Law Professor Criticizes Intermediate Sanctions Regs

[2] I will be out of my office for most of July, so if you should need to contact me, please do via email at darjones@law.pitt.edu or by leaving a message at (412) 648-7758.

Sincerely,

[4] Charitable organizations, too, enjoy a paradise of sorts. Indeed, to be free of taxation might be the closest that humankind can expect to get to paradise. Other than the pursuit of charity, no other joint economic undertaking escapes taxation. But as with the Biblical residence in paradise, there is one, and only one, unyielding condition imposed on those who undertake charitable activities. ¹ Those who stand in the relationship of "owner" vis-a- vis the charity may never share in the charity's surplus wealth. To state the matter in the Tax Code's ("the Code") technical jargon, no part of an organization's net earnings may inure to the benefit of an insider. ² A violation of that commandment, no matter how small, justifies immediate revocation of tax exemption. ³ Profit taking is apparently so inimical to the concept of charity that the first violation is sufficient to warrant the consequence. ⁴

[5] That consequence, revocation of tax exemption, oftentimes has repercussions felt by more than just the charity, itself, or the insiders who caused the charity to violate the commandment. Revoking tax exemption will normally result in the elimination or decrease in the amount of goods or services provided in a charitable manner, and in some instances may have no effect on the insiders. For this reason, Congress thought it wise to enact a system of "intermediate sanctions," ⁵ by which to precisely punish insiders without harming the beneficiaries who depend upon the organization's tax-exempt existence. Congress confirmed that profit taking is indeed inimical to tax exemption, but also held out the possibility that the charity would suffer something less than the complete loss of exemption upon an instance of profit taking. Essentially, an insider who violates the profit taking prohibition is hit with a 25% excise tax and, in addition, must either return the ill-gotten gains to charity or pay twice the amount to the government. ⁶ The organization still faces the possibility of revocation, but that consequence and its unintended repercussions is no longer inevitable.

[6] Still, Congress has never redefined the fundamental commandment such that a first violation would completely escape consequence. Recent events, though, have made that result more than a hypothetical possibility. First, there was the Seventh Circuit's decision in United Cancer Council v. Commissioner, ⁷ wherein Judge Posner adhered to the letter, if not the spirit of IRC 501(c)(3) and appeared to explicitly adopt the "first bite" rule. The letter of IRC 501(c)(3) prevents the distribution of profit to insiders -- correctly defined by Judge Posner to mean a director, manager or person of similar authority or stature within the organization. ⁸ Technically, a person who is on the verge of being hired as such is not an insider at the time of the hiring. At the moment immediately before hiring, the person is an "outsider." As a result, her fortuitous negotiation of a contract that pays her an unreasonable amount -- that is, a contract resulting in the distribution of profit -- does not violate the literal commandment. The latter day insider is thus allowed a "first bite" at the entity's profits without fear of causing the revocation of tax exemption.

[7] Judge Posner's opinion came at a time when the Service was actively fighting the first bite rule on another front. Before and after the Service's first set of proposed regulations concerning the new intermediate sanctions scheme, ⁹ many commentators argued that no imposition of the lesser intermediate sanction was authorized when a charity distributes profit to a person via a contract made when the recipient was not yet an insider. ¹⁰ That is, the prohibition against profit taking should not apply until after the recipient becomes a literal insider and then only if she receives profit by virtue of new arrangement not related to the first arrangement. Such a rule, like the result in United Cancer Council, would essentially mean that a latter day insider might have already taken profit from the charity without fear of consequence. The Service rejected calls to explicitly include such a rule in its first set of regulations, but Judge Posner's opinion was issued in the midst of the rulemaking process. The opinion made it much more likely that years of rulemaking would succumb, at least in part, to a successful challenge if the rules were finally implemented without the first bite rule.

[8] Understandably, when the Service revised the proposed regulations and reissued them in both temporary and proposed form, it conceded the literal statutory and judicial support by explicitly including the first bite rule. ¹¹ As a result, there now exists what might rightly be viewed as the proverbial loophole through which a charity's profit might be distributed with impunity. Although the Service felt compelled to concede its very technical error, it appears also to have unnecessarily conceded the entire fight concerning the improper distribution of profit. Judge Posner's opinion hardly requires such a result. In fact, the opinion most clearly indicates that another doctrine -- the prohibition against private benefit -- be used to address such profit distributions when made to a person who is an outsider. ¹² But while the Service complied with Posner's first dictate -- that it refrain from exacting a punishment against an outsider under the prohibition against profit taking -- it completely ignored his corresponding suggestion that punishment should be had under the theory of private benefit.

