improve the humor and the level of the jokes and -- but she is not here. I brought her out a limerick. Fortunately, this is being recorded, and it will be reproduced in EOTR.

[29] MS. BJORKLUND: It better be clean.

[30] MR. FERGUSON: Carolyn, this is for you, and it was told to me on a vacation that I took a few months ago by an 87-year-old widow, who loved limericks. And it has nothing whatsoever to do with anything we are talking about here but, it struck me as being somewhat amusing. It goes like this:

There was a young man named McBride, who fell down a privy

[32] Finally, before we start out with our government review, this is probably as good a time as any to acknowledge that we are losing from the government, but not from this committee, somebody who has given us an awful lot of good guidance, good effort, and wonderful speeches -- he is going to be on four panels -- and I thought it might be fitting just to put together a little something to give him to carry back, since I had to carry it all the way out here, to signify one of the most intense efforts that he went through in the last part of his government service. We all heard, perhaps more often than we wanted to, about the government's full scale war on the used auto donation program. As Marc Owens was running out of cash and looking for a job in the private sector, apparently he needed a deduction and he had a car, I understand, that couldn't be sold, but was still new enough in terms of manufacture to hit a blue book price that was okay. So, what we brought is a replica of Marc's car.

[33] [Laughter.]

[34] Now this car doesn't run, but it does have on the sides the words "like new" and "high FMV" and it has on the windshield "IRC 170 Special" and with it goes the current version of the Kelly Blue book, which has inscribed on the front "To Marc Owens, with admiration and affection from his many friends in the ABA Tax Section's EO Committee." Marc.

[35] That's it. I'm going to move over to the side and ask Marc Owens, Susan Brown, and Vicki Hansen to come up and tell us what the government's planning for us.

[36] Also, for all of you who are speaking, a little more administrative detail. Everybody who speaks at one of these things has to sign a speaker release form. Most of you will have been given them beforehand. Vicki, I have yours, because we didn't know where you were. This is just something giving the ABA assurance that you are not going to sue them for unauthorized reproduction of your comments on the transcript.

[37] At the risk of stating the obvious, the panelists include, starting from the end, Vicki Hansen, who is currently the Acting Area Manager TE/GE of the Los Angeles Office. She just assumed that title in the latest restructuring shift, as I understand it. Welcome; we are delighted that you could make it down here. Susan Brown, from Treasury, and some of us know her from far earlier than that, who has been a frequent and valuable contributor to this committee's deliberations, and Marc Owens, who I'm not even going to introduce anymore. I thought that perhaps we'd start with Susan and then -- oh, I'm sorry, we are going to start with Vicki. Enough said; please go ahead.

Developments at the IRS

[38] MS. HANSEN: I thought I would ask to go first because my remarks are rather limited this morning, especially since I'm just an actor at this point. Bob is exactly correct that I was kind of a last minute substitution. Not only was I not sure of exactly what we were going to be doing this morning, but I wasn't even sure where we were. So I've been wandering around at the Sheraton for the last 15 minutes and I'm just glad that I made it down here.

[39] I'm sure most of you know, but I do want to cover just a few items in regards to our restructuring in the IRS. As you know, our major restructuring effort is designed to refocus our mission and goals to build on examples of top quality service in the private sector, to help us work harder to assist you in understanding and meeting your tax law responsibilities, and to ensure that our tax laws are applied fairly. And to that end we're changing our structure to serve four specific groups of taxpayers with common needs, interests, and problems: (1) wage and investment income; (2) small business self employed; (3) large and mid-size businesses (that particular division is going to be operational in March of this year); and, of course (4) tax exempt and government entities, which is the former EP/EO.

[40] As mentioned, I'm an acting EO area manager. The TE/GE Division, as one of our smallest divisions, was the first to become operational. We stood up on December 5, 1999, and while we still have many internal organizational details to finalize, we are beginning to operate along the prescribed restructuring guidelines. We're moving toward an organization that's directed toward our three major customer segments: (1) exempt organizations; (2) employee plans; and (3) government entities. In EO and EP we are going to be organized along our three major activities; (1) examinations; (2) determinations or rulings and agreements; and (3) customer education and outreach. Within government entities we'll be organized along our three major customer segments: (1) tax-exempt bonds; (2) federal, state, and local entities; and (3) Indian tribal governments.

[41] EP and EO of course are going to be divided into six major geographical areas and California will be part of the Pacific Coast area.

[42] At this time, as I'm sure you are aware, we've only filled six of our major key positions in the new Tax Exempt/Government Entities organization and if you've been involved with the EP/EO IRS community for any length of time, I'm sure you will recognize most of their names. Our Commissioner is Evelyn Petschek; the deputy is Darlene Berthod; the director of Employee Plans is Carol Gold; director of Exempt Organizations is Steven Miller; director of EP Exams is Preston Butcher; and Director of EO Exams is Rosie Slaughter. With the exception of Preston and Rosie all of these individuals will be located in Washington, D.C. Rosie is going to be headquartered in Dallas and Preston is going to be headquartered in Baltimore.

[43] The interviews for the Area Manager positions were held the first two weeks in January and we've been assured that the selections will be made known by the end of this month. So very shortly you will know the names of the area managers here in the Pacific Coast area with whom you will be dealing in the future.

[44] Bob had suggested that I might want to discuss the effects of restructuring on our local operations. Restructuring of course is supposed to be transparent to the public, and I would hope that none of you have had experiences with our local organization that would be contrary to that presumption. But the restructuring process has inevitably produced some operational strains. For instance, we've sent seven volunteers to participate on implementation teams during Phase one and two, and during Phase three, which started this week, we'll send another eight individuals. They consist of both managers and bargaining unit employees, some of whom are key players in our organization. So, as you can imagine, it isn't always easy to fill these positions on a temporary basis and make sure that our operations run as smoothly as we would like.

[45] Also, we've changed our lines of authority. I'm sure you've heard the phrase "top to bottom" accountability mentioned in regards to restructuring. Until our stand-up on December 5, each of our four key district offices in EP/EO reported to a district director where the key district office was located. Those directors also evaluated the performance of the EP/EO Key District offices. Now, of course, under the new TE/GE structure, we on the Pacific Coast no longer will report to a district director but instead to the director of EP or EO examinations. This has a tremendous impact, of course, just in terms of our normal day-to-day operations, even in terms of, for example, whose signature goes on our determination letters and whose authority we use to extend statute consents. Even mundane things, like approval of outside employment requests for our employees. And, again, while all of these things should be transparent to the public, we've had to adjust patterns of thinking that many of us have had engraved for decades. So, we are working at these changes.

[46] In addition, the host sites for processing our personnel actions and our time keeping have been changed. Inevitably, because of the restructuring, some of our managers will no longer have managerial positions at the branch or division level. So, we're going to have some personnel changes that may be somewhat disruptive internally. But, the bottom line is that hopefully none of this is going to disrupt any of our operations or adversely affect our relationships with public.

[47] In terms of customer service, we had a local section within Los Angeles that responded to approximately 1,000 inquiries each month. Our local customer service section was closed in November and the responsibility for answering taxpayer inquiries was shifted to Cincinnati. They have a very professional operation there, from what I have seen so far; I haven't visited but have had an opportunity to hear how they operate. They have sophisticated equipment that will monitor the types of calls; what types of specialty questions they receive; and the length of the calls. Hopefully all this information will enable us, upon analysis, to provide even better service in terms of the types of questions and how well we can answer them, to the public.

[48] If you are curious about how our congressional and Taxpayer Advocate cases are going to be handled, they are still going to be worked if they pertain to a determination case that's being worked here in the Pacific Coast within Pacific Coast and the same for their Taxpayer Advocate cases; those will not be forwarded to Customer Service in Cincinnati.

[49] We are developing commitment under the new measures for restructuring -- customer satisfaction, business results, and employee satisfaction. Our goals for customer satisfaction deal with the cycle times for examinations and for determinations, and if you are not aware of this, our cycle time goals for determinations for this fiscal year is 89 days, and for examinations, 238 days, and obviously we endeavor to improve on those goals every year.

[50] I also wanted to briefly mention our workplan goals. I am sure you are aware that every year we prepare a workplan that determines how we are going to utilize our resources during the year. We plan a certain amount of time for determination work, examinations (including what types of returns we'll audit), what projects we'll work, and how much time we will spend on administrative items (such as training, annual leave, and that sort of thing). During this fiscal year we're continuing to devote our resources to several major programs. Here within the Pacific or the old Western Key District Office we're planning to spend about 7 percent of our direct time on determinations; approximately 30 percent on the coordinated examination program; about 7 percent on tax-exempt bonds; and 10 to 15 percent on gaming. What is particularly new this year is that we're also planning to spend about 10 percent of our time on education and outreach. This is a new category for us to be tracking and I think that this demonstrates a commitment to our goal to meet with our customers and to try to provide educational opportunities and additional information about the Service. We hope that the changes that we are making in our organization continue to contribute to the service that we provide you. Thank you.

[51] MS. BROWN: Okay, well following up on the general overview of the impact of the restructuring, I can report that yesterday I had the pleasure of attending the official swearing-in ceremony of Evelyn Petschek as Commissioner of TE/GE. In addition to Evelyn, five other executives were sworn in: the commissioners of the three other divisions, the Chief of Agency-Wide Shared Services, and the Chief of Criminal Investigation. Congratulations to Evelyn and the other five.

[52] Bob Ferguson mentioned that the ABA is going to be submitting proposals for guidance for the coming year. Some of the items he mentioned -- section 4958 final regulations, the section 507 revenue ruling, a notice requesting comment on Internet issues -- these are all very familiar. They were on last year's business plan. Anything that was on last year's business plan that you haven't seen published yet, we are continuing to work on, so don't give up hope. [The 2000 IRS business plan was released March 21. See Doc 2000-8725 (21 original pages) or 2000 TNT 56-18 .]

[53] I thought I would highlight some of the current regulation projects for you briefly. I apologize if this sounds a bit like a laundry list. Intermediate sanctions is at the top of the list. The Joint Treasury and IRS Working Group continues to meet. We are working to develop consensus on the key issues. Obviously, these are difficult issues and we are giving them careful thought. We hope to enable the committee to have a discussion forum at the next ABA meeting, but I can't make any predictions as to when final regulations might be issued.

[54] The travel tour regulations will be issued in final form in a matter of days. You can expect to see more examples that address specific comments that were received. Other than that, I encourage you to watch the tax press, because as I said they will be issued shortly. Corporate sponsorship regulations are also very close. I would say that all of the substantive decisions have been made. At this point, it's a question of production. [For the travel tour regulations, see Doc 2000-3707 (5 original pages); 2000 TNT 31-13 ; or The Exempt Organization Tax Review, March 2000, p. 491. For the corporate sponsorship regs, see Doc 2000-6180 (8 original pages); 2000 TNT 44-85 ; or p. 133 in this edition.]

[55] I might take a little bit of a detour here. You will remember that proposed regulations on corporate sponsorship were first issued in 1993. In 1997, section 513(i) was enacted. Section 513(i) provides a statutory safe harbor for qualified sponsorship payments, which are not treated as unrelated business taxable income to the recipient organization. The statutory provision codifies in large part the proposed regulations with the significant exception of the tainting rule, which has been eliminated. The regulations when they are issued will be in proposed form. That will give all of you another opportunity for comment. One aspect of the 1993 regulations that I would like to highlight because it may have faded from everyone's memory is the approach taken in those regulations to the so called "exploitation rule" under section 512. Section 512 as you know defines unrelated business taxable income. As a general rule, you are allowed to deduct from gross income from any unrelated trade or business that is regularly carried on only those expenses that are directly connected with the conduct of that business. If the unrelated trade or business is one that exploits an exempt activity, you may not deduct expenses that relate to the exempt activity in calculating your unrelated business taxable income. That's the general rule. There is a very narrow exception in the regulations under section 512. That exception applies where the unrelated business activity is an activity normally conducted by taxable entities for profit and where the taxable entities engaged in that business would also normally conduct the exempt activity. The example that is in the regulations is the sale of advertising. If taxable entities engaged in the sale of advertising would normally publish editorial material in connection with those advertising activities, then an exempt organization that sells advertising in connection with an exempt publication activity may apply any excess expenses from the exempt publication activity to offset its advertising income if certain requirements are met. It's a very narrow exception.

[56] One of the commentators on the 1993 regulations expressed concern that examples included in the 1993 regulations went too far in allowing expenses from an exempt activity -- in the example it was the conduct of a Bowl game -- to offset income from a separate unrelated activity, which in the example was the sale of wearing apparel bearing the logo of the Bowl game. The concern was expressed that if you interpret the exception to the exploitation rule too broadly, the exception swallows the general rule. An organization wouldn't need to worry about whether a particular payment is a qualified sponsorship payment or income from an unrelated business regularly carried on to the extent that the organization had excess exempt function expenses that would offset the income, leaving it with no net taxable income. You might all want to take out a copy of your 1993 proposed regulations and take another look at that issue.

[57] That was a long detour. Private foundation disclosure regulations were issued in final form in January. They will apply to returns due on or after March 13 of this year. For foundations that have a calendar year fiscal year, that means your 1999 Forms 990-PF will be subject to the new rules. You will not have to publish notice of availability of your 1999 returns, but you will have to make the returns available for inspection and provide copies to anyone who requests them.

[58] On the disclosure theme, as you all know, the IRS Restructuring and Reform Act in 1998 directed both the Joint Committee on Taxation and the Department of Treasury to conduct studies on the confidentiality of taxpayer information including specifically whether the public interest would be served by greater disclosure of information relating to tax-exempt organizations. It is my understanding that the Joint Committee study will be published on Monday. Treasury is still working on its part of the study. I don't know if Rick Grafmeyer is going to join us at any time during the day. If he does, he may want to talk about the Joint Committee's study. [For the JCT disclosure study, see The Exempt Organization Tax Review, March 2000, p. 567.]

[59] Another project that was issued in October of last year was proposed regulations relating to the so-called "son of Accelerated CRT" abuse. I will outline this abuse very briefly for those of you who are not familiar with it. You may recall a prior abuse referred to as "accelerated CRT" that was shut down by a combination of regulation and legislation in 1997. This latest abuse is a similar abuse in that it involves the attempt to use a charitable remainder trust to convert appreciated assets into cash while avoiding tax on the gain. In essence, the proposed regulations provide that, to the extent a distribution from a CRT represents the proceeds of a borrowing, a forward sales contract, or another transaction that is ordinarily not a taxable transaction, and the distribution is not a distribution of cash contributed to the trust, the trust will be deemed to have sold a pro rata portion of trust assets in order to fund the distribution to the non-charitable beneficiary. The result is that the non-charitable beneficiary is taxed to the extent of any gain on the deemed sale. Those of you who have read the regulations may have noticed that there is an antiabuse rule within the antiabuse rule. That is there because we are trying to prevent "grandson of accelerated CRT." Under that antiabuse rule any transaction that has the purpose or effect of circumventing the deemed sale rule included in the proposed regulation will be disregarded. The deadline for comments on this regulation was January 19, 2000. To my knowledge, we have not received any comments. I take that as a good sign.

[60] While we are talking about abuses, let me just mention that the Tax Relief Extension Act of 1999 that was signed into law in December included an amendment to section 170. It added section 170(f)(10) relating to charitable split dollar insurance transactions. I have spoken about those before. The new legislation does two things. It clarifies current law by confirming that no deduction is available for contributions to charity which are used to pay premiums on a "personal benefit contract," which benefits the donor or members of the donor's family. It imposes a tax on any charity that pays those premiums, and requires charities to report the payment of those premiums. The tax applies only to insurance premiums paid after December 19, 1999. The reporting obligation relates back to any premiums paid after February 8, 1999. I understand that the IRS is working on a form that will be used to report those premium payments for 1999.

[61] I should talk a little bit about legislation. Let me mention one specific legislative proposal and then turn things over to Marc. Then if you want to come back and talk a little bit more about legislation, we can do that. Yesterday, President Clinton announced several education tax initiatives that will be included in the administration's budget for fiscal year 2001. One is an expansion of the Lifetime Learning Credit. The Lifetime Learning Credit was enacted in 1997. It is a non-refundable tax credit available to families for tuition expenses they incur for college, graduate school, and job training. Under current law, the credit rate is 20 percent. The proposal would increase the credit rate to 28 percent. The expenses eligible for the credit are currently limited to $5,000 of expenses per year; in 2003, that limit will increase to $10,000 of expenses. With the 28 percent credit, families would be entitled to a tax credit of up to $2,800. Under the proposal, taxpayers would be given the option of claiming a deduction instead of the credit, which is an option not available under current law. It is my understanding that there is a small number of taxpayers who don't get the full benefit of the tax credit because of interactions with the alternative minimum tax. The deduction option will help those taxpayers. The president also announced that some of the education tax incentives that were proposed last year -- specifically the elimination of the 60-month limit on the deduction of student loan interest, and the expansion of the section 127 exclusion for certain employer-provided educational assistance to include graduate level education -- will also be included in the 2001 budget. As a reminder, the Extension Act of 1999 did extend the current law exclusion under section 127 for undergraduate education through the year 2001. The budget proposal would simply expand it to include graduate education as well.

[62] Okay, why don't I turn things over to Marc Owens. Then time permitting we can come back and discuss other legislative issues.

[63] MR. OWENS: Good morning. I was going to slip away in the twilight of a lackluster career without saying anything about used car donation programs. But in light of this flagrant baiting by the committee, I'm revising my views. Maybe we could have a special session on the topic and instead of the cash bar.

[64] My contribution to this panel this morning is going to be to talk about some of the issues that are pending in headquarters, not the precedential guidance kinds of issues but some of the more significant questions that are coming up in the rulings process and the applications process that you might want to watch out for. They could sow the seeds of future guidance projects or they could be of fairly significant interest even without rising to the level of precedential guidance.

[65] I would like to start out by noting that even though there is a fair degree of turmoil associated with the restructuring, reorganization, as Vicki Hansen indicated, we're trying to identify all those little pieces of running an organization that have to change to reflect all the new duties and responsibilities. It seems that by default, I get to sign or approve everything that no one else can figure out the appropriate person for so, I still have a job of sorts with the agency. The printed conference brochure describes my status as formerly with the Internal Revenue Service. That's another careless error by the American Bar Association. I am still with the Internal Revenue Service. As part of that adjustment process we are trying to continue the normal sorts of activities that we have traditionally undertaken. This is the time of year for example, when we begin the drafting process for the next Continuing Professional Educational Textbook. There will be one for the 2001 fiscal year. We are in the process of selecting those topics now. Hopefully, it will be out on schedule in late August or early September but, there is going to be, in addition to the reorganization, a physical move of the TE/GE unit sometime in that time period so there could be some delays but you can anticipate a textbook this year.

[66] On to some of those issues. There are a group of them in the health care area that I think are worth watching for. The first involves a series of ruling requests that we have gotten for various kinds of compensation programs. We aren't receiving ruling requests on specific dollar amounts of compensation. What we are seeing are proposals by various pieces of the health care industry to create some form of revenue sharing compensation for either employees or revenue sharing compensation for executive level personnel. These are revenue sharing driven, not expense reduction programs so they don't seem to implicate the gain sharing positions of the Inspector General, Health and Human Services. Those ruling requests, though, have obvious implications under section 4958. The regulations are still in proposed form so I don't anticipate them moving real fast through the system but we are seeing them. We have gotten some requests and it's very helpful to see the kinds of fact patterns, the kinds of procedures and mechanisms that the industry is trying to come up with to both compensate its key people in a fashion that keeps them in the organization but also manages to navigate all the tax law.

[67] The second health care issue -- we're seeing a number of both applications for exemption and ruling requests from hospitals that are in the process of acquiring both for-profit and nonprofit nursing homes, extended care, extended living kinds of facilities. It seems that there is an interest in expanding beyond just regular health care into even assisted living kinds of arrangements, where you have perhaps an increasingly high level of assistance which may or may not include medical assistance being provided to people who have agreed to become residents. There are obvious issues relating to valuation of these assets particularly where it's a taxable entity that is being acquired by the tax-exempt organization and there are also some issues relating to the residual control, if any, that a for-profit owner may continue to have when the facility is absorbed by the tax-exempt organization. Those cases are moving and answers probably will be coming out over the next few months.

[68] We are seeing another grouping of cases involving hospitals reacting to changes in the economics of their industry -- tax-exempt hospitals finding themselves with excess capacity and leasing out that excess capacity to other health care providers or other health care organizations of various kinds and the leasing could include the facility or parts of a facility. It also could include employees or the entire staff in addition to the hospital beds or the various pieces of equipment. Because the parties are not related in these transactions, there are questions to be addressed regarding the characterization of the income from these arrangements or whether some part of it is subject to unrelated business tax. We are working those cases as well. I don't anticipate those being significantly held up as they move through the system.

[69] We are seeing a number of issues coming up involving limited liability companies. You all are, I'm sure, aware of Announcement 99-102 regarding the disregarded entity which is basically reflected on the Form 990 as part of the tax-exempt organization. We're of the view that that means that you do not have to file an application for exemption for that disregarded entity; you simply report on the Form 990 the financials of that unit. We also are seeing our first cases involving limited liability companies that have elected treatment as corporations, filing applications for exemption for themselves as charities. We have taken a position internally that that is possible so you will see some applications for exemption come through the system where limited liability companies have themselves established tax exemption independently of their respective parents. The question there is really how they have met the organizational requirements for a dissolution provision, a purposes clause, and those are all sort of mechanical questions that can be answered.

[70] We have a new group of questions that I don't have an answer for just yet, but we are thinking about and that deal with the issue of if you have a limited liability company, and it directly receives a charitable contribution, as in a used car, is the donor entitled to take a charitable contribution deduction? Or does the contribution have to be made to the parent charity? That's an interesting question. It's one that we are currently considering and as I say, I don't have the answer for you, we are coordinating that with the income tax and accounting people who would handle the section 170 issue directly. I would expect some answers in the not- too-distant future in that area as well.

[71] The final sort of group of interesting cases involves the Internet. Certainly we are very interested in putting out that request for comments that Susan mentioned but in the interim we are seeing some cases. We aren't seeing any cases incidentally yet involving advertising. We haven't had any ruling requests come forward in that area, for example, nor have we seen it come up in the audit process yet, at least not to the headquarters level. We are continuing to see applications for exemption from Internet service providers, both those attempting to qualify as charities either because they serve a low income group or some other disadvantaged group or perhaps because of affiliation with a local or state governmental agency. We're also seeing requests for exemption under section 501(c)(12) of cooperative organizations analogous to 501(c)(12) telephone cooperatives, Internet communication cooperatives, really, and we are also just recently received a couple of applications for exemption from Internet fundraising organizations. Organizations that are going to facilitate the process of donors selecting and making contributions to charities. Those are brand new and they will be very interesting to work through. There are obviously issues, the regular garden variety issues relating to private benefit that one needs to think through. There are also some interesting questions on deductibility, I think as well.

[72] That's kind of a quick summary or sketch of the interesting stuff pending in the Division. There are also a couple of court cases that are underway that are worth watching. There will probably be discussions about some of the health care cases later on today but, the two that I think are most interesting, one is the set of recent actions involving revocation of exemption and intermediate sanctions penalties. It's a series of cases collectively called the Sta-Home Health Care cases recently filed in Tax Court and they are the first section 4958 cases that have come to fruition. There are others still in the administration processing stream.

[73] The other case that's significant -- actually there were appellate court arguments yesterday back in Washington -- is the Branch Ministries/Church at Pierce Creek case. As you no doubt recall that is the church in Binghamton, New York, that in 1992 on the eve of the presidential election ran full-page advertisements in USA Today and the Washington Times suggesting that bad things would happen to you if you voted for then-Governor Bill Clinton for president of the United States. The Service took the position that that was intervention in a political campaign and contravention of the section 501(c)(3) absolute prohibition. The Branch Ministries Church lost its tax-exempt status, challenged that status in district court, federal court in Washington, United States District Court for the District of Columbia, under section 7428. The government prevailed at the lower court level, it was appealed, the hearing was heard yesterday. I understand the judges were engaged in the oral arguments, asked a number of questions. The distinctions between the church and the government's views of the political campaign prohibition were rather clearly defined. I understand that the church took the position that there was no limit on the amount of political campaign activity they could conduct and that the Internal Revenue Service was without any powers to address that situation. The government took the opposite position. I hope there will be a near- term opinion and we can see where the case goes at that point. I've always assumed that this one was being set up to go to the Supreme Court because there really has been no question of facts here and the organization seemed quite willing to move forward into the litigation process as a result.

[74] So, those are the two cases I think are most interesting. The first one, the Sta-Home Health Care is really a collection of cases. It will be an interesting window on the interplay between revocation of exemption and imposition of intermediate sanctions penalties.

[75] With that, I guess we have a few minutes for more legislation and maybe a few minutes for questions?

[76] MR. FERGUSON: We have questions. If any of you has questions, just step up to the mike and you will be acknowledged as time goes along. Susan do you have some other words on legislation?

[77] MS. BROWN: We can or we can go straight to questions, whichever.

[78] MR. FERGUSON: It seems that nobody has any questions. Milt, you are so easy.

[79] MR. CERNY: I couldn't let this opportunity pass, Marc Owens. Now that the mailing list cases hopefully have been resolved, what actions do you see appeals offices taking with the large backlog of cases that they have pending? Are they starting to notify organizations about the fact that they may not owe any tax?

[80] MR. OWENS: That's a good question Milt. Obviously, as we came to the realization that there was a not a future for us in the federal court system on that issue, toward the end of last year we began a reassessment of our position and in mid-December we issued a memorandum to our field offices directing them to start to work through the backlog of cases and resolve them. Unless a particular fact pattern involves significant services I anticipate those cases will be closed along the lines you suggested. There may be other issues perhaps in a particular case but, unless the cases have a significant service component along the lines perhaps of the DAV case, I would see those being processed pretty quickly, pretty efficiently. Hopefully, the appeals offices are following that lead.

[81] MR. FERGUSON: If I could insert a follow-up. Is there any thought being given to guidance or just spreading the word on how the Service will handle its cases where there is a significant Service element in terms of allocation approaches? In other words something that may help to let people know what the rules are that everybody can work in?

[82] MR. OWENS: Yes.

[83] MR. FERGUSON: He didn't even say it was a good question. That's usually the giveaway that it's not going to get answered. Thank you.

[84] MR. McCOY: I wondered, what's up in the donor advised fund area? A lot of us had thought that this area was clearing up after the standards that were developed and described in the CPE text last year. I'm aware of a recent incident where a latter day donor advised fund that included those provisions went in for a ruling on a kind of innocuous pooled income fund point and after a long delay was told that the whole thing was held up and they wouldn't rule, they even gave back the user fee on the basis of some kind of a study or project. I wonder what's up there?

[85] MR. OWENS: That whole area continues to be of interest to the Service. In addition, there is the New Dynamics case pending in court as well, where the advice perhaps moved a little further towards direction. Susan, you have something you want to --

[86] MS. BROWN: Yes, I think that I would agree that the area of donor advised funds is one where there is a need for additional guidance. I think that section 170 principles help to some degree. I think that if a donor retains too much control over assets contributed to charity, there is certainly a question whether there is a completed gift for section 170 purposes. You are all familiar with the regulations that apply to community trusts. Those help define when contributions received by the community trust may be included in public support for purposes of the public support calculation. But there is a sense of uncertainty as to how those rules would apply in a non-trust context. So, I think there is a need for guidance. The ABA, it sounds like, will be proposing that there be some guidance issued in this area. I can't speak to the specifics of the ruling request that you mentioned but I think it's part of a larger examination of what rules should guide donor-advised funds in their operations. I might also mention that there is interest on the Hill. At least last year interest was expressed again in providing some clarification in this area, so it is one to watch.

[87] MS. WOODS: This is a question for Susan and/or Marc with respect to the soon to be proposed reg. 513(i). There was a suggestion a few months ago, I think by Marc, that those regulations might begin to address some of the Internet issues. Things along the lines of the corporate sponsorship acknowledgment on a Web site with a link, stationary link versus a moving banner, the relevance of those for tax purposes. Will that be the case, that there will be some element of the Internet issues in those regulations? Or will that be reserved for this request for comment?

[88] MS. BROWN: One of the issues we had to deal with in working on the corporate sponsorship regulations is whether to go out ahead of our request for comments on this issue. I think that the Internet issues impact a lot more than corporate sponsorship and so we hated to go out with a rule before we heard from you all what sort of rules might make sense. So, I think that you'll find for the most part the regulations are silent on the issue but the preamble will make reference to the fact that we're conducting a larger study of Internet issues and how they impact on normal tax rules.

[89] MR. OWENS: The "Sturm und Drang" of tax administration got us out of sequence in our projects. We had confidently anticipated the Internet announcement would fly out earlier in the year. But it hasn't.

[90] MS. BROWN: I hope the notice will be coming out at roughly the same time as the corporate sponsorship regulations are issued in proposed form. If not, people should certainly comment on the issues that you mentioned.

[91] MR. ROYALTY: There were a couple of interesting legislative proposals in the tax bill that Clinton vetoed last year. One dealt with section 512(b)(13) and it would have amended section 512(b)(13) so it would have only applied to excess payment. And the other one related to an exception process to the self-dealing rules. Do you anticipate those proposals being reintroduced this year?

[92] MS. BROWN: Both of those proposals were proposals that, as you said, made it into the vetoed tax bill, which shows a good deal of support for them on the Hill. I can tell you that the administration has concerns about both proposals, so I would not anticipate that they'd be in anything that the administration would propose this year. On the section 4941 waiver procedure that you mentioned, for those of you who are not familiar with it, the vetoed tax bill would have directed the Secretary of the Treasury to develop a procedure for granting waivers of the self-dealing prohibitions in particular cases. The 1969 Act, as you know, flatly prohibits a lot of transactions between a private foundation and a disqualified person that might appear to be beneficial, such as a below market rental of property to a private foundation. The reason for the absolute prohibition, according to the legislative history, is to prevent any temptation to misuse private foundations for personal gain. There is some beauty in the absolute rules and if you admit certain waivers of those rules in particular cases, you open the area up for possible inconsistency in the treatment of individual taxpayers. Apart from that, there's a resource issue: Does the IRS have the capacity to deal with requests for waivers in particular instances? I think that from the administration's point of view, to the extent that the section 4941 restrictions are perceived to be too absolute, let's make some statutory exceptions that would then apply uniformly to all taxpayers. Or perhaps create a waiver procedure that's more narrowly tailored, such as a waiver procedure that would allow for a private foundation and its disqualified persons to unwind business arrangements, where the unwind is deemed by the secretary to be in the best interests of the foundation, but not permit waivers in more general circumstances.

[93] On the section 512(b)(13) modification, under current law certain payments of interest, royalties, rents, and annuities from a controlled entity to a tax-exempt parent are taxable income to the tax-exempt parent to the extent they derive from an unrelated trade or business conducted by the controlled organization. The proposal would modify that rule so that the payments would be taxable only to the extent that they exceed fair market value. There is considerable debate as to which rule makes sense in this area. The administration thinks that the present law approach is the correct one. Certainly there has been a good deal of debate. A question I throw out to people whose view differs on this point is whether, if you want a fair market value approach, it would be better as a matter of tax simplification simply to repeal section 512(b)(13) and rely on normal section 482 principles to ensure that the payments are at fair market value. But, as I said, that's currently not the administration's position.

[94] MR. FERGUSON: We've just about run out of time. I would add a couple of things. I went down last Friday to the breakout session for this two-day modernization of the IRS conference that was held in Washington. There's one additional staff appointment which I don't think has been widely circulated. Sarah Hall Ingram as you all know is chief counsel to the TE/GE Department. She has appointed as her deputy Nan Marks, which is a relatively new announcement. There will be other announcements coming out quite quickly. The first ones I think will be the area managers because there's a big push to get the area offices up and operational under that title.

[95] The other thing is the jargon down there is so, so, management consultant that you simply can't believe it. We heard nothing but references to customers and customer clusters. Customer to me includes the implication that there is some volition on the part of the person receiving the service. If that's so, there would seem to be reason to think that there would be application of the anti-trust laws. Couldn't we bust up and get at least an oligopoly of these wonderful services that are being provided and we could have a consolidated IRS and an American IRS? Something to think on. There is another one that I love. It's called "end-to-end" accountability; sounds like an NFL offensive line, doesn't it? But my favorite and it popped out of one of the IRS publications, is they say that there is still going to be room and they intend to use and I quote, "target enforcement activities for the intentionally non-compliant." There has to be an easier way to say that -- I think you were telling us about a seven fold letter that says it a little bit better.

[96] With that, I would like to thank the panelists.

[97] [Applause.]

"When the Left Hand Is Required to Leave the Right

The Treasury's Public Policy Power: Identity,

[100] MR. CERNY: I think this is the last meeting I'm coming to. The last meeting (the mid-year meeting) I was attacked by Branch Ministries because of my IRS background, so now and it's on Bob Jones. It's hard to imagine, but it's been 17 years since the historic Supreme Court decision in Bob Jones University and its companion case, Goldborough Christian Schools, and as we all know the Court ruled that the operation of a racially discriminatory private school in violation of public policy against racial discrimination in education could not qualify as a charitable organization under section 501(c)(3). What's of interest today, is that this issue has arisen again in another context --

[101] PROF. BRODY: The materials for this are in your handout for the committee, which appears in a different order. Milt's paper is last in your material.

[102] MR. CERNY: You will find in those materials a copy of the technical advice memorandum that was prepared in the Kamehameha Schools and was then released by the Bishop Estate on its Web site and as you review that TAM, the question came up to the National Office of the IRS whether or not a trust that restricts admission to children of Hawaiian ancestry is inconsistent with the requirements of tax-exempt status. I think the IRS in a well reasoned TAM that's located in your reading materials dated February 1999 held that this preference was not the type of persuasive racial discretion that violates the public policy against racial discrimination in education. We might ask, what is the real question here? Is the real question -- why was this issue even raised in light of the Service's history on this matter? Professor Brennen in a proposed paper, which he will be summarizing for you, has excellently pulled together a number of the authorities in this area, and has taken a broad view of the whole issue of the use and role of the federal public policy in tax administration and also illegal activities. It might be well at this initial point in our panel to revisit the application of the federal public policy doctrine as it applies to the exemption of organizations described in section 501(c)(3) -- in light of this technical advice memorandum and in the currently pending United States Supreme Court review of Rice v. Cayatanto, which regards a voting limitation imposed by the State of Hawaii that permits only those of Hawaiian ancestry to vote for whose benefit the trust was established. This restriction creates the possibility of a prohibited racial preference in special trustee under Article 15 of the U.S. Constitution elections.

[103] The lower courts have not found it to be a discriminatory activity, but the Supreme Court has agreed to hear the case. As we look at Bob Jones in its historical context, we will see why the IRS formulated the position in the application of this federal public policy doctrine. We have to go back to Brown v. Board of Education, which struck down state laws mandating separate but equal private schools through separate black and white school systems. Before 1970, a number of states were not vigorously enforcing the desegregation of the public school systems as required by Brown. Some states were initiating massive resistance to integration. The IRS began to see a movement toward creation of white only academies, council school foundation organizations. In addition to that there were schools being formed by parents who were concerned that certain religious values were not being taught in the public schools. Again, this was on the heels of the Supreme Court striking down mandated school prayer in public schools in Abington v. Schemp.