[9] Perhaps one reason for the Service's undertaking of only half the job with respect to prohibiting a charity's distribution of profit is that the theory of private benefit is, at this very moment, so incorrectly stated and doctrinally muddled as to be rendered useless. The Service's informal adherence to a theory of private benefit entirely contrary to that stated in its regulations is proof enough of this assertion. As formally posited in the regulations, the private benefit doctrine might even force the Service to stand idly by while profits are distributed under the protective language of the first bite rule.

[10] The purpose of this article then is first to show how the Service's concession to the first bite rule, without a corresponding restatement of the private benefit doctrine, renders the public powerless to prevent a charity's distribution of profit in certain significant circumstances. In the absence of corrective action, the more aggressive and savvy charities will quickly recognize and exploit the loophole. Second, the article discusses and refines a proposal I've previously made concerning a restatement of the private benefit doctrine in a manner that would close the loophole. ¹³ Since the private benefit doctrine is so very closely related to the prohibition against profit distribution (yet distinguishable nevertheless), it seems only logical that a revision of one rule would occasion a reconsideration of the other. In Part II, I briefly outline the facts and holding of United Cancer Council In Part III, I summarize the details of Temporary/Proposed Regulation 53.4958- 4T(a)(3) and provide some speculative predictions from the viewpoint of a charity that seeks to circumvent the prohibition against profit taking. In Part IV, I compare and contrast the formal and informal private benefit doctrines and conclude that the formal articulation allows profit taking in all but the most extreme cases. In Part V, I redefine and restate the private benefit doctrine consistent with the Service's informal articulation and in a manner that would address profit taking in a profit much more predictable and comprehensive manner than would the present, formal articulation of that doctrine.

II. UNITED CANCER COUNCIL, INC. AND THE BIRTH OF THE FIRST BITE RULE

[11] United Cancer Council was never explicitly about the first bite rule, at least not at the appellate level. Nevertheless, the rule might be viewed as a logical outgrowth of Judge Posner's opinion in that case. UCC, Inc. (UCC) was an offshoot of the American Cancer Society. ¹⁴ It focused on preventing and ameliorating the effects of cancer, rather than searching for a cure. ¹⁵ In 1984, UCC hired a corporate fundraiser, with which it had no previous connection, to raise funds for UCC under an exclusive contract. ¹⁶ Over the course of five years, the fundraiser raised nearly $29 million dollars on behalf of UCC, but nearly $27 million of that went to the fundraiser as compensation and expense reimbursements. Only approximately $2 million over five years went to UCC's charitable purpose. ¹⁷ The Service argued, and the Tax Court agreed, that because the fandraiser had exclusive control over UCC's fundraising campaign, including UCC's mailing list, it occupied a status akin to "owner" vis-a-vis UCC and was therefore an insider. ¹⁸ The Tax Court specifically rejected UCC's argument that it was not yet an insider and therefore could not have violated the prohibition against profit taking at the time of the agreement. In particular, the Tax Court stated that it was not aware of any such "one-free-bite" principle. ¹⁹ Having found that the fundraiser was an insider, the Tax Court went on to conclude that the payments made were entirely unreasonable and therefore violated the prohibition against profit taking. ²⁰

[12] Judge Posner, speaking for a three-judge panel of the Seventh Circuit Court of Appeals, reversed the Tax Court, though he never mentioned the first bite rule. It was, of course, undisputed that prior to entering into the contract whereby it took nearly 95% of UCC's gross "earnings," the fundraiser could not be described as an "insider" within the meaning of IRC 501(c)(3). As a matter of strict statutory construction, then, the Court was not entirely unreasonable in concluding that the prohibition against profit taking did not apply to UCC at the time of the contract. But the fundraiser could have been deemed an insider at the moment right after the contract was signed, and therefore any profit taking thereafter would violate the prohibition. Indeed, Judge Posner acknowledged that even an outside fundraiser could be an insider, ²¹ but rejected the finding in this case, apparently because the contract had been negotiated with the fundraiser prior to the fundraiser having any connection to UCC. Taken by itself, this holding suggests that the Service has no weapons by which to combat profit distribution so long as the recipient was not an insider prior to the distribution.