[104] So on the one hand the Lawyers Committee for Civil Rights, representing black parents in a class action suit in Green v. Regan, took the position that the IRS should be more aggressive against racially discriminatory schools. On the other hand there were the arguments for the parents who were forming these schools, many of them based on Biblical interpretations that encouraged separation of the races. The Service, as usual, was in the middle of this struggle as these schools applied for exemption and the deductibility of contributions. This question, as you can quite well imagine, presented serious federal public policy questions and constitutional issues as to whether the government could grant tax privileges to schools that violated the public policy against racial discrimination in education. Initially the Service took the cautious approach by denying exemption only to those schools that received government support. But, the federal court decisions made it clear that even de facto school segregation could lead to court ordered desegregation. The white-only private schools stood as a haven in these desegregating public school districts, Norwood v. Harrison and Blumfield v. Dodd being the leading cases, first by the Nixon White House, which saw the formation of these schools as a roadblock to expand for public school desegregation. The IRS published its position denying the exemption to racially discriminatory private schools in Rev. Rul. 71-447. Rev. Rul. 71-447, was a landmark revenue ruling in the law of tax-exempt organizations, because it announced for the first time in the tax-exempt area, the concept of how charity would be applied to all charitable organizations, whether they were educational or otherwise. Finding that they are subject to their purpose may not be illegal or contrary to public policy.

[105] The IRS based its conclusion regarding racially discriminatory schools on the general premise that racial discrimination in education was contrary to public policy and it advanced these premises. First, that an educational trust must be a common law charity in order to be exempt under section 501(c)(3). Second, every charitable trust is subject to the requirement that its purpose may not be illegal or contrary to the public policy. And, third, as reflected in the numerous federal statutes, court cases, executive orders, etc., there is a clear public policy against racial discrimination, whether public or private. Looking to federal legislation, executive orders, and the federal courts' interpretation of the Civil Rights law, the IRS determined that there was an established federal public policy against racial discrimination in education. To determine whether a school was racially discriminatory was determined by applying certain factors contained in Rev. Proc. 72-54. In 1975 the U.S. Commission on Civil Rights criticized the IRS because it lacked specific guidelines to identify whether schools were operated on a racially discriminatory basis. As a result of that, we saw the creation of Rev. Proc. 75-50, that tested whether or not there was affirmative evidence that a school actually operated for non-discriminatory purposes.

[106] As these cases proceeded through the courts the IRS position was sustained. The IRS was now in a position to have the Supreme Court rule specifically on the merits of using the federal public policy test to determine qualification for tax-exempt status under Rev. Rul. 71-447. In Bob Jones University and Goldsborough Christian Schools, the court consolidated for hearing before these institutions which were religious private schools, so we had the issue we raised today, whether the equal protection provision or the religious provision would prevail and whether freedom of association would overcome any of the arguments with regard to whether or not this was an illegal activity. And, as you all know the history of this decision, the Service's position was ignored when the Justice Department and the Treasury Department jointly decided that in order for the Service to pursue this position there had to be a legislative enactment or some legislation that would support that position. William T. Coleman was the court appointed amicus by the Supreme Court to argue the IRS's case before the Supreme Court. The Supreme Court held in 8 to 1 vote -- with only Justice Rehnquist dissenting -- that the IRS was correct in its position that the term charity includes the educational and the other provisions under section 501(c)(3), was all inclusive, and that an organization had to meet that charitable trust concept on illegal activity. Thus, it could not be involved in illegal activity or activities that would violate the public policy of the United States. The same analysis was true of racially restricted charitable trusts, those trusts that were set up for white only students where no scholarships funds were made for minorities, etc. The Service had a number of these organizations before it and it ruled on those organizations in separate rulings. It also ruled favorably with regard to universities that had both white- only trusts and also had minority trusts that this type of preference was not pervasive racial discrimination that would defeat right to tax-exempt status. This whole question of what is the public policy, how is the federal public policy determined, and whether the concept can be applied to areas is open to question. I think there was a very telling argument that was made by Mr. Coleman before the Supreme Court when he was asked that question by one of the justices: Can this concept be applied to other areas of exempt organizations activities? Coleman, in his response back to the judge said, "we didn't fight a civil war in those other areas that led to the development of this federal public policy." In this whole milieu of activities we have not only established federal public policies in certain areas, but we also have the potential of organizations being involved in illegal activities -- organizations that were set up for an illegal purpose. We have a published revenue ruling with regard to an organization that was set up to disrupt a community through civil rights violations, etc., individuals chaining themselves to a building and disrupting traffic. The Service published a ruling that said that the organization's primary purpose there was illegal, and thus, it could not qualify either as a charity or an organization under section 501(c)(4).

[107] So, the question I think we have today as we look at these issues again in light of affirmative action is -- What is the basis for affirmative action? What is the statutory basis? What is the case law? What are the executive orders, etc., to establish this policy? We look at illegal activities which other members of this panel will discuss. In my view, you have to weigh what is that illegal activity. Is it substantial in nature? Is that illegal activity one that goes to the heart of the organization's tax-exempt status? Is it a gambling violation, as Marc Owens has talked about here? If you violate a state gambling law does that take away your right to tax- exempt status? What about a social club involved in gambling that may or may not be permitted under state law? This is a very difficult question. It really requires a thorough and rigorous analysis before you can reach a conclusion that there is a violation of the federal public policy and whether the effect of that illegal activity effects an organization's tax-exempt status.

[108] PROF. BRODY: Thank you very much Milt. Jay?

[109] MR. ROTZ: Okay. As Milt's discussion of Bob Jones indicates, that's fairly recent history, but the underlying requirement for exemption under section 501(c)(3) certainly goes back even before that and continues to be extremely important even today. Quite aside from cases of discrimination it is also important in the area illegal activities of which exempt organizations are frequently engaged in, or are attempting to be engaged in. It all derives from the basic requirement that to be exempt, the organization has to, obviously, be a charitable organization, but it also cannot be engaged in illegal activities where those activities are contrary to clearly defined public policy. I want to emphasize that clearly defined public policy is the area in which the administration is so difficult for the IRS. Not only does the "clearly defined" requirement apply to public policy problems of violations, it also applies to the illegal activities, and there we have a different set of things to be concerned about.

[110] Obviously, there is a quantitative versus qualitative test that Milt Cerny referred to, it can't be something like a zoning violation or something like that to cause loss of the exemption. It has to be something that goes to the essence of exemption. When we are dealing with tax-exempt organizations, not only do we have to determine whether something is illegal, but also recognize that an exempt organization operates through its officers and employees, so quite often they may be engaging in an activity that is illegal but not with the sanction of the exempt organization. So, we have the additional difficulty of attributing the acts of officers and sometimes members to the exempt organization itself. That's sort of a threshold question. But once we determine that the organization is knowingly engaged in this activity that we are going to question, we have to clearly determine that the activity is illegal. Typically, the law that we are looking at is not that clear: that's why we have courts to tell us and interpret the laws. So our ideal situation is for us to have a court decision that has previously determined that this exact activity was illegal; that makes the case pretty easy for us and there is no question. We would view that as inconsistent with tax exemption and revoke exemption for it. That's rare however. The easy case is always rare. Quite often we have to look to the administrative agency that may be regulating exempt organizations from some other area. Health and Human Services (HHS) is concerned with Medicare and Medicaid fraud, the Justice Department with anti- trust violations. In those situations, if we get a clear statement from the administrative agency that it's an illegal activity, then we would probably have to take action on it even without a court taking a position on it.

[111] However, those kinds of actions are typically settled with a consent decree. In other words the agency determines that "we think what you are doing is illegal but, if you stop it and go forward in a different way, that's the end of this investigation." Was it illegal? We don't know, we never get the opinion of the experts that know something about that law.

[112] Quite often we will have the situations that are so obvious that the Service would have to look foolish if it didn't take action against an organization that is so clearly engaged in illegal activity. Quite often that occurs with a fundraising gaming operation. Exempt organizations are increasingly engaging in gaming activity some illegal, some questionable.

[113] I'll just give you a typical example. Typically the law requires that the organization be exempt under section 501(c)(3) and that the work be performed by volunteers. Take a bingo game. You have thousands and thousands of dollars walking through the door each night, hundreds of thousands sometimes. Well the first thing you need is security. Clearly, you are not going to expect a volunteer to show up with a hand gun -- and the necessary expertise to provide security -- so clearly the intention was "well, okay, for some things, if you don't have the expertise you can contract out, that's fine." Well, if people are inexperienced in bingo games they might decide that they're giving too much money away, they might accidentally give too much money away so, you need the expertise to determine jackpots and call out the numbers and limit volunteers to checking the cards and things like that. So eventually you end up with a couple of volunteers who have been going around collecting the money or checking the cards, those are the volunteers that are clearly volunteers. But are they really? Every time you check a winning card and you call in the numbers then you almost always get a tip from the person playing. Are they volunteers? They're not compensated by the exempt organization. But are they really volunteers? Even things that on their face look so simple are sometimes not.

[114] And finally, we do occasionally have a fairly easy case in the illegal area. Sometimes it's clearly illegal the way they are doing it, by not using volunteers, but in that particular jurisdiction law is simply not enforced, either for lack of manpower or political purposes, and the authorities admit they don't enforce it. The exempt organization does it knowing it's not going to be enforced. Is it illegal? Is it a basis for loss of exemption? Sometimes it is a case where it is so clear, that even the exempt operation will concede that it is illegal, and that's what we have encountered in some of the gaming activities.

[115] In areas other than illegal activities, which is difficult enough to deal with, we do have public policy concerns that Milt was talking about in the Bob Jones case, and the article that is attached as part of your materials was written to kind of tell our agents or kind of hold their hands and agree with them, that in areas of trying to determine clearly defined illegal activities or violations of public policy, they are not alone. The Service recognizes that it is very difficult, and in my experience the Service has been extremely conservative and very careful to make it clear that we are looking to some other body to clearly define public policy. A court case like Bob Jones is nice, we like to see it. I think that makes it easy whenever a court will come along and tell us well, you were right there.

[116] But, typically we don't have that. We have to look to things like legislation, executive orders, that somehow show a clear governmental intention to promote this kind of activity. Where we can't find that we will, sometimes on our own, attempt to define a necessary public policy in which to make the tax decision. But we do look at that sort of material. We would in some cases look at the state law if necessary. Typically if a state law is being violated or if it's questionable that it's being violated, we may find some overriding public policy considerations there to take adverse action. But basically the TAM that Milt mentioned, and I agree with him, is a very well reasoned one. If you take a look at that you see we obviously had a difficult time reaching that decision but, what we did, we looked at the numerous federal statutes intended to help native Hawaiian individuals intended. I believe in that TAM, it lists as many as 10 different separate federal statutes that are intended to help native Hawaiians. It would just be ridiculous for the Service to fail to consider -- to just ignore something like that when the Congress has so many times indicated that something to help native Hawaiian students or children is in the public interest. We couldn't do anything but this to go the way we did in that case. I agree with Milt on that.

[117] PROF. BRODY: Thank you very much Jay. Let me turn over the only other working microphone to David.

[118] PROF. BRENNEN: Thank you Evelyn. I'll just pick up on where Jay Rotz just left off.

[119] The Treasury Department finds it difficult to deal with the public policy issue and that's really the whole focus of my concern and the premise for my paper, is that Bob Jones is both problematic and quite dangerous. It's problematic, because it's a case in which the Court has recognized a power in a governmental agency where that governmental agency has not gotten a specific grant of authority from Congress to do what it is doing. Congress has never instructed the Treasury Department that it has authority to operate in this public policy area. There is mention of trust law doctrine, but when you look through the materials and through the records and also at the paper you will see that there is no clear guidance given that indicates that trust law doctrine is indeed a basis for saying that Treasury has the authority to act in the area of public policy.

[120] That type of governmental structure is dangerous and I use the affirmative action debate as an example of that. It's dangerous because as Jay has said and Milt referred to, there is no guiding principle to say what clearly defined or clearly established public policy. Who's to say that we have not already reached the point where affirmative action is contrary to public policy and maybe the Treasury Department is doing something wrong? My personal opinion is that we haven't reached that point but the point that I'm trying to make is that there is guidance to tell the Treasury Department that first of all you have authority to do this, and secondly that these are the parameters you must use to decide when a public policy standard has indeed been violated.

[121] Now notice that I am distinguishing between the illegality issue or violation of law issue that Jay was referring to and the public policy issue because I think they're two very different considerations. My main concern and focus is with this question of public policy, although some of my arguments can be applied to the illegality provisions as well. The Bishop Estate case is one of those cases where Treasury has indicated that it will look to a pending court case in the United States Supreme Court to sort of come to its final conclusion after it actually reached the conclusion in the TAM, as you can read in your materials. That's one of the reasons why the Bob Jones case is so problematic, because even the Treasury is kind of hedging its bets. It's saying "well, we think it's okay but let's just wait and see what the court says and then we might change our mind."

[122] Some have indicated that that might be a red herring, but I think it demonstrates the problems and the dangers that I'm talking about in terms of there not being any clear guidance from government on this issue. My proposed solution, and where my current research is going, is that we focus in on this question of violations of law; that is, focus in on Treasury looking to see if a charity has violated a law and how the Treasury is going to make that determination.

[123] One possibility -- again, just using the example of affirmative action that I use in the paper and that's going to apply in other areas -- is to draw on tax expenditure analysis. Maybe through that analysis we can find some sense of whether or not the tax-exempt status of a charity is equivalent to financial funding that's required under many of the federal civil rights laws, and use that as a basis for saying "well, let HHS or the other agency that's charged with deciding these issues make a decision as to whether or not there is a violation of Title VI" for example. That will take it out of the context of being a public policy decision and bring it back to what Jay was talking about and making it a legal decision.

[124] Then we get into the issues of substantiality of the legal violation and those types of issues. I think those are issues that are very legitimate for the Treasury to make under its current statutory authority but, I don't think that there is the authority in the public policy area.

[125] I am near the end of my time here. I want to conclude by mentioning that despite the statements that were made at oral argument in the Bob Jones case, 17 years ago, and some assertions that have been made since then, the statement that I'm referring to is the one Milt referred to about how "we didn't fight a Civil War about these other issues." The opinion itself does not restrict application of this public policy doctrine to racial discrimination, so there is no limit on the areas in which the Treasury can apply this power.

[126] For example, with the recent VMI case in Virginia, there is no basis for saying -- or I couldn't find a basis -- that the Treasury couldn't draw on that and if the Treasury, using whatever mechanism it used, could say "well, an all female school or an all male school, whatever the case might be, is violating a clearly defined public policy" and then refer to the VMI decision as the basis for its determination. That's really the focus and really the problem that I'm trying to highlight with respect to this allocation of governmental authority issue.

[127] PROF. BRODY: Thank you very much. I welcome questions from the audience. Lisa?

[128] MS. RUNQUIST: There is another problem, I think, with Bob Jones, and that's that what they did was not illegal, but, that it was agreed that what they did was based on a firmly held religious belief. And in Bob Jones, I think that what happened was a constitutional right to freedom of religion was overruled on the basis of some amorphous public policy argument. I agree, they may be reprehensible in what they did, it may be something that none of us agrees with, but it wasn't illegal and to have something that was agreed to be a firmly held religious belief, which is a constitutional right, overruled by public policy, I think is a real problem.

[129] PROF. BRENNEN: Well, I guess I can go ahead a state my personal view. I do think the result in Bob Jones is a good result in the technical sense. The judgment itself, that Bob Jones University should not be discriminating against blacks, I think is a good result. My problem is with the mechanism of how the Court reached that result, and I think that some changes in the structure of our laws, as I suggest in the paper, might have gotten the correct result for the correct reasons.

[130] PROF. BRODY: Phil.

[131] MR. ROYALTY: This is a question for Milt and Jay. Would the Service challenge the section (c)(3) status of an organization that discriminated based on gender, under current law?

[132] MR. ROTZ: There was a study on this years and years ago and it never went anywhere. This was like 25, 30 years ago.

[133] MR. CERNY: I don't know that the law is at the same point, but it is quickly approaching that status. I remember the study and we considered it for a long time and with the advice of chief counsel we decided to put it off for another day.

[134] MR. ROTZ: I think, again, you're going to find a situation like gender or elderly discrimination, etc., again, the line of cases: Is it the executive orders? Is it the various interpretations that will support the established federal public policy? In other words, that's why I think the Court, in making this decision in regard to racial discrimination, had to decide whether or not it was constitutional to deny this exemption, was this restriction so narrowly drawn so that it would pass the strict scrutiny test. And it was obvious to the Court that that is the case with racial discrimination -- it may not necessarily be there with regard to other types of discrimination at this point.

[135] MS. FAYE: This is for any of the panelists. I'm wondering how you would analyze a situation in which state or local law makes something legal, but there is arguably a federal public policy against it. "Maybe it's not a strong enough public policy," might be your answer. My two examples are, first, where you have a nonprofit forum to distribute marijuana for medicinal purposes (which has happened in San Francisco) and two,where you have a nonprofit forum to distribute needles to reduce the transmission of HIV among drug users.

[136] PROF. BRODY: Jay?

[137] MR. ROTZ: Let me think about that a little bit. Certainly I think if we could find an overriding public policy, federal public policy, I believe that would have to take precedence over a state law that made it legal.

[138] PROF. BRENNEN: I do want to stick to that issue. That's one of the issues in a broad sense that I talk about is how do we figure out what types of public policy are to be addressed here. Is it federal public policy, is it state public policy, or is it kind of a meshing of both? Clearly defined national public policy is what the opinion says. It doesn't really limit it to federal public policy. So in that case I think the justices really didn't contemplate that type of a situation, because the opinion only refers to federal sources of law. Yet I think it's clearly acceptable to rely on state decisions, for example. Look at all of the affirmative action decisions primarily emanating from the various states and not necessarily from the federal government. My concern is what do we do when we get to the point where all 50 states have anti-affirmative action laws but the federal government doesn't. Does that mean that the Treasury can act or can't act? That would be problematic in my mind. The situation you described with the needles and marijuana, I think that that would be a problem and I don't know how the Service or the Treasury would react to that particular situation.

[139] MR. COLVIN: I believe there's another question that regards an exception to this doctrine, where the effort made by the tax-exempt organization is to challenge the constitutionality of a local law -- gay marriage, for example -- where it hasn't been decided by a higher court. The purpose of supporting the litigation is to get the question of whether the local law is constitutional before an appellate body.

[140] PROF. BRODY: Jay's material -- the CPE Textbook chapter that you have -- distinguishes the protesters who were chaining themselves to the buildings, an illegal activity, from the people who were doing public-interest litigation, which was a legal method of achieving their ends.

[141] MR. ROTZ: I think that's important, because I think the whole concept and purpose of the public interest law firm and the public interest legal organization is to bring issues to resolution. These issues that you're pointing to are still being considered; they haven't been resolved yet by the court system and the question is "can an organization engage in those activities to raise these issues." The Service has a revenue ruling out there that says, as long as you are not involved in an illegal activity, as long as that activity furthers your charitable intent or purpose, you can raise these issues and get them resolved.

[142] PROF. APRILL: I wonder if we aren't looking a little narrowly. What about use of the public policy doctrine in different contexts, which happens all of the time; it's equally amorphous, but it does have a long history. To look at only in the area of exempt organization and trust law, I think cuts off some other areas we need to look at. David, I just don't know if you did that in the article and --

[143] PROF. BRENNEN: Well, no I did not go beyond using the examples that are talked about here, primarily the affirmative action example and the gender example I mentioned. But, I think that's a valid issue that is how do we distinguish the Treasury's authority to make public policy decisions in those areas with respect to business deduction, and things of that sort with the public policy authority to make decisions in these areas that I'm talking about. The only answer that I would have to that at this point is that those areas are kind of historically part of what the Treasury Department has been doing and kind of draws on the expertise of the agency in terms of economic areas and my kind of issues are that the Treasury is going into the social areas that really have nothing to do with the traditional mission as charged by Congress.

[144] PROF. BRODY: In a different context, Congress has spoken. Several subsections in 162 overrode a series of Supreme Court cases upholding the IRS's ability to deny business deductions under certain public policy grounds. Effectively, Congress said, "These are the only public policy grounds: you can no longer claim section 162 deductions for fines, bribes, kickbacks, and that sort of thing." Congress has not similarly responded to Bob Jones.

[145] I like to thank my panel for a galloping, but terrific, overview of the public policy.

[146] MR. FERGUSON: As we are getting the next and last panel up, I'd like to just acknowledge one other thing. We have leaving the panel a gentleman who has given us a massive of time and insight, Jay Rotz, if I could. Jay, pay attention, I was trying to say thank you for all your years of service at the Service and welcome you back to the private sector and we will look forward to hearing a great more of you in that role but, thank you for all your years of government work.

[147] I never met a microphone I couldn't work. Our last panel is a UBIT panel, which I will let Lorry Spitzer, who is the moderator both identify and then introduce his panelist.

UBIT Current Developments: When Can UBIT

[149] Catherine Livingston, formerly of the Treasury Department, a familiar speaker to all of us, is with Caplin & Drysdale now. Cathy is going to be talking about some of the legislative proposals to fix or at least further adjust the UBIT that have been on the table and talked about actively recently. With that, Dick, if you could lead off with the current developments. I should point out that Dick's outline is in the back of the room and is a very thorough and helpful summary of UBIT rules.

[150] MR. GALLAGHER: The outline is a first draft of a outline I'm preparing for the OMI Conference in March, so you are free to criticize and point out all the typos to me so I can get them corrected before that event.

[151] My portion of this panel can be mercifully short because a good part of what I was going to say has already been said. We don't have sponsorship regulations, we don't have travel and tour regulations. Marc has eluded to the field memo which I understand has been circulated in the field but has not yet made its way into the Freedom of Information Room, telling field agents what to do with the mailing list affinity card cases. Marc has said publicly before that the cases should be resolved along the lines of the rationale of the Oregon State University cases and that's not very useful until we really see the memo because the Oregon State University case, according to the Ninth Circuit Court of Appeals judge, only involved 40 to 50 hours of services over a period of two years and he expressed doubt that the paying organization would have paid $1 million for the 40 to 50 hours of service. So I suppose if you've got a case where you only have 40 to 50 hours of services over a period of two years, you can feel pretty comfortable that you can close your file. But in many cases what's a substantial level of service and how we allocate costs will haunt you for a while, even though its clear the Service is on a resolution mission.

[152] In the context of royalties, I have cited on page 13 of my outline a private letter ruling (No. 199938041) I think is very significant and has not been given a lot of attention by our own EO press. I guess I think it is significant because our office was involved in it for some time. If you look this up on the Tax Notes Today research cite, you will see that they cite the ruling by guessing it involved the American Association of Retired Persons, so for convenience I'll refer to it as the AARP ruling.

[153] The resolution of this organization as described in the ruling is an interesting one. The parent organization created a for- profit subsidiary to which it transferred its mailing list on a no- fee basis and (under guidelines set forth from the ruling) employees, resources, and the like who are to provide the services described as a fairly extensive royalty program, but retained the third-party royalties at the current level. One might think that under well- established principles of for-profit subsidiaries that's a no brainer, but the magic of the ruling is that if it separates the services from the royalty and actually has all of the services being provided at the for-profit level and all of the royalties being paid to the parent and there are some rather extensive circumstances outlined in that ruling about how that's to be done and the composition of the board, such as there cannot be a majority board overlap but staff can be on the board and fact the executive director is designated as the chairman of the for profit subsidiary.

[154] And, interesting enough, you'll find in the ruling a requirement that the organization report to the IRS annually about its compliance with this letter ruling which is kind of an interesting reverse audit process that keeps the issue, one would think, closed out on a year to year basis assuming there is continuing compliance. So, for people looking for ways to separate what are clearly substantial services from a royalty program through an organization that is large enough and significant enough to have this kind of an approach, I think this one outlines an approach that the IRS has accepted and may well presumably accept in other similar situations.

[155] MR. FERGUSON: Just a quick question. I wonder if that might apply in the rental income area, where the provision of substantial services could cause the rental income to become taxable and those activities where dropped perhaps into a taxable subsidiary whether you might be able to protect the rental income flow as tax exempt.

[156] MR. GALLAGHER: I can only guess at the answer. One would imagine that the same rationale would apply in a situation in which the IRS is, I think, rather desperately looking for a way to get this stuff resolved. In large organizations the amount of resources that the IRS has to spend allocating expenses and goofing around with all of this especially when there are millions of dollars at stake and dozens of lawyers fighting them all the way is quite large and they're looking for a way to resolve that and this letter ruling approach is a way to get a resolution without necessarily doing it on a formula type of basis. One of the interesting things about the annual reporting mechanism, which is a little unusual, is that if one can speculate that if there are questions down the road, you have a pretty strong case for prospective treatment, because you've effectively submitted information on an annual basis for review. One hopes, assuming people of good faith and intent, that you could get this fairly and safely behind you on a year to year basis which in large organizations with lots at stake is pretty important to do.

[157] MS. BROWN: Can I also ask whether this structure helps you avoid the section 512(b)(13) problem, because the royalties flow directly from the third party back to the tax exempt charity, they never come through the holding controlled subsidiary so you never have to worry about the section 512(b)(13) consequence.

[158] MR. GALLAGHER: That's precisely the point, is that you keep the royalties at the parent level and you never face a section 512(b)(13) problem, you bifurcate the services to the for-profit level where they are taxable but they're probably not very profitable. In the ruling there is a formula for how those costs are to be determined, how the fees are supposed to be charged and derived and so forth, but we all know the services aren't where the major profit function is, the major profit function is the royalties so that is protected at the parent level.

[159] The Internet is obviously the new frontier. I'm hesitant to insult this sophisticated group by producing an outline which I call a UBIT primer, but I did that on purpose because I think one of the interesting things about the Internet is that it forces us all to go back to our own primary knowledge about what UBIT is. Is it a trade of business? Is it a regularly carried on? We've had all those cases going on for years and what we thought we had fixed in our heads is really all fresh stuff in the context of Internet activity. I would commend to you Christina Nooney's excellent article in the current edition of The Exempt Organization Tax Review. She takes the 2000 CPE text, which I'm sure you've all read, and really picks it apart and does a very good analysis of what's out there on the Internet.

[160] I like to tell clients about how important Web sites are. I think you got some indication of that earlier today. If you imagine yourself hypothetically to be Marc Owens or his successor and you get a phone call from a prominent individual who got your name from the chairman of the Senate Finance Committee or a reporter from The Washington Post or The New York Times, or maybe the Chairman of the Senate Finance Committee himself complaining about some organization he read about or heard about and wants you to do something about, you instantly say, "Gee, I can't talk to you Mr. prominent citizen or United States senator because. I have to worry about privacy acts and confidentiality acts and I've got the largest Inspector General in the government, even bigger than the Defense Department, and I can't talk to you about this. And then you hang up the phone and you go "Holy Moses." So, in the olden days you'd order up the Form 1023 and hope that the Service could find it, which of course they can't, or the latest Form 990, which he hasn't any better access to than you and I do. But today you hang up on the caller and you turn to your computer and you type www.charity-I-just-heard-about.org, and then you get an instant impression of what that charity is, and that impression might set the tone for how the IRS looks at your organization for a long time. So I think the Web sites and how they're designed is more than just a unrelated trade or business question. It's a really important entree point for the Services or some attorney general's view of what your organization is and, I fear that some of our clients don't really appreciate that. Having said that, I'll turn it over to the theorists.

[161] MR. SPITZER: One of the topics that we wanted to talk about is whether the UBIT has effectively become an elective tax. Is it really a dog that doesn't bite? In saying that, I don't want to suggest any kind of a flippancy toward the tax but simply to observe a couple of areas in which practitioners, I think very predictably and appropriately, have taken the UBIT rules as they now exist and used them to minimize the amount of UBIT that is owed by exempt organizations. In thinking about my talk, I asked whether this an aggressive tax shelter or even an abusive tax shelter? I decided no. But in deciding that, I had to figure out a definition of those two terms. I decided that an aggressive tax shelter is a creative reading of the code and the regulations that I hadn't thought of before. An abusive tax shelter is also one that I hadn't thought of, but is one I can't understand. I might put the chutzpah trust provisions in that last category. To my mind at least, the biggest UBIT exception that a lot can be driven through is the royalty exception. Certainly the string of cases that we've seen culminating in the Oregon case involving affinity credit cards and the use of mailing lists suggests strongly that the royalty definition is very broad. Virtually any trade or business can be boiled down to intellectual property of one sort or another. It can simply be licensed to another party and that other party can conduct the business and pay out a royalty to the exempt organization, even a royalty that is based on the net income that's derived in that trade or business. If services need to be provided by the exempt organization, they could elude it if they are relatively small. That's not going to be problem under current case law. If they are more substantial, then perhaps we follow the course that is outlined in the AARP ruling of setting up a separate taxable subsidiary to clearly separate the services that are provided in conjunction with the licensing of intellectual property.

[162] A TAM that came along earlier in 1999, TAM 9941043, strikes me as having broad implications as to whether the IRS can ultimately collect tax from the UBIT. It involves a section 501(c)(3) organization, I believe in Washington State, that is promoting amateur hockey. It's conducting both bingo pull-tab operations, the latter being taxable and subject to unrelated business income tax. Except that under the laws of Washington, anyone conducting pull-tab activities needs to direct the profits of that activity to a tax- exempt organization or to tax-exempt functions. Well, here is a section (c)(3) organization. It conducts this taxable activity and it simply gives the money to itself. It transfers the money from its pull-tab account to its charitable account and then spends it for its charitable purposes. Held by the IRS that this amount is fully deductible, not as a charitable deduction, which would be limited to the section 512(b)(10) limitations of 50 percent or 10 percent but rather it's deductible as a section 162 expense. That leads me to ask what if a state passed a law saying that any charity that carries on any unrelated business activity must dedicate those proceeds to a charitable activity as a condition of carrying on the unrelated activity. Wouldn't that simply eliminate the UBIT because all of the payments would become tax deductible? I should note that this TAM is in fact not a dramatic change in the law. It follows pretty much the holdings of the South End Italian Independent Club, which is a 1986 Tax Court decision pretty much to the same effect and the Women of the Motion Picture Industry, a Tax Court memorandum decision in '97.

[163] The third area that suggest to me that UBIT is broadly elective are the allocation rules. Certainly the Second Circuit's decision in the Rensselaer Polytechnic case has become old law at this point. I'm not sure that the IRS has really become comfortable with that holding. A charity that wants to use a facility in an unrelated function doesn't need to simply allocate marginal costs to that unrelated business activity, but can fully allocate all of the expenses of the field house, in the case of the Rensselaer decision, that are properly allocable between an exempt use and a taxable use based on hours of use. I also find the exploitation rules that are set up to deal with advertising exempt periodicals to similarly be strikingly broad in the amount of deductions that can be allocated against unrelated income. Those rules state, and I often argue with people about whether they really mean this or not, that if an exempt function is being exploited by a unrelated business activity and the exempt function is of the sort of activity that taxable businesses carry on, such as maybe running professional football or running a taxable journal, that the expenses of the exempt function can be fully allocated against the unrelated business income, at least to bring UBIT down to zero. When you first read the exploitation rule, you think, geez, it's going to be a negative rule, but it can be used very effectively by exempt organizations to reduce or eliminate unrelated business income.

[164] The final area that Cathy and I talked about briefly involves the semi-creative use the Subpart F rules. It involves exempt organizations that might have, for example, taxable debt financed income which would otherwise be subject to tax under section 514. The question is, can it find a way through the use of a foreign corporation, through the use of some kind of blocker corporation, to avoid the imposition of UBIT. And, Cathy if you could address that briefly, it would be great.

[165] MS. LIVINGSTON: I don't have the ruling number in front of me, but you will find it in the Letter Ruling Alert in the February edition of EOTR. The Service has published the first ruling on Subpart F income and UBIT since the law was changed in 1996 to address Subpart F insurance income and what this ruling says is that a charity that's set up a wholly owned off-shore subsidiary, a tax haven of all places surprisingly, the Camens, then had that subsidiary invest as a partner in a partnership that was going to produce debt financed income. The ruling concludes that the charity has no UBIT as a result either of the partnership income before its paid out to the foreign subsidiary simply on the basic partnership rule concept that you have the income whether or not distributed, that doesn't generate UBIT. When the partnership actually makes a distribution to the foreign subsidiary such that the U.S. charity has Subpart F income, that Subpart F income will not be UBIT because the Subpart F income is analogized to a dividend which is a excludable from UBIT and then finally, when the foreign subsidiary actually makes a distribution of the dividend to the U.S. charity that as a dividend will be excludable from UBIT. So by interposing this wholly owned subsidiary in a tax haven between the charity and the debt financed income the debt financed income goes away. That's one place where the IRS has actually said you can do indirectly what you can't do directly. [LTR 199952086, see The Exempt Organization Tax Review, February 2000, p. 263 and 274.]

[166] MR. SPITZER: Cathy, I don't know if you are prepared to answer this question, but is there something unique about the fact that it involves unrelated debt financed income? What about investment in a partnership that's producing UBIT from a trade or business? Would this same technique perhaps work?

[167] MS. LIVINGSTON: To the best of my knowledge, and I'm no expert on Subpart F, I think it should, because the general principle articulated quite firmly in the ruling is that all Subpart F income except the Subpart F insurance income that's touched directly by section 512(b)(17) will be analogized to a dividend and therefore excludable. They repeat the rationale from a whole string of earlier private letter rulings that states that Subpart F is not about the incidence of taxation, it is about the timing. And, so if you are a taxable U.S. entity with Subpart F income, Subpart F could accelerate your responsibility for paying tax. But it cannot generate a liability for U.S. tax-exempt entity that it would not otherwise have. Now, I should say that the Treasury Department is due out with a Subpart F study. There has been a huge amount of study about Subpart F in the international tax community since the issuance of Notice 98-11 in 1998 and various congressional actions and debates since then. I don't think there is any intent for that Subpart F study to hit exempt organizations directly but it may cause some more in-depth analysis of Subpart F in this particular scheme could become a casualty of that but, that would be sometime in the future, it's going to take a while before anyone is going to do anything with Subpart F directly.

[168] MR. SPITZER: So all of those put together are by no means an exhaustive list of the exceptions that apply to UBIT, but it does at least raise a question as to whether the UBIT has effectively become an elective tax. For those organizations that do recognize UBIT, it has always been a question as to how much unrelated business income is too much. I know it is something that I'm sure all of our clients have asked us from time to time. The answer is never clear as to whether or not a little bit of UBIT is okay, but what if half of your income is from UBIT. To that end I thought that a 1999 Field Service Advisory prompted some thinking on this question.

[169] Field Service Advice 199910007 involves four charities that conduct an annual sports tournament. The Field Service Advice, although not giving exact numbers, makes it clear that the revenues of these charities are enormous from the conduct of the sports tournaments but that their expenditures are enormous as well. They are off set by a large amount of expenses, in particular payments to the pros of substantial amounts. At the end of the day only a very small amount of income actually gets paid to the charity. It gets paid over to another charitable organization. This Field Service Advice raised in my mind both the question of whether it's an unrelated activity or not and whether or not an organization that maybe spends 90 to 95 percent of its time conducting one kind of an activity that might otherwise be taxable and only gives a small amount of charity might retain its tax exempt status. I think that this Field Service Advise suggests that that can be the case.

[170] Now, thinking about this issue, I looked back a little bit and, as with many issues it brought to mind the expression that there is nothing new under the sun. There has been a lot written on this area, an outline and an article I recommend to you. One is by my co- panelist Dick Gallagher, who back in 1991 wrote an outline on the question of how much UBIT is too much. Also, an article by Tom Troyer in 1992 in Tax Notes addressed this question as well. They both point to a couple of significant points of guidance that we need to keep in mind. One is Rev. Rul. 64-182, which is familiar to us as the so- called commensurate-in-scope ruling, which holds that even an organization that's renting out space in an office building, and the ruling isn't clear as to whether that's generating UBIT or not, can retain its tax-exempt status so long as the charitable activities it conducts, which in that case I believe were giving money to other charities, are commensurate in scope with its assets. In thinking about that revenue ruling, the IRS at that time put together a general counsel memorandum, which it then revisited in 1971. It's a GCM that I think is highly instructive and it's one that I would recommend all of us to take a fresh look at if this question comes up.

[171] It's GCM 34682, I think in a very reasoned and logical manner it rejects the notion that just because you have a lot of UBIT, even if most of your income is UBIT, you don't necessarily lose your tax exempt status. The ruling says we simply cannot under the law apply that kind of test. So, that leaves us with cases where, for example, a charity that owns nothing but stock in an S corporation. Where all of its income is unrelated business income. But does it lose its exempt status for that reason? Absolutely not. What about a charity that's carrying on an active trade or business and generates lots of income from it. Yet it gives its net income away. In discretionary manner it hands over its income to another charity. Does it necessarily lose its exempt function because most of what it does is carrying on its taxable business?

[172] The answer is no, it doesn't lose its tax-exempt status. It is very surprising as we talk about the destination of income test that the Supreme Court had laid out in 1924 in the Trinidad case. We look at the unrelated business income rule as though it overruled the Supreme Court or changed the law that the Supreme Court was interpreting. With respect to the taxability of income, that's absolutely true. But with respect to the loss of tax exempt status it's not the case. Trinidad is still good law as to the question of whether or not an exempt organization carrying on a unrelated trade or business can retain its exempt status so long as the purpose of generating those funds is ultimately for charitable purposes.

[173] Now, this doesn't mean that anything goes. It is certainly the case that if there is a whiff of private inurement, or if this unrelated trade or business is really generating the insiders in the organization private benefit, that the IRS won't come in and aggressively enforce the law here. In that situation, yes, you've got to watch out if you've got too much UBIT. But, for the exempt organization that wants to carry on very substantial unrelated business income activities, I think that there is solid law for the proposition that it does not automatically jeopardize its tax exempt status because of that.

[174] The final point that I wanted to raise before moving to Cathy is kind of an intriguing question of whether or the IRS applies the unrelated business income tax as a form of intermediate sanction. It comes up in my mind in particular in the joint venture area where the IRS says, look, if you enter into a joint venture and you are not controlling that activity you may well jeopardize your tax exempt status. And that's fine where that's all the exempt entity is doing as in the whole hospital joint venture ruling. But it doesn't make a lot sense when you've got an enormous charity and it's entering into a so called ancillary joint venture as a relatively tiny part of its overall activities. But the IRS has said informally, and it will be interesting to see if this becomes more formally stated, that even if your exempt status remains intact, we are going to impose the unrelated business income tax on that income. Kind of as an intermediate sanction between loss of tax exemption and doing nothing at all. So, the UBIT, although to the jaundiced eye might appear somewhat elective, still remains an important enforcement tool for the IRS. Kind of a yellow flag for an exempt organization to simply slow down a little bit and to look at itself to see if it's doing too much of a unrelated business. Has it lost sight of its charitable purposes? But, if it can honestly answer to itself that no, it hasn't, that it is making good use of its assets, I think the organization can proceed forward.

[175] Okay, that was on somewhat of the academic level. Cathy, if you would address some of the legislative rules.

[176] MS. LIVINGSTON: I'll leave it to Dick to give us hand signals as whether these are theoretical or practical.

[177] We spent a whole day with the Hauser Center going into lots of different aspects of UBIT, allowing ourselves to be so theoretical as to think, what would happen if it disappeared altogether or if we could make wholesale changes to it? What would those look like and we ultimately concluded after a lot of discussion as Laurie said, that there wasn't anything that we could image that would be useful, productive, or principled that would support wholesale exempt or repeal of the UBIT or massive changes to it. But we did talk about some incremental changes that might make some significant improvements in the mechanics of the existing tax.

[178] We talked at first about section 512(b)(13) and I think Susan gave us a very cogent answer about where Treasury is on that currently. Section 512(b)(13) as you remember was changed in the 1997 law so that you no longer have the option of creating a second-tier subsidiary to avoid what would otherwise be the imposition of unrelated business income tax on returns of rents, royalties, or other kinds of deductible payments from the taxable subsidiary to the tax-exempt parent. Notwithstanding whatever policy concerns have been raised, that didn't stop us from discussing at some length the benefits that could be raised by trying to modify the statute again to allow some kind of appropriate arms-length measurement of payments between the subsidiary and the parent-principally, because of this odd result that occurs currently. But, say you are a tax-exempt charity, you've got a building. You live in the building, but you also have some empty space on the first floor. If you put your taxable subsidiary into that empty office space and charge them a market level of rent, that rent is going to be, in essence, a taxable stream of income.

[179] If you take an unrelated party and stick them into that same office space the rent back to you is going to be tax free, which gives you this odd incentive to kick your own child out of the building and bring somebody else in or maybe have your subsidiary switch office space with the unrelated entity across the street so that you can maximize the tax advantage of having that free and empty space in your own building. That does seem to a kind of a odd result. Now, Susan has suggested maybe what charities need to do is to consider whether they are willing to buy into all of the requirements that come with complying with section 482, and maybe charities are and maybe charities aren't. But I think it will be an ongoing concern to the tax-exempt community that section 512(b)(13) is currently producing this odd incentive pattern and that people will continue to make an effort to do something to change it so that at least charities will be indifferent as between doing business with their own subsidiaries than doing business with unrelated parties.

[180] We also talked about whether the debt financed income rules in section 514 make any sense. I went back and looked at an article that Susie McDowell wrote in the wake of a symposium that Laura Chisolm convened. It's a really comprehensive look at unrelated debt financed income and it appears in a Case Western Reserve Law Review from 1989, Volume 39 starting at page 705. Susie tried to spin through all the different potential policy rationales for why section 514 looks the way it does, and in particular, why under section 514(c)(9) we've given a free pass to pension plans and educational institutions that wish to acquire through debt financing real property, but we don't have that same kind of exemption for any other kind of section 501(c)(3) organization other than a tax entity. She said, well, does this have something to do with trying to encourage organizations to maintain public support -- support from the public at large so that they remain accountable rather than allowing them to, in effect, do a certain kind of overcharge where they use their tax-exempt status and leverage together to produce more income and to allow them support their activities in that fashion?

[181] She says that argument falls apart as soon as you allow at least some of the section 501(c)(3) organizations into the scheme and also it falls apart when you have Chapter 42 to police private foundations, and now we know we also have section 4958 to police accountability of public charities. So, using 514 as this very indirect and very burdensome means of ensuring public support or insuring that is public accountability doesn't seem to be a very strong argument. Potentially you could say 514 was in there to police the so-called Clay Brown transactions and on trading on tax-exempt status, as that decision and others have since said, is one of the rationales.

[182] But, she makes some very good arguments as to why that also falls apart, because she points out that even though it does create parity with respect to any stream of income that is debt financed, it's very rare that 100 percent of the income coming out of any of these kinds of partnership arrangements is going to be debt financed, and that means the tax-exempt partner is going to continue to have a comparative advantage compared the taxable partners in a transaction. We know that the debt-financed rules clearly do shut down some of that kind of trading and arbitrage until the 337(d) regulations came down. There certainly were Indian tribes and other tax exempts that were interposing themselves into the stream transaction and allowing abusive tax shelters or other kinds of questionable schemes to go forward, and we know that the Treasury set up proposals on abusive tax shelters including a specific tax on tax in different entities that participate in these kinds of schemes. If section 514 were really shutting this stuff down they wouldn't need to add those additional measures. Then last of all she says as long as we believe strongly in having the stream of passive income remain tax free for tax-exempt entities then we can't be complaining that when you add leverage to the picture somehow it's a slightly sweeter stream.

[183] Either we want the passive income to be tax free to help support the activities of the organization and maintain trust with the donors or we don't. I think her set of arguments is pretty persuasive and may cause us to want to take some action or make some proposals about getting section 514 cut back or repealed altogether because it creates a tremendous amount of legal work and not necessarily a tremendous amount of benefits. Another thing we talked about was enforcement in the gift shop area where we all know that inside any museum gift shop or any other gift shop operated by a charity, you've got a mix of some kinds of articles that are taxable when sold and sometimes which are not. There are number of TAMs out which were discussed at some length and very helpfully in Dick's outline that tell you how you try and make that distinction. But, when I was still in government, I had a very interesting meeting with a senator who walked in with Don Lubick and the senator said, nice to see you, I have a question for you, and he held up two neckties and he said, which one is taxable.

[184] One of these was sold by a museum gift shop in New York, one of these was sold by a museum gift shop in Virginia, one of them was taxable, one of them was not; you tell me which is which and, for the life of us we obviously couldn't answer the questions, they just looked like to fairly nice neckties. He gave us the neckties. He said you take them back to Treasury and you try and figure out how we are going to get some consistency here, short of the IRS starting to publish for their agents large photographic catalogues for neckwear and trying to explain to them these kind are taxable and these kind aren't. This does point out a big problem and it's going to get worse with the Internet because now all of these organizations have figured out that you can take their gift shop and you can put it online and you can generate significantly more revenue by selling to people who can't necessarily make it to your institution. As long as the Internet Tax Freedom Act is in effect there's no sales tax owed on this stuff either and that makes it a particularly an inviting time to go out there and make sales over the Internet.

[185] I think this is going to put some pressure on what has been a sort of an ad hoc system which has been going as well as it can, but the chewing gum and rubber band may come apart reasonably soon and we may get a lot more pressure from exempt organizations to getting a more rational and published scheme that explains when am I going to have UBIT on my gift shop sales and when am I not. Also there is a limitation contained inside the corporate sponsorship statutes of section 513(i) which may get another look, particularly after we get past the regulatory stage and we see how this whole scheme is working in practice, and that is the limitation in section 513(i) which says corporate sponsorship works except in periodicals. When you have a periodical somehow the statutory provisions don't apply and that leaves you sort of scratching your head and saying well what does apply, maybe it's sort of like an organization that doesn't make the section 501(h) election 4911 in the regulations under there don't apply, but it's the only thing we have so we incorporate it by reference as kind of a touch point. Maybe the same thing will happen with periodical advertising.

[186] We don't have section 513(i) directly available, but we might use the same acknowledgment advertisement distinction as a way of figuring out where that box appears on half the page in the monthly magazine of the organization is or is not going to generate UBIT for the organization. But it may be worked out, particularly if as we all hope, the corporate sponsorship scheme in the regulations thereunder make things work reasonably well and give you a fair degree of certainty -- establish some limits where the charities know there are certain places you cannot go unless you want to pay this UBIT tax that comes with them. Maybe there will be consensus that it would be appropriate to apply those same rules directly to periodicals as well. Call that a wish list if you will for improvement in UBIT, section 512(b)(13) debt financed income, the periodical limitation in section 513(i), and consistent enforcement in the gift shop area.

[187] I will just mention finally one other item where we rejected the value of making an effort for improvement and that's in the cost allocation area. There has been a crying need in some sectors for a long time for understanding of what kind of cost allocation is or isn't acceptable to the IRS. In fact our higher education community has made a fairly formal proposal to the Treasury and the IRS asking for approval of certain mechanisms they use according to the federal grant rules. Harvey Dale was the one who made this point and I have to say that I personally do agree with him. He said we could put a huge amount time and effort into outlining cost allocations schemes for UBIT, but is it worth it? There's a huge amount of time and effort that goes into cost allocation on the taxable side of the House, and the people who deal with those rules say it may not necessarily be to your benefit to have a greater degree of specificity you may be living in the best of all possible worlds and Rensselaer Polytech as Lorry acknowledged because it allows you pretty much to do whatever you think is reasonable and if you can articulate good reasons for it and you can get your auditors and accountants to agree, maybe that's far better than having the IRS dictate anything to you even as a safe harbor so at least within the confines of that day of thinking hard about UBIT that we did not come to any consensus that it would be beneficial to the system to improve the specificity of the rules on cost allocation.

[188] MR. SPITZER: We should point out that in the audio tape version of the presentation today the ABA is going to use the newest digital technology and both Dick's and my talk will be shortened by several minutes by removing the uh and ahs. Cathy's talk actually will not be shortened it will be slightly lengthened. I don't know how you can think so fast, but that was great.

[189] MS. LIVINGSTON: I was keeping my eye on my watch Lorry because I knew it was lunchtime.

[190] MR. GALLAGHER: I have three random thoughts which I will try to dispel quickly with no ums and ahs. The first is one of the interesting aspects of the IRS reorganization -- whether or not they can in fact create some consistency between the ruling approach and the litigation approach. Orange County, you may recall some time ago, Orange County, New York was a case in which the court ruled there was private inurement throughout the case. The court ruled against the Orange County Air Cultural Society on a basis that the IRS would have clearly given up a favorable ruling and that had to do with the fact that the litigating people, including the Justice Department in certain circumstances don't necessarily talk to headquarters. The second is that, in all the discussion about UBIT we need to realize there's a distinction between private foundations and public charities. Private foundations have a limitation that they cannot have UBIT if it's produced from a sole proprietorship activity because it is automatically 100-percent excess business holding which is in excess of the 20-percent limitation unless it's in the context of a functioning related business in which case you've got an 85- percent limitation and some greater room. And, in that context, Lorry made the point that an organization that held all Subchapter S stock would not lose its exemption, I pulled up the following hypothetical to you for it to ruminate on. A private foundations sole asset is a 20 percent interest in an S corporation. No disqualified person owns any stock in the S corporation, it has no ability to influence the board of directors as to its distribution and dividend policies and in fact, the board of directors regularly distributes only enough cash to pay the taxes on the S corporation dividends. It happens coincidentally that the amount of cash annually distributed by the board of directors to pay the taxes on the dividends on the S corporation income is equal exactly to 5 percent of the value of the holding of the S corporation stock by the private foundation. Under section 4942 the foundation gets credit against its distributable amount for the amount of income taxes it pays. Therefore, it pays out the entire amount it receives in income taxes and has a distributable amount of zero, is that foundation still exempt?

[191] MR. SANDERS: Cathy, another point when you are talking about section 514(c)(9), on one of the impossible areas are the fractions rule and very few people really understand it and that's another question, is it really necessary at this point when you are dealing with partnership allocations.

[192] MR. WHALEY: Last year or the year before last, there was a private ruling violation and it involved a section (c)(3) organization that held a fairground and it only operated its fair about 16 days out of the year and it rented out the fair grounds to a number of organizations throughout the year from several days to several weeks. It rendered services to the lessees or users and the IRS in the private ruling analyzed those services they found that some of the services really were not for the benefit of the lessee but to protect the interest of the lessor and some of the services clearly were for the benefit of the lessees. Those were separately charged for and the IRS ruled that the ones that benefited the lessees were unrelated trade or business income but the rents were never taxed, which suggested if you'd separately break services out in set circumstances you can avoid the rule that says that if rental income -- services are involved -- that the rental income is not taxable. I have questions as to whether that ruling is good. I could argue the other way but I'd point out that that's out there. The other thing that I'd like to point out because discussion is being disseminated and will be printed and, that is that many organizations like you were saying are -- rather than decide how much UBIT they should have they're going to put it in a for profit subsidiary.

The Future Regulation of Charities -- The Case for

[194] MS. BJORKLUND: As Bob said, this panel is an outgrowth of a program held at the National Program on Philanthropy and the Law at NYU Law School in October 1999 on private foundations. All of us participated in that program. In the January 2000 issue of The Exempt Organization Tax Review, you will find the papers from that program have been published, including Bob Ferguson's program paper, "Avoiding Private Foundation Status," which goes through many of the issues that we are going to be talking about and Tom Troyer's paper, "The 1969 Private Foundation Law Historical Perspective on Its Origins and Underpinnings." If you have an interest in this topic and haven't read those papers, I commend them to you because they're very thought provoking. What they did was provoke a discussion among the people in that room where we all started to say, "Do we need a two- tier system?" and, if so, what would it look like? If we're going to change from the system that we have now, should we go to a one-tier system and, if so, what would it look like? So we thought that we might try to raise some of these issues in an informal discussion today just so that we could get your thoughts on this topic.

[195] We all think of the private foundation rules as something that we live with and work with everyday. It was very interesting to me for me to read an article recently that put them in the perspective of history. These were written in 1969, at the time of the Vietnam War, long hair, and a very different cultural setting. We look back at that and say, "Oh God, that was so long ago." And yet, the rules are the same as they were then. So, has there been so much change such that these rules should change as well? Wright Patman's hearings into charity operations and anecdotal testimony on abuses by those in control of closely held charities and the subsequent Treasury report really shaped the way that these rules evolved or were enacted. But the question now is, "Are the abuses that were chronicled in the '50s and '60s the abuses that would exist or do exist today?" Are these rules from 1969 the correct ones? Do they need tweaking?

[196] In order to frame the discussion we thought it would be helpful to state some guiding principles. I think that when the 1969 Act was made into law there was an expectation, at least on the part of Wright Patman, that existing foundations would terminate in large numbers and therefore section 507, the private foundation termination rules, would apply. I don't think that that happened, even though that was the expectation. The legacy is that we are left with section 507. We've heard about section 507 today; I will not go into it. I think that there was an expectation that new foundations would not be formed. I'm going to come back to that in a minute. I think there was an expectation that the section 4940 tax on net investment income would be used to subsidize a very large and effective regulatory scheme. There was an expectation that increased regulation would keep private foundations in check. There was an expectation that payment of private foundation excise taxes would be substantial where behavior modification failed and lines were crossed.

[197] Now what has happened in these 32 years with regard to those expectations? There was no spate of terminations between 1969 and 1975. Were people inhibited from creating new foundations? The Council on Foundations records show that there were 2,000 foundations in 1950 and that there were 46,000 foundations in 1999.

[198] What I find interesting about those statistics, which come from the Council on Foundations 50th Anniversary Magazine issue, is that the percentage of private foundations to all charities remained unchanged from 1950 to the present. By comparison, if there were 46,000 private foundations in 1999 it's also interesting to note that there were 25,962 supporting organizations in 1999. Of course, the supporting organization alternative was created under the same 1969 Act. Out of the 46,000 private foundations only about 30 percent or about 12,200 held assets in excess of $1 million or more or made grants of $100,000 or more per year.

[199] The third expectation I talked about was the section 4940 tax. Has that in fact been expended on regulation? As we know, the answer to that question is no. And we are going to talk more about that in a minute.

[200] Has regulation increased to keep private foundations in check? Have private foundations been paying significant excise taxes? We are going to talk about these guiding principles and how they have played out by referring to a chart, which is the last item in the committee handout. We're going to just do this in a very informal way and go down the Chapter 42 excise taxes and talk about the case for applying or for not applying these rules to all charities equally. Marc Owens has put together another one-page handout in the back, and we are going to be referring to this as well.

[201] MR. OWENS: There are actually two handouts. One is the examination experience in the private foundation area beginning in the 1990 fiscal year and the second is a front and back single sheet with excise tax collections from 1971 on and the Form 990-PF return filings from 1990 on.

[202] MS. BJORKLUND: So, let's start with section 4940. Fred Stokeld wrote an article in the October 4, 1999, issue of Tax Notes entitled "Is It Time to Give the Foundation Tax the Heave Ho?" So a lot of people are asking these questions. We tried to find how many times this provision had been cited for example, in ruling requests. It's kind of hard to do that by doing a Lexis or Westlaw search but we found 283 citations to section 4940. We know that this provision does not apply to public charities but only to private foundations. We know it's the only excise tax that cannot be avoided and we know that it has changed in amount over the years. So, Marc and Celia, what do we think we can say about 4940?

[203] MR. OWENS: In terms of systematic analysis, the Service recently completed a audit project involving a small sample of small private foundations and, one of the findings from that study was that the 4940 tax is a little difficult for the smaller organizations to calculate. There was not an insignificant error rate found in making those calculations, in both directions, by the way -- not only in one direction, as a cynic might suspect -- indicating that there really are some true problems in how to calculate that tax even if you are trying hard. I guess from our standpoint the 4940 tax even after a quarter century or so is a difficult thing for foundations to grapple with.

[204] MS. ROADY: I think Fred Stokeld had it right. There are a lot of problems with the 4940 tax. We all know that it doesn't achieve the purposes it was intended to. It raises far more revenue than expected and the revenues have never been devoted to the intended purpose. The provision that would even allow that to happen is now gone. So, we have to ask ourselves whether this tax serves any legitimate purpose. It may be a good time to look at it now because we're in a situation where we have budget surpluses. There is also a further issue, which is the complexity of the tax, which Marc talked about.

[205] The complexity is further complicated by a provision that was intended to be beneficial to foundations, and that's the ability to pay a 1-percent excise tax instead of paying a 2-percent excise tax. That provision is very complex as well. Some foundations do take advantage of that provision and go through the calculation. But the way that provision works, foundations can actually be penalized if they pay out an extra amount, which increases the base amount and makes it harder to qualify for the 1-percent tax. The question we should be asking is whether there any reason at all for private foundations to pay the tax?

[206] I think the answer is no from a policy standpoint. But at a minimum, there is no reason to have this 2-percent or 1-percent alternative. The excise taxes that are paid by foundations reduce dollar for dollar the amount of their payout requirement. By eliminating the tax, we would simply redirect the money from the federal Treasury into the charitable stream. I assume the folks at Treasury are mindful of these points and will be thinking about this for the coming legislative season. Perhaps Fred was a good predictor and the time has come to do something on this.

[207] MS. BJORKLUND: Let's skip over section 4941 so that we can do it with public charity analogue, section 4958. Let's jump instead to section 4942, the tax on undistributed income. Public charities have no payout obligation and yet we know that most public charities are presumed to be expending large amounts of money. We just heard a presentation on what they may or may not be expending it on which may or may not be their charitable purposes. This provision doesn't seem to be one where people have gone in for a huge number of rulings. There were 975 cites and, Marc and Celia, what do we think about public charities, private foundations, and the need for the minimum payout rule?

[208] MR. OWENS: I guess here, I would point to the chart on excise tax collections which shows that there certainly doesn't seem to be any common theme here. And frankly that's another finding of the last two systematic reviews that the Service did of foundations -- with regard to the Chapter 42 taxes, generally there is pretty good compliance. There are anecdotal instances of problems in all the excise taxes but nothing systemic. The excise tax regimen seems to operate at least with that level of success as a measurement.

[209] MS. ROADY: In preparing for this panel, I had a chance to re-read Tom Troyer's paper that was written for the NYU conference. Victoria mentioned it; it's in the January issue of the EOTR. Tom's paper was instructive on the issue of the payout requirement, and why it should apply only to private foundations and not public charities. Tom reviews the original rationale for this distinction, which is compelling today. It has to do with the issue of control and the extent to which the folks who are in control of the organization are the ones who are putting their charitable dollars into the organization. There is an immediate tax deduction, of course, for contributions to foundations, and the payout requirement was intended to ensure a commensurate public benefit in terms of distributions into the charitable stream.

[210] The payout distinction reflects a balancing in terms of what degree of regulation is appropriate. Public charities that have the diverse control and that are not controlled by one individual should have more latitude in how they go about conducting their charitable programs; foundations, particularly those under the founder's control, need these kinds of restrictions. As far as I know, the Council on Foundations and other foundation groups are not clamoring for repeal of the payout requirement, and this is another indication that the original purpose continues to be valid.

[211] MR. OWENS: I think it might be an observation that the luncheon presentation also involved potential issues relating to payout rates of public charities and whether there might not be need for something similar by applicable there. I agree with Celia that there is no great cry to get rid of the requirement and I think that if we were to do that there are a large number of private foundations who would probably take their spending down below the 5 percent that they are currently required to expend. There may be some that are just making it because they know they have to. I'm a little more concerned as to why it is thought that there is no spending requirement that ought to be imposed on public charities. In saying that, I don't mean all public charities but rather those that are not private foundations because they qualify under section 170(b)(1)(A)(vi). Operating charities, churches, hospitals, what have you, have their budgets and they have plenty of calls on their finances to make sure that they, or most of them, make sure that they spend what they should be on programs. Section 509(a)(2)s end up getting their funds primarily from services and therefore there is a pull that is very direct on them to make expenditures because the people that are giving them money require it.

[212] There is no such analogue for a section 170(b)(1)(A)(vi) where contributions come in from the public and the expenditures are to a completely different group -- the charitable class that they support with donor advised funds being a good example where the fund managers that put these things together can increase their management fees by accumulating income and enlarging the fund. I'm not at all convinced that a section 170(b)(1)(A)(vi) ought not to be subject to these requirements and if it were me I'd have one set of rules apply to all and it would be to apply the section 4942 requirement on the public charities.

[213] MS. BJORKLUND: I'm glad you mentioned the donor advised fund because I wanted to mention that as a footnote. Several donor advised funds, including those initiated by Vanguard Charitable Endowment Program and the Fidelity Gift Fund, have voluntarily adopted a group-wide 5-percent payout minimum. A question that had been raised in the past is how should that be done, on a fund-by-fund basis or on an aggregation-of-funds basis? The organizations have voluntarily adopted a 5-percent payout on an aggregated basis, which is similar to what we have here for private foundations.

[214] The next provision is section 4943, the tax on excess business holdings. It does not apply to public charities; it does apply to private foundations and there was a new proposal to amend the threshold, which we can talk about in a minute. This is one of the least ruled on of the Chapter 42 provisions. We got 355 hits. Then we look at Marc's chart. Marc maybe you can talk a little bit about section 4943 because those look like small numbers to me on your chart.

[215] MR. OWENS: I would say that certainly based on my experiences, well, it's a rare day when you see a section 4943 issue come up, and that's reflected in the excise tax data as well. I think, it seems to be a rule that is much more easily self administered.

[216] MS. BJORKLUND: I guess, then, the question arises as to why is someone lobbying to get this provision changed?

[217] MS. ROADY: That's a good question. I could speculate but I certainly can't answer that question. One thing I would note is that Tom Troyer's article is helpful and instructive on this issue as well. Apparently an analysis was done before the 1969 Act, before the excess business holdings rules came into play, as to what kind of returns foundations got on, what would now be called excess business holdings. Not surprisingly, the study showed that foundations were getting very low returns on these investments. Accordingly, the study concluded that there must be another reason for foundations to hold these investments. Tom's article has some wonderful quotes from some of the financial planning magazines of the era that talk about how "this is the way to keep control of your family business without having to pay taxes," and "you can have family members that can be employed by the foundation and still run the business," and so forth. There seems to have been good evidence of abuses in the pre-excess- business-holdings days, and I would imagine that abuses would happen if the rules were eliminated. In terms of public charities, once gain we can see that the control factors are different and should be decisive. It's also important to remember that public charities often have wholly owned for-profit subsidiaries, which serve very important functions for the organizations.

[218] MS. BJORKLUND: We should note that the supporting organization provides a planning opportunity to do in a jointly controlled entity what the private foundation doesn't allow with the excess business holdings. There have been questions about whether there should be application of the excess business holdings limits in other contexts. But certainly, if someone has a wholly owned business to leave to an entity, they think of their college or university or supporting organization generally because of these rules. So we do know that this rule has had a behavior-modification effect.

[219] Let's turn to the next tax, section 4944, the tax on investments that jeopardize charitable purposes. The jeopardy investment tax does not apply to public charities but does apply to private foundations. In New York, if not in other states, we do see the state attorney general actively pursuing questions of diversification and the appropriateness of holding particular assets. We got 292 cites for the jeopardizing-investment provision, which is quite a bit lower than for some of the other provisions.

[220] MR. OWENS: The excise tax collections here show that this is the least common of the Chapter 42 taxes and indeed we took a quick poll of some of our old timers in the Division to see if they recall seeing any significant 4944 cases and what they might have involved and just a handful of fact patterns were brought up and things that were fairly obvious, like a private foundation selling its entire endowment short, things like that. It certainly doesn't seem to be an area where the foundations are exploring the gray margin; they seem to be staying clear of things that are questionable for the most part.

[221] MS. ROADY: Victoria, my guess is that most of those 292 cites under section 4944 actually relate to program related investments rather than jeopardizing investments per se.

[222] MS. BJORKLUND: I think you are right.

[223] MS. ROADY: In my experience, there are relatively few transactions which might actually be jeopardy investments. Marc's numbers bear this out. One question here is whether this area is best enforced by the IRS or is more properly enforced by the state attorney general.

[224] MS. BJORKLUND: I do have an active matter now under this provision. I'm not going to go into it but one should also be aware that this is an abatable penalty and when people in good faith try to do the right thing on their investments. We do work with clients all the time on investments, and we show them the regulations that were written in 1972. They look at that list and they laugh because it sounds like these are horrible things and yet today risk management prescribes many of these as the way of managing one's portfolio in accordance with modern portfolio management theories. There is a disconnect there, or, perhaps like our bell bottoms and other things that we don't care to recall, this provision is showing its age.

[225] Section 4945, the tax on taxable expenditures is next. It does not apply to public charities; it does apply to private foundations; and covers things like grants to foreign organizations, grants to individuals, and lobbying expenditures. We got the most citation hits on this provision, 2,146. Comments?

[226] MR. OWENS: I guess I would point out that some aspects of section 4945 do have analogous provisions for public charities. When you look at the section 4955 excise tax on political campaign expenditures and on the section 4911 lobbying tax you see some similar rules applicable to public charities. We do see section 4945 violations from time to time. The statistics on excise tax collections suggest it's not overly common, but it does occur. It seems that the cases, more recently, have been a spate of political campaign expenditure cases with private foundations either making political contributions directly or perhaps involved in some sort of indirect campaign contribution, so there does seem to be some audit interest on section 4945.

[227] MS. ROADY: I think Marc makes a good point. In some parts of section 4945, we really do have parity with public charities. For example, the prohibition on making political expenditures is the same for both, it's just enforced under sections 4955 or 4945 depending on whether you are a public charity or a private foundation. The lobbying rules are a bit different but the definitions are largely the same, at least for private foundations and electing public charities. But section 4945 also has a lot of fairly picky rules about various kinds of grantmaking, and here one has to question the benefits versus the burdens of those kinds of rules. As the meeting of the Subcommittee on Private Foundations this morning, John Edie handed out a proposal to simplify international grantmaking that the Council on Foundations is working on with the IRS and Treasury. This proposal makes a lot of sense. There are a lot of funny quirky little rules in section 4945 that just can't be worth the candle. Given the costs to foundations in complying with some of these rules, are we really protecting foundation assets from misuse in any significant way? I think the answer is no. This is an area that may not need legislative changes, but certainly could benefit from some administrative review, particularly in areas like international grantmaking, equivalency rulings, and flow through requirements.

[228] MR. FERGUSON: I'd like to put a big amen to what Celia has just said and ask Marc a question. If he has the answer available; you may not. It seems to me that the section 4945 taxes that come into the Treasury each year, probably a small part of them from unintended mistakes perhaps for the unwarily who screw up on the procedures as Celia was talking about, and the much greater percentage or probably violations of the substance of section 4945, which never were reported on the return in the first place and where the procedures are ignored or just never get reported on the return. If that's the case, it seems to me that simplifying the grantmaking stuff would do nothing except get rid of those who pay the tax because they made an inadvertent mistake and that the rest of the taxes that are raised are raised because of substantive violations that never appear in the return in the first place; is that a good profile for what's happening?

[229] MR. OWENS: Well, it's a little hard to make the statistics tell that kind of story with great definitiveness. We did do a statistically valid study back in 1990 of a sample of foundations and focused on the incidents of self-identification and payment of excise taxes and it's virtually nil.

[230] MR. FERGUSON: Our office has eight copies of Form 4720 and they are yellow with age.

[231] MS. BJORKLUND: I do want to underscore something that Celia mentioned, and that is the global grantmaking both by public charities and by private foundations. This has grown exponentially since these rules were adopted. The compliance costs are enormous. We have a client that puts paralegals on airplanes and flies them to various places around the world to collect the expenditure responsibility forms. They know they have to do this, but it strains cost/benefit analysis to get the forms. It's not a question of noncompliance. But, we really have to all creatively think about this and think about what we want to do with this provision.

[232] We've saved the best for last, sections 4941 and 4958. Section 4941 is the tax on self-dealing. We got 1,088 hits on that one. No fairness standard applies. We've talked about it today, that it is an all-or-nothing, black-line test. Compare section 4958. I noted here that it is still too new to evaluate in practice and that it incorporates a fairness standard. So this is the situation where the positive experience with the section 4941 tax lead to the enactment of a corresponding provision for public charities.

[233] MR. OWENS: I think here, we do see self-dealing issues come up in the prior foundation audits the numbers may not always be significant but we do see them from time to time. Section 4958 tax, it is true, is probably to new to compare. I think that over time it's going to be very interesting, because Congress took completely opposite approaches to dealing with the transgression. Section 4941, of course, prohibiting all except for a certain narrow categories of interactions; section 4958 taking a different approach and allowing only the excess to be taxed. Which one works better, I don't know, but certainly we do see self-dealing from time to time and some of the self-dealing acts can be rather large.

[234] MS. BJORKLUND: Marc, I wonder if you could generalize on whether the self-dealing acts that you see are the kind of things that would also be violations of section 4958. If we were dealing with a public charity, i.e., non-fair market value transactions, versus somebody who is doing a below market rent of foundation space from a disqualified person. Do we know whether -- which kind you see?

[235] MR. OWENS: Well, I would have to sort of rely on an anecdotal sense of that. The statistical data doesn't divide up that way. My guess, though, would be that the majority of cases involved those kinds of transactions that would not trigger section 4958 tax. In other words, there are some where effort was made to try and give the foundation the better part of the deal. It just so happens that it was structurally bad and was constructed by people ignorant of the rules or for what ever reason. The larger dollar amounts I think do represent problematic situations that would also be section 4958 excess benefit transactions. We do see some of those, they tend to be the bigger cases.

[236] MS. ROADY: I think section 4941 can be a trap for the unwary for small foundations that get their tax exemptions and then go off and operate on their own based on common sense. It's easy for these foundations to inadvertently stumble into some self-dealing transactions. There is a legitimate question as to whether section 4941 is needed, or whether section 4958 would do sufficient to hit non-fair market value transactions. Are we mainly catching people for foot faults that aren't really abusive? I don't know, but that's an interesting question. With overreaching clients, section 4941 is a handy thing to have, since we can say "you can't do it." But after we've had experience with section 4958 for some period of time, we may be in a better position to decide whether we should go to one standard or the other.

[237] MS. BJORKLUND: I think our time is up, but do we have any questions.

[238] PROF. BRODY: I have a question, I'm not sure it's an excess business holding question or a jeopardy investment question; it's about diversification. My big thing is diversification and you can have a private foundation as we do that owns less than 20 percent of the company and have 100 percent of its assets in that company if it's a very big company and so we have some rather larger foundations whose fortunes go up and down with the value of the company and I don't know why. We don't want that to be treated as a jeopardy investment; it's not an excess business holding and then I guess more to the point, why don't we want a jeopardy investment concept like that, a diversification requirement to apply to public charities as well? There are some universities that are saddled with stock that the donor requires them to hold or something like that, and that bothers me. Also, Marc talked about how turning over your endowment might be a jeopardy investment. Think about the charities that put their money with New Era Philanthropy. They weren't private foundations that were doing that, but they were making a play for that. I don't know what happened to them, I assume they have no tax problems but why shouldn't those fiduciaries have to account for that?

[239] MS. BJORKLUND: I think that you answered your own question, in part by using the word fiduciary. I think this has been traditionally been an area of state law rather than federal law. Are the state regulators looking at these questions? In New York, the state regulators are acting very aggressively. They are asking questions about diversification. They are asking about holdings of public charities and private foundations. And when they ask them of private foundations it's interesting that they do refer to the federal law.

[240] PROF. BRODY: Do the New York regulators apply federal law?

[241] MS. BJORKLUND: Well, no it's more like "We're asking you because we know you also have this federal obligation and we want to know how you are treating it for your 990-PF, but we are also asking because we are interested."

[242] MR. STAFFER: One of the items that did not make it into the 1969 Bill but was in the proposal was a limited life for private foundations and I'd like to know what this panel thinks of re- instituting that. I've had two clients who specifically have asked for only 25 years on their private foundations.

[243] MR. OWENS: I would only note that I have seen news accounts of foundations that have tried to spend themselves out existence and have been unable to do so.

[244] MS. ROADY: We're working with one of those foundations right now. In this case, the founder expressed the goal that this foundation would have a limited life but the stock market gains the last few years have made it difficult for the organization to ramp up its spending enough to do that. In general, though, I think there's no justification to impose a limited life on foundations. There is abundant evidence that foundations are serving a very useful purpose and it's hard to imagine any policy justification for limiting their useful life.

[245] MR. FERGUSON: We have two more questions. I'd ask that they be brief because we are running into the time for the cash bar, and nobody wants to --

[246] MR. GALLAGHER: Three brief observations and one question. I think there are three areas for possible expansion of this discussion that haven't been raised today. One of them is a follow-up on Eric who was actually only half right. The limited life got knocked out of the 1969 Act but the termination tax, which makes no sense outside the context of a limited life, got enacted and took on a light of its own. That's a question of why that still exists. The second is that part of the existing private foundation rules, it seems to me, ought to be examined in the context of who the penalties apply against. The intermediate sanctions, the theory was we had to get the innocent party out of the way of being the penalized party and in fact they both of them jeopardizing investment and the section 4945 tax, but we have the foundation being hurt. I had a very large jeopardizing assessment imposed upon [inaudible] didn't make any money but there's no loss of money. The only loss of money was the money that was paid to the IRS -- sort of jeopardizing investment tax, which seems kind of silly to me. The third in this context seems to me if we are going to have a different set of rules apply to public charities and private foundations we ought to go back and examine what a private foundation is.

[247] Those definitions are 30-years old and they were politicized and the section 509(a)(2) we think are symphonies but they were originally intended to be garden clubs and we still have the $5,000 substantial contributor limitation so you can convert a section 509(a)(2) into a private foundation much to easily. I've seen that happen several times so we ought to be reexamining the whole question of what is a private foundation. My question is, can this committee do something about all that, can we take that on as a meaningful project, and since much of it has to take place in the statutory context it's not something the Treasury can change or the IRS can change and the IRS is not showing a great propensity for going out and making statutory changes. Is that something we can do something about, should that be a meaningful project for this committee?

[248] MS. BJORKLUND: I refer that question to our chairman.

[249] MR. FERGUSON: Dick was that a voluntary? I think we may. If there is -- we can talk about it after the meeting and if there's nothing trespassing it would be appropriate.

[250] MS. BJORKLUND: I think part of the reason that we are having this discussion is because these are very thought provoking questions.

[251] MR. COLVIN: A couple of comments, I think, from Celia refer to the underlining policy concern with control by the owners of the entity and I wondered if more attention could be given to that and the regulatory structure that we now have. It's only really significant in section 509(a)(3) where there is a 49 percent limit on donor control but it seems to me that you might end up with a much simpler system. If that were focused on as the test for allowing greater latitude, deciding where the public charity is, or deciding what a private foundation is and strictly regulating them.

[252] MS. BJORKLUND: Thank you all very much!

[253] MR. FERGUSON: Our last panel is a discussion of the burned out hospitals and Victoria and I are both going to sit down because this is a huge panel.

Life After Health Care -- Post Acquisition Problems of

[255] This is also a very good panel to follow the preceding panel as you'll see as we talk about some of the public charity, private foundation crossover issues that arise here. This is a very different environment from the classic private foundation context where you have essentially organizations without substantial operating assets. Here you've got hospitals that have substantial operating assets that have now converted either wholly or partially through joint ventures into non-operating organizations with cash assets but with many difficult transitional issues.

[256] So, what I'd like to do is briefly introduce the panel in the order that they will be proceeding. Second to my right is Jim Schwartz, Jim is now partner with Manatt, Phelps & Phillips in Los Angeles and he recently joined that firm a very distinguished career as a deputy attorney general in the California Office of the Attorney General where he has handled charitable trusts and charitable organization matters for decades.

[257] To my immediate right is George Reyes. George is a Partner with Best, Best & Krieger in Riverside, California, and George actually is going to be talking about the issues from the perspective of the health lawyer between a rock and a hard place. The rock being the IRS and the hard place being the attorney general here in California. I'm going to be talking about some of the public charity, private foundation issues and Jim has passed out to you a PLR that we'll be focusing on because it raises a wide range of section 4940 through section 4945 issues.

[258] Marc, of course, is going to be talking about the Internal Revenue Service perspective both at Headquarters and in the field and the initiatives there. And then to Marc's left is Leonard Avant, who is a Revenue Agent from Denver. I've had the privilege of locking horns with Leonard since 1990 and the very first CEP audit and he brings the perspective from ground zero. So, we are going to proceed in that order. I'd like to turn it over to Jim to talk about some charitable trusts pre- and post-sale issues.

[259] MR. SCHWARTZ: Thanks Doug. My distinguished career has now changed and I have gone over to the dark side as we say. I'm not a tax lawyer; I'm at best cocktail party dangerous. So I won't try and talk to you about tax law, but I will talk to you a little bit about charitable trust law. Because when we deal with hospital conversions, which is the colloquial way we refer to these transactions, it is charitable trust law that tends in fact to drive the deal. That is because state regulators, whether they're at the attorney general's office or the Department of Insurance or whatever the specific agency is, tend to impose conditions on the transaction. Those conditions, at least in California, will find their way into amended articles and bylaws of the charitable corporation and subsequently find their way into court approval procedures. There ends up being a court order that tells you exactly what restrictions exist on how a conversion foundation can use its money.

[260] These rules, quite frankly, differ significantly from state to state. You don't have the same certainty that you might have in the federal tax system where you have a single agency making decisions. In the state venues you will have some state attorneys general who, for example, take a laissez faire attitude, saying essentially that a conversion foundation may use its money for anything it wants to, provided it doesn't cost them their 501(c)(3) status. In the middle are states -- New York is one -- that use something called the quasi cy pres standard. That standard allows you to use the assets for health purposes if you are foundation created from a hospital conversion, but does not put specific restrictions on that use, i.e., if it's for health purposes that will be sufficient. And, then you have states like California, which follow a very strict cy pres rule. The phrase is actually cy pres comme possible, which is normal French for "or nearly as possible" and that's exactly what it means. And so, we have in this state requirements that the monies that are generated from hospital conversions and that go into these foundations be used for restricted purposes and are tied to past performances when it was an acute care hospital.

[261] I was told that we should talk about post conversion issues so I don't want to get too involved in pre-conversion issues, except to tell you that these are the rules that affect the deals. After the deal is closed, the attorney general in California is committed to annual auditing of the post-conversion foundations. There has recently been a bill enacted in California, AB-254, authored by Gil Cedillo, that actually pays the attorney general for doing such audits, i.e., the attorney general can now collect from the charity the costs of auditing. There is a slightly different rule for amounts of for-profit conversions. In for-profit conversions there is no time limit on how long the attorney general can charge the charity for these amounts. In nonprofit-to-nonprofit deals, which we now cover in California as of January 1 of this year, the language is somewhat ambiguous. It talks about a two-year limit on charging those expenses back to the charity, but it's two years from the end of the imposed conditions in the deal. A lot of these conditions are perpetual so the issue arises as to whether that means there is a perpetual right to charge back audit costs. The provision is found in section 5924(d) of the Corporations Code.

[262] A task force has recently been created to deal with this (that I'm honored to sit on) and I'm sure that we will discuss these issues and others. But one of the problems that occur when the attorney general's office sets the parameters of the deal, is that those parameters may in fact conflict with federal tax rules. We've had that happen in the past.

[263] I'm going to let George talk about that with respect to joint ventures. In California, the attorney general essentially looks at a joint venture as an investment. If the charity is going to sell its assets, and is going to take a piece of a for-profit hospital in exchange that for-profit hospital is a business. We look at it in the same way we look at oil and gas investments, or a shopping center investment. So, the issues that would arise with respect to any prudent investment are the issues the attorney general looks at. They look at whether there is a diversified portfolio; are you getting market returns? Can you access your capital? Can you get out of the deal? Those are very different issues than the IRS looks at under Rev. Rul. 98-15. The IRS looks primarily at control. I'll now let George talk on what it feels like to be between a rock and a hard place.

[264] MR. REYES: Thanks Jim. As Doug said, I am a transactional lawyer who has had some experience representing hospitals in both sales and whole hospital joint venture transactions. I cut my teeth on this with a transaction that involved working with Jim Schwartz when he was in the attorney general's office. I've confronted the issues involved, both pre-sale and post-sale.

[265] The most difficult pre-conversion issue in a whole hospital joint venture transaction, as far as the charitable trust issues are concerned, is how to comply with California trust law, which as Jim stated basically says that when you've got a hospital which holds its assets under California law in a charitable trust and now the hospital sells its assets so they are now no longer owned by a nonprofit, but rather by a for-profit, how do you hold true to the charitable purposes that you once had? The way you hold true to those purposes under the cy pres doctrine that he was talking about is to start with an analysis of the hospital prior to the transaction, and specifically ascertain how much, out of the expenditures of that hospital over some reasonable period of time, were devoted to inpatient care, and how much were devoted to outpatient care, and how much were devoted to health education. We drafted articles of incorporation that were approved by a court that said, based on this unscientific analysis, that 55 percent was inpatient care, 42.5 percent was outpatient care, and 2.5 percent was for health education. Somewhat arbitrary, but those are the restrictions that the attorney general's office imposed.

[266] Post conversion what you are left with is a foundation that is trying to live under those rules, and the difficulty is that they are trying to do good things in the community in terms of health care for indigents but they have to make sure that for every 42.5 cents they spend for outpatient care, they have to spend 55 cents on inpatient care. But how do you make an expenditure for inpatient care when you are not operating a hospital anymore? The foundation has to turn over that 55 cents to the other hospitals (that are either governmental or section 501(c)(3) hospitals) in the community, and that's sometimes difficult to do. Negotiating the restrictions was one thing to make a deal happen; but living under them is proving to be something else for the foundation.

[267] Then, as if that wasn't difficult enough, along comes Rev. Rul. 98-15, and I'm sure that you all are familiar with that. I know the people I'm sitting with are certainly familiar with that, and I'm a little sheepish, because I'm not a tax lawyer, but Rev. Rul. 98-15 comes along, and says that from a tax perspective, what you did to comply with state law isn't good enough. Under state law, we dealt with the attorney general's office, and went through an analysis with respect to fair market value. The attorney general's office makes sure, (usually through an auction process) that hospital assets were properly valued and that the nonprofit receives fair market value for those assets under California's definition in the transaction. We also made sure that under trust law that what was retained by the foundation that resulted in the whole hospital joint venture transaction was a "prudent investment" under the diversification standard under California law. You'd think that the attorney general's oversight with respect to fair market value and prudent investment ought to be relevant considerations to the IRS. Yet Rev. Rul. 98-15 comes along and suggests that that's not good enough.

[268] Rev. Rul. 98-15 as you know, sets up two situations, the "good" situation, and the "bad" situation. The "good" situation basically focused on control. Of the 5-member board, there was a 3- to-2 representation in favor of the nonprofit. There was a management agreement entered into with a unrelated third party to manage the hospital. The "bad" situation had a 50-50 board. Neither of the situations talks specifically about the percentage ownership between the for-profit and non-profit in the whole hospital joint venture. The "bad" situation had a related party, a subsidiary of the for- profit, as the manager. The exempt status of the nonprofit that owned an interest in the joint venture was in jeopardy in the "bad" situation and was upheld in the "good" situation.

[269] The difficulty, in where a successor foundation in these kinds of transactions finds itself, is that under the prudent- investor standard, that we dealt with the attorney general's office on, which basically put a premium on having a lesser interest, this is in direct conflict with what seems to be the standard required in Rev. Rul. 98-15, which is that you have a greater interest. A greater interest, which would be what you would have to have in order to exercise effective control to make sure that the for-profit, which is supposed to have charitable purposes, operates so that the nonprofit's it is charitable purposes are fulfilled through the for- profit. Well, in the real world to have effective control you've got to have a majority. These for-profit companies, Columbia, Tenent, etc., are not going to make sizable investments in hospitals, community hospitals that are out there, and cede control to nonprofits. But, apparently that is what is necessary, and that's just not "real world." Now, I guess not "real world" means then these transactions just can't be done, but there are good reasons for these transactions to be done, and that's why a lot of them were done.

[270] We have hospitals that were faced with making no money, at risk of closure because of that situation, being squeezed by managed care, needing access to capital, needing the cost efficiencies of having supply contracts through these large for-profit organizations. And then, we have IRS coming along saying that you can't do these transactions. Also, there's another facet in Rev. Rul. 98-15, which is that the distinction between having a manager that is either affiliated with your for-profit partner or not. In the good situation you need to have an unaffiliated manager. How realistic is that? That's hiring a manager to manage the hospital that is owned by a for-profit (you know 75 percent or perhaps less) and it hires a competitor to manage the hospital. I don't think so. So there are a number of problems, I think with Rev. Rul. 98-15, and we can get into it a little bit more, I hope -- or maybe I hope we don't -- but representing hospitals that have been in transactions like this, that are caught between the devil and the deep blue sea, Jim on the one hand and Marc on the other, is extremely difficult, and a lot of things are not "real world," both what the AG imposed as well as what the IRS is looking at imposing.

[271] MR. MANCINO: Thanks George. You might add that in California, because of licensure requirements every hospital has to undergo a seismic retrofitting, the capital demands for California hospitals over the next four years are going to be enormous and I think that is simply going to accelerate the pressure to pursue sales as well as joint ventures of nonprofit hospitals simply because there is not enough capital in the traditional debt markets and certainly the philanthropic markets to anywhere near began to meet those capital requirements in this state.

[272] I'm going to talk about some of the public charity/private foundation transitional issues. It's kind of interesting listening to the last panel; I think they set a wonderful stage because they looked at those issues from the traditional approach. In this environment, whether it's hospitals or whether educational organizations are selling their assets to dot-com companies, the monitrization of charitable assets that we are going to see in the next 10 years will probably dramatically surpass the monitorization of nonprofit operating assets that we've seen in the past decade. I think many of you share that view. So let's talk briefly about the public charity transitional options.

[273] Obviously in the hospital context, a hospital is a public charity because of what it does. It operates a hospital and under sections 170(b)(1)(A)(iii) and 509(a)(1) it's entitled to per se public charity status because of the nature of its activities. When a sale transaction occurs, it no longer is in the business of operating the hospital. So, as illustrated in the private letter ruling that I distributed, there the Service ruled that the hospital was eligible for the alternate classification as a section 509(a)(2) organization, because dual public charity classifications are permissible number one, and the historic gross receipts from the conduct of the related trade or business, i.e., operation of a hospital, are counted for purposes of meeting the one-third support test under section 509(a)(2).

[274] The Service ruled in several instances that that is an appropriate alternative public charity status for some period of time. The problem that we see, however, is the fact that you have this large endowment that comes in, so you start immediately generating investment income that can potentially bump you against the one-third limitation on net UBI and investment income. Now we've mitigated that to some degree, particularly in this market, by looking at the portfolio mix, and so you invest in portfolios that have shorter term current yields and longer term capital appreciation if you can do that and at least defer to the maximum period of time of roughly four years the potential for maintaining section 509(a)(2) public charity status.

[275] But at some point in time you hit the wall. Because unless they engage in active fund raising and become a section 170(b)(1)(A)(vi) organization, in which case they theoretically can derive 90 percent of their income from investment income, or they become a section 509(a)(3) support organization of another public charity, they will become private foundations. Many community foundations have offered themselves and have become involved. Actually in the case of one here in Southern California, Centiella Hospital, the community foundations have become supported organizations for these conversion foundations, and also they may be able to transfer those funds to community foundations. In some of the early HMO conversions in the state, the organizations frankly weren't interested in maintaining control over the assets in part, because some of the amounts involved were not that consequential, and so instead remaining in existence and remaining grantmaking organizations, they turned the funds over to the, you know, the School of Medicine at UCLA or at USC or the School of Dentistry, and a couple of the dental HMO cases, and so they've gone out of business. But, Carolyn Osteen asked me a couple of weeks ago, a couple of months ago now, why don't people do section 509(a)(3) organizations or give their money away? And the answer is control.

[276] It's plain and simple. Very often the persons who were in control of the organization before are no longer going to be involved the organization afterward, and they would like to maintain control over the corpus of the estate that they've created, hopefully through their good or bad management, as the case may be. That being the case, let's talk briefly about what happens when you cease to be a public charity. Now, there is not a lot of authority out here in the published world, but there is one GCM that talks about the fact that a section 509(a)(3) organization immediately ceases to qualify as such when the supported organization disappears or is no longer a section 501(c)(3), (4), or (6) organization. And, so in the particular private letter ruling you have there, that was a situation of a parent corporation of a multi-hospital system, where instead of selling the assets of the operating subsidiaries and thereby have the opportunity of remaining a section 509(a)(3) organization of these, now converted section 509(a)(2) organizations for some period of time in the future, the corporations in the actual transaction were actually merged with and into the actually tax exempt acquire. In this case the parent company which is common in these hospital structures, ceased to be a public charity. Now let's take a look at the character of these organizations. An increasing number of these organizations have significant amounts of publicly traded stock. This particular situation involved an organization that controlled 40 percent of the voting power of a New York Stock Exchange listed Fortune 100 company. It's a pretty big block, so you have a number of issues that I'm going to be talking about in a minute. As Celia alluded to you in your earlier panel, many of these organizations have wholly owned subsidiaries that are private companies that are fully or partially owned by the exempt organization but certainly, typically at least the majority owned, if not 80 to 81 percent, in order to obtain consolidation benefits in some cases. Many of these corporations have assets that have either unusable to the buyer or are related to the activities of the previous tax exempt organization activities, like a captive insurance company. That may require several years to run off the tail on malpractice claims.

[277] Then you have certain retained activities from time to time that are related. For example, in this particular example, the organization had a large practice management division that the acquiring organization did not want to take over because that's not their business, and so, this organization was faced with the need to dispose of those operating assets that were held in for profit entities over some period of time but they certainly couldn't be accomplished by closing at which the time the organization ceased to be a public charity. So, how do we deal with the transition? Well first of all, the first significant ruling obtained described in that PLR was the issue related to the application of the 2-percent tax on net investment income. As you know, that applies not only on interest dividends, rents, royalties, and that kind of investment income, but also on capital gains, short- and long-term. So, the first problem we faced was the organization formed by this company 20 years ago or more. Obviously it paid for the stock by making cash capital contributions in exchange for the voting shares it had, and of course, fortuitously, unlike many of their investments, the value appreciated dramatically over a period of time, so you have a large amount of built-in gain that existed at the time the organization ceased to be a public charity. So what do you do?

[278] Do you force the organization to sell the stock while it's a public charity, forgetting about whether there are any restrictions on transfers and other impediments to doing that, not to mention market conditions at the time and other kinds of issues, or do you create some relief? Well, what the Service did there is that it basically recognized this problem, and said that at the time the organization ceases to be a public charity, you in effect mark the basis to market for purposes of calculating 2-percent tax on net investment income so it's only the gain that is earned from and after the date it becomes a private foundation that's subject to the 2- percent tax on net investment income.

[279] A second issue relates to excess business holdings. Notwithstanding the fact that you don't see those issues very often, we are increasingly seeing these issues in this kind of context, and the problem arises with my public stock as well as with my privately owned corporations and partnership that vastly exceed the 20-percent limitations and cannot qualify for the 35-percent limitation available if you can demonstrate the organization is controlled by some third party. Well again, the answer to that was to really look at what these organizations were, and almost de facto treat them as separate organizations. First, as an organization as a public charity that had the freedom to make investments by stock, buy partnership interests and so forth, and in fact did so, and then a private foundation that has no ability to do that without because of the sizes of investments. So what got the Service to agree with us that this should be treated as in effect like a gift, because the private foundation in effect paid no consideration to the public charity and, therefore, the investments fell under section 4943(c)(6), which is the 60-month gift exception. This allows an orderly transition in terms of the disposition of those assets, and is very consistent with the policy of section 4943.

[280] You mentioned section 4944, another sleeper. Well, again, there was an example I remember of a tech advice, a number of years ago where the directors of the organization were liable for tax under section 4944 because they invested in a public company on whose board they served. So, it's not a matter of simply having section 4944(b) limited in its application to private companies but, it can apply to ownership interest in public companies. Well there too is an exception in section 4944 for assets acquired by gift. The notion that an organization ought to be able to not be charged with a higher level of fiduciary duty with respect to assets acquired by gift is sort embedded in section 4944 and we got the Service to agree, to the rationale, that we really treat these two organizations as separate, and treat the receipt of the stock and partnership interests by the private foundation as received for other than consideration, and therefore, avoid the application of section 4944 to the transaction. Lastly, the organizations frequently will have partnership interest in operating businesses, stock in for-profit subsidiaries that was put in those kinds of entities for very valid business reasons like limiting liability, keeping them out of obligated groups, and the like, but nonetheless the underlining activities would be related trades or businesses if carried on by the organization itself.

[281] So again, the Service, I think appropriately ruled that in several of those cases where there was a demonstrably appropriate exempt purpose being furthered, like a for-profit, off-shore captive insurance company, that those should be treated as program related investments and thus, not be subject to either section 4943 excess business holdings requirements or section 4944 jeopardy investment requirements. I think with that I would like to turn things over to Marc and Leonard.

[282] MR. OWENS: I realize that Leonard and I are all that stand between this group and the cocktail hour, so we will be extraordinarily brief. I agreed to do this panel when I thought it was going to be Doug doing a hypothetical deal and I would get to trash it. A couple of observations: the CEP audits -- there are currently 35 health care CEP exams underway, 22 college and universities CEP exams, some of which have a hospital component to them. Some of those are part of the special targeted audit program looking at joint ventures between for-profits and tax exempts where you have an Exam CEP team looking at the for-profit and EO CEP team looking at the tax exempt entity. There seem to have been two results so far coming out of that audit activity. One is a feeling in my cynical view, of the papering of these deals up front, and that is we found a couple of situations in which there was little resemblance between the promises made on paper to create the deal and what actually happened in practice. I'm talking about agreements by the joint venture entity to provide a certain level of charity care -- out the window -- never even approached the agreed on levels, and the exempt organization never inquired or had any sense that something was amiss, funds used for inappropriate purposes, political campaign intervention, things of that nature. We have seen evidence that we think supports Rev. Rul. 98-15's conclusions. We have yet to see evidence that suggests that we arrived at incorrect conclusions or conclusions that should be adjusted or modified in a significant degree.

[283] We have not yet seen any joint ventures that seem to have been run through a legitimate and rigorous business investment analysis along the lines perhaps of what would be applied to the regular endowment. In other words, looking at the stocks available on the New York Stock Exchange and selecting the ones that have the highest return and the lowest risk. There seems to be a different dynamic at work in the joint venture situations, a dynamic that is governed by secrecy, lack of competitive bidding, and incidentally, some of these findings were collaborated by a GAO study as well of these joint ventures. So, I can't speak for what the California Attorney General's Office accepts as evidence of business investment analysis, but I have some views of my own. The other result we are seeing is a little bit of a boomlet, if you will, in ruling requests or trial approaches on ruling requests involving a couple of scenarios. In one, the joint venture is being unwound and the exempt organization is trying to buy back the hospital, get it back, either because the for-profit is in the process of closing it down and everybody in the community is going to have to buy a car so they can drive 100 miles to the next nearest hospital, or there is a lease back arrangement.

[284] In other words, in order to keep that health care in the community, the exempt organization, or some sort of a community group, is attempting to lease back the facility from the for-profit. In both those situations we have concerns about valuation, fair market value, either of the lease or the purchase transaction. If it's a lease arrangement, we are going to be looking for a clear community benefit there. We are going to be looking at precisely the amount of control and involvement the for profit owner retains in the activity. We are going to want to see a community board, a real community board, in charge of the operation to ensure that it actually operates as Rev. Rul. 69-545 would suggest. I think we would be willing to entertain closing agreement overtures in this area. They would involve those cases that are not already under examination, but may require some sort of limited scope examination so that we can verify to our satisfaction precisely what happened. That once again is being fed by the results of some of the audit activities we have under way. There's a bit of a credibility problem with some of the paper in some of these deals. So, we would be willing to entertain closing agreements overtures if organizations are interested. There have been some unwinds, if you will, that we have put our stamp of approval on, so it is not an impossible hurdle to achieve. With that, I'll turn it over to Leonard.

[285] MR. AVANT: I'm a large case team coordinator, and I've audited large health care providers for the past 10 years. Rev. Rul. 98-15 is generally used in the determination process where an exempt health care system contemplates a merger or acquisition and requests a private letter ruling from the Service. When I am assigned a case to which Rev. Rul. 98-15 relates, it has already passed the first hurdle in that the National Office of the Service has approved the plan and the exempt organization is to retain its exempt status as long as it adheres to the plan. What I am looking for is whether or not the parties to the transaction have followed the plan. If the plan calls for the board of directors to be 50 percent from the exempt entity and 50 percent from the taxable entity we, in the examination process, will review the board structure to assure that is the case.

[286] Some of the issues we have explored -- not necessarily in my cases but throughout the country -- are whether the board of directors charged with the responsibility of representing the exempt organization's interests have become tainted by a relationship with the taxable side of the transaction. Perhaps the exempt organization's officers have acquired stock in the for-profit or guarantees of employment.

[287] We look at the community as a whole to see how the relationships have evolved over time. As an example, has the location of the exempt component been exploited in that charity care patients are funneled in its direction while more affluent patients are funneled toward the taxable component? We also look at the decisions being made by the board to make sure community benefit is represented and not just the bottom line of the taxable partner. So that is generally what we are looking for in our audits -- is the approved joint venture or acquisition plan being followed?

[288] MR. MANCINO: Leonard have you had any issues where you've looked at the unrelated business income characterization of the distributive share of income from an LLC or partnership in these contexts and formed any judgments as to what it takes to tip it into the relatedness side versus causing it to be treated as income from an unrelated trade or business?

[289] MR. AVANT: I've not raised the issue of unrelated business income in one of these acquisitions. I don't think we've really gotten that far. The first thing we are looking at is the exempt component: Does it continue to qualify? I think that's what all of our discussions have been about. We haven't developed unrelated business issues yet.

[290] MR. MANCINO: Why don't we take a couple of questions here. I know we're interfering with the cocktail hour, but maybe two or three of them. Peter.

[291] MR. GUTHRIE: Doug this would be for you and also for Marc. In reading the private letter ruling, it says that the supporting organization may continue to be treated under section 509(a)(3) until the medical centers have wound up their operations and dissolved and then it goes on with the second condition under section (a)(2) support runs out, which, ever comes earlier. We talked a few years ago about what the National Office position was if an organization said that we want to install a long range planning committee; we want to continue as an operating charity; we want some kind of an alternative medical delivery system, such as a community clinic; we want to fit the activities into an area where there is no support; such as treatment of the uninsured, AIDS, etc., and the answer wasn't clear what the National Office would do during that period so long as the public support continued because there was some discussion about it terminating once the purpose terminated.

[292] I've had some success in these kinds of continuing -- they are not really conversions but really material change in operation that is still related. Is there any policy at the National Office level or is there any thought from a practitioner's standpoint as to whether you can keep it during this process?

[293] MR. OWENS: I don't think you'll be seeing any particular policy statement on that point Peter, but I think our approach would focus on the extent and definitiveness of the plans for the new activity. I think we are quite aware that particularly large-scale, complex activities take time to do correctly. It takes time to set up some sort of a new medical care delivery system, or some new treatment facility; that doesn't happen overnight. It may take one or more years to do correctly. The key is going to be: Is there a plan that's reasonable? Is that plan being executed? We've seen a similar issue arise with new schools, new educational institutions. An entity qualifies as a school when it has a faculty and a student body but that takes time, first you need to build a building, and so on and so forth. So, I think the key is going to be the planning.

[294] MR. MANCINO: Does that indicate, Marc -- actually, Peter's question raised a very interesting issue. Obviously on the incoming basis, you are ruling regularly, like even a new hospital, will take two, three, five years to construct and you are ruling that they're a section 170(b)(1)(A)(iii) organization from the outset, the date of incorporation. The converse is the case in the termination situation where you have one of two questions: either the one that Peter raised and that is the planning for alternate activities and there have been some private letter rulings in the '80s involving organizations that were operating clinics and therefore were entitled to section 170(b)(1)(A)(iii) classification. But the issue that he presents, I think squarely is this issue of wind up. Let's say you are going to be nothing other than a grant-making foundation. Once you've terminated and wound down all of your operating businesses, would the Service entertain that kind of ruling request that during that wind- down phase you remain a section 170(b)(1)(A)(iii) organization?

[295] MR. OWENS: I think our analysis would be that you would convert to a section 509(a)(2) public charity and you'd be subject to the averaging rule which would turn you into a private foundation a year or two out, depending on the nature of income.

[296] MR. MANCINO: But, that's what you've done in the past with that ruling and a number of other PLRs. But I think it still raises a question, particularly where you have issues that are going to take years to resolve, like malpractice wind-down issues, you know, where you don't want to be a private foundation four years out.

[297] MR. OWENS: Well, I guess our concern would be when you are dealing with the new organization or the effort to create a new activity you have something forward looking that will turn into an active medical provider at a date in the future as opposed to something that is winding down and is not going to be returning to anything approaching a medical care provider. In that situation where the future of the organization is in another direction, we would be looking at the section 509(a)(2) kind of analysis focusing on the pattern of income, rather than trying to preserve in formaldehyde the section 170(b)(1)(A)(iii) status.

[298] MR. MANCINO: George, do you have a comment?

[299] MR. REYES: Yes, I have a follow-up related question. Doug, in the whole hospital joint venture setting as opposed to the outright sale where you have the successor foundation that used to be the parent organization of the hospital that ended up now being owned by the for-profit. What about the section 509(a)(1) status of that organization? Situation one in Rev. Rul. 98-15 says that entity, the one that works, of course who knows if you would ever find one that works -- but the one that works would be a 509(a)(1) because on a passthrough analysis the fact that the nonprofit owns an interest in the hospital, you're able to give it section 509(a)(1) status because of that but, suppose you're not quite in situation one as most everyone is and, what would be the section 509(a)(1) analysis there?

[300] MR. MANCINO: I think that's a very good question because it relates to many areas besides just hospitals; low-income housing partnerships would be an example. My view is that and we will differ with regard to the degree of control that has to be exerted over the underlying operations of the joint venture from what the Service's position is. But, ultimately you ought to be able under the aggregate principle of partnership taxation treat the distributive share of profits and losses of the partnership as gross receipts from the conduct of a related trade or business and maybe have the alternative or an additional classification under section 509(a)(2) available to the organization that's participating. I think where we're going to see this is in those instances where the organization actually became a limited partner in the partnership so, by law in order to preserve its limited -- for good reason, to have limited liability -- liability it cannot be involved in the management of the partnership itself. And, I think that is very true and maybe Mike can comment on it in the low-income housing context.

[301] MR. SANDERS: There are a lot of analogies but I think low- income housing, I hate to say this, with the large health care group here but, probably there are a lot of distinctions in favor of low- income housing under Rev. Rul. 98-15. You are not dealing with a national company that's negotiating aggressively. It's a whole different focus in those deals and I think the National Office understands that. However, they have not ruled on this point distinguishing one from the other. Let me make a few points on this. I suspect that the IRS is more liberal on field audit with regard to the Rev. Rul. 98-15 issues than it is for ruling purposes and I've got that sense. I don't know if that's acknowledged across the board but I think we can do a lot better in negotiating a case directly at the audit level than we will, I mean obviously we are only going to get a ruling today if we have that perfect case and then the point is made that it doesn't exist.

[302] I guess what I'm saying is I think the National Office is more liberal, -- I'll say it another way, the field office on audit is more liberal than the National Office is in issuing rulings today. That's number one. Number two and very important to most of us, we talk about the ancillary joint venture and this issue of control and the unrelated business income implications that are discussed in almost every conference. We need guidance from Treasury and the Service on that because it doesn't make sense to me, I say this every time I get an opportunity, it doesn't make sense to me that because of this control issue that somehow or other we have an unrelated business income toll charge. I don't follow it and it's suggested but we really, I don't think you can get there under an analysis of sections 511 through 514. So, I think the National Office needs to focus on that and we need help in the ancillary case. Whole hospital joint ventures is a different situation.

[303] MR. MANCINO: I think I'll close with one remark and maybe Marc, Leonard, Jim, and George might have something. I think the other discussion that was very relevant to this panel that we had today was this issue of Rev. Rul. 64-182 in the commensurate test. In the ancillary joint venture or even in the whole hospital joint venture context where the surviving organization has something more than an endowment that is not dependent on the joint venture for its grantmaking -- in other words, in the situations 1 and 2 the organizations were both dependent on their distributive shares from the joint venture to fund their grantmaking -- that doesn't exist in the real world. The real world is that many of these organizations unless they are in financial distress will have substantial assets. Not necessarily endowment-related assets but accumulated assets and excessive liabilities that will be available for funding. My view at least, and I'd be interested in what our panelists think about this, is that even he worst-case scenario in that situation should be that it is a UBIT question, rather than a loss of exemption question and that as long as the organization is conducting a bona fide grant- making program or other exempt activities commensurate in scope with its resources including, but not limited to those derived from the joint venture, then it shouldn't be entitled to remain exempt and then deal with it from an unrelated business income context. And of course that raises the issues with regard to excess business holdings and other issues like that but, fundamentally, I think that's where the analysis goes. Gentlemen, final parting comments.

[304] We'll take your observation under advisement.

[305] Thanks very much; thank the panel. Since we are running late Bob is going to announce that he's buying drinks for everybody.

[306] MR. FERGUSON: The cash bar is open, please those of you who will be here tomorrow afternoon don't miss the panel over in the Sheraton.

[307] Thank you this concludes our program.