[13] There is some basis in the opinion, though, from which to conclude the Court may have ruled otherwise if it thought the public had no other way of preventing the diversion of profit from the charitable cause. After determining that the Tax Court was incorrect in finding that the fundraiser was an insider, Judge Posner suggested a different theory by which the Service might have rectified the apparent distribution of profit:

Maybe tax law has a role to play in assuring the prudent

III. TEMPORARY AND PROPOSED REGULATION 53.4958-4T(a)(3): FORMAL ADOPTION OF THE FIRST BITE RULE

[15] Prior to United Cancer Council, the Service requested public comments on forthcoming regulations pertaining to the intermediate sanctions provision. ²³ Comments received in response to both the request and the subsequently proposed regulations specifically sought the adoption of the first bite rule. ²⁴ The Service rather obliquely rejected the first bite rule by including an example whereby a previously unrelated party was deemed an insider by virtue of its first ever transaction with a charity and thereafter subject to the profit-taking prohibition and sanctions with respect to that very same transaction. ²⁵ In response to United Cancer Council, however, the Service withdrew that example and issued new temporary and proposed regulations adopting the first bite rule. ²⁶ In doing so, the Service specifically discussed that part of United Cancer Council's holding that the prohibition against profit taking was inapplicable to a latter day insiders, ²⁷ suggesting that the reversal was practically mandated by the Court's decision. But the Service did not discuss the Court's suggestion of an alternative approach to prevent the diversion of charitable profits to non- insiders. Because it neglected to take up and elaborate upon the Court's alternative approach, the Service has most likely precipitated the sort of mischief not contemplated by the Court, and which quite correctly motivated the Service's initial refusal to adopt the first bite rule.

[16] Simply put, Temporary and Proposed Regulation 53.4958-4T(a)(3) provides that sanctions for violating the prohibition against profit taking will not apply when a fixed payment is made pursuant to the first agreement between a charity and a person previously unrelated to the charity. A fixed payment is, in essence, a payment that is determinable solely by the objective terms of an initial agreement. ²⁸ The payment may be determined by application of a formula stated in the agreement, including a formula based upon the organization's net revenue, but may not otherwise be subject to the discretion of any person with respect to whether the payment is to be made or the amount of payment. ²⁹ Thus, although the recipient may become an insider by virtue of the agreement -- for example, when a charity hires a previously unassociated person to act as its CEO -- and thereafter receive a salary far in excess of what is reasonable, no sanction will apply for violation of the profit taking prohibitions. In essence, the latter day insider is allowed to take as big a first bite of the charity's profits as he can get, without fear of sanction.

[17] A brief example demonstrates the mischief that might result from such a rule. Suppose, for example, that a tax-exempt hospital heavily oriented towards expensive, inpatient specialty care seeks to acquire general practitioners and their practices to make itself more competitive in the managed care environment. Suppose also that only a few physician practice groups, none of whom are insiders with respect to the hospital, operate in the community served by the tax-exempt health care organization, but that at least one for-profit hospital serves the same community. In order to entice as many general practitioners to its employ and away from its for-profit competitor, the tax-exempt hospital might be willing to pay far more than market price for both the physicians' practice assets and/or their future services as hospital staff physicians. Under the first bite rule, the hospital could pay highly inflated prices for the physician practice assets. Thereafter, the hospital could employ the practitioners under separate contract, paying them only reasonable salaries. The inflated amounts paid for the practice assets would actually serve as a means of frontloading a distribution of profit to potential latter day insiders. The first bite rule, though, would preclude the Service from attacking the hospital's payment of inflated prices for the practice assets because at the time of the agreement, the physicians would not yet have become insiders.

[18] The Seventh Circuit would undoubtedly agree with the result in the hypothetical above insofar as the prohibition against profit taking is concerned. But the Court probably would have gone further to suggest that perhaps the hospital's course of conduct supports a determination that it was operating for the private benefit of the physicians. Unfortunately, however, the present regulatory articulation of the private benefit doctrine might not allow the Service to take action in response to the hypothetical. As the next section demonstrates, the private benefit rule as presently articulated would probably provide redress only in the most extreme cases such as that presented in UCC. Where a charity is not so singularly identified with or dependent upon a single bad transaction, but distributes profit nevertheless, the private benefit doctrine as presently articulated will be of little use.

IV. FIRST BITE AND PRIVATE BENEFIT

[19] The Service has actually been of two minds with regards to the private benefit doctrine, at least since 1991. On the one hand, Treasury Regulation 1.501(c)(3)-1, which contains the Service's formal articulation of the private benefit doctrine, lends itself to the conclusion that an "insubstantial" amount of private benefit will not occasion the revocation of tax exemption. Substantiality is a relative term that compares the private benefit conveyed with the public good achieved by the charity. If the private benefit is insubstantial, relative to the overall good achieved, there is no private benefit violation under present law. In fact, this is the precise holding of American Campaign Academy v. Commissioner, ³⁰ wherein the tax court interpreted the Service's regulation thusly:

[S]hould petitioner be shown to benefit private interests, it

[20] But what about the less extreme but more common cases represented by our hospital hypothetical in Part III? If we assume the hospital had an overall operating budget of 40 million dollars and over the course of a year or two paid inflated prices aggregating $400,000 in purchasing five different physician practices, can it really be said that the misappropriation amounting to 1 percent of the hospital's budget is "substantial" and therefore justifies revoking tax exemption under the private benefit doctrine as formally articulated? What if the inflated purchase price is paid to just one physician who thereafter is hired as the hospital's chief medical officer? In either case, tax exemption has contributed to making a noncharitable beneficiary wealthy, and most likely at the expense of the public good that should otherwise have been achieved with the inflated purchase price. The formal articulation does not allow redress if the expenditure was entirely inappropriate but nevertheless insubstantial. The best that can be said is that it is highly debatable that the formally stated private benefit doctrine would serve to rectify the situation, as perhaps the Seventh Circuit assumed. Clearly, then, the combination of the first bite rule and the private benefit doctrine as formally articulated creates an insufferable loophole through which profit may be distributed.

[21] Informally, though, the Service has defined the private benefit doctrine in a manner that would redress the result hypothesized above. In General Counsel Memorandum 39862 /32/, the Service explained the private benefit theory thusly:

Prologue: Any private benefit arising from a particular activity

[23] We can know that the Service's informal articulation is the better approach through an application of what John Rawls called "reflective equilibrium." That is, we posit a rule that appears to provide the best solution in the abstract. We then test that rule by application to particular facts. If upon application to particular facts we arrive at an absurd or insufferable result, we should revise the rule so that it does not allow for such a result. By this process we first posit and then continually revise until we have eliminated absurd results to the extent possible.

[24] The question for present purposes is whether it is absurd or insufferable that tax exemption should continue when a charity spends a portion of its publicly subsidized wealth in a manner that does not benefit the public, but instead conveys a private benefit. A second question, one posed by the Seventh Circuit and Part 2 of the Service's informal articulation, is whether tax exemption remains appropriate when even an otherwise appropriate expenditure yields so little public good relative to the private benefit derived solely by the expenditure. In the extreme cases such as that presented in UCC we might easily conclude that maintaining tax exemption is absurd and that the formal articulation of the private benefit doctrine is sufficient to address the result. But in the more common, less extreme cases such as that presented by our hypothetical, the formal articulation is insufficient though the private profit taking may be as equally absurd or insufferable. It should never make any sense -- i.e., it is presumptively absurd -- that a publicly subsidized entity should be allowed to give away part of the store to private interests without question simply because it uses the better part of its store for public good. Suppose, for example, that instead of overpaying latter day insiders, our hypothetical hospital simply made a gift of $400,000 to a city official who was soon (but only later) to become the hospital's CEO. The first bite rule and the formal articulation of the private benefit doctrine would not allow for redress since the distribution was not made to an insider and, still, only one percent of the hospital's resources have been improperly diverted. Only the informal articulation would provide a basis for redress by asking first whether the expenditure was even appropriate, regardless of its substantiality.

[25] Note, too, that the informal approach does not necessarily condemn the distribution to an outsider in our asset purchase hypothetical. Instead, it allows the Service (the public's representative, after all) to question the distribution's appropriateness, regardless of its substantiality. If the distribution is found to be inappropriate, the Service may take corrective action, up to and including revocation, without further inquiry. If the distribution is found to be appropriate, the Service may then ask whether the cost outweighs the benefit, as the Court in UCC suggested. The formal approach not only ignores the appropriateness of the distribution but also condemns the distribution only in the rare instances that the distribution can be viewed as "substantial" relative to the entire universe of the hospital's activities. The absurdity of that result -- providing the public with no occasion to question the appropriateness of a distribution however small in a relative sense, and then condemning even an inappropriate distribution only when it is substantial in a global sense -- demands that we reconsider the articulation of private benefit so that such a result is not possible.

V. REDEFINING PRIVATE BENEFIT TO STEM THE FIRST BITE LOSS

[26] The first bite rule, when applied in conjunction with the private benefit doctrine as presently articulated, would allow for a significant diversion of tax exempt wealth to private interests. Perhaps it is no coincidence that the Seventh Circuit's opinion, to which the Service pointed in codifying the first bite rule, never explicitly or directly referred to the rule. The opinion cannot fairly be read as condoning an improper distribution of wealth. Instead, the opinion merely indicates that the prohibition against profit taking was the wrong theory by which to address such distributions. It is not unreasonable to assume, based upon the Court's explicit discussion to that effect, that the Court nevertheless thought it appropriate that a charity's publicly subsidized wealth never be used for private benefit. The Court appears to assume that the private benefit doctrine would reach those distributions to which the profit taking prohibition did not apply. In the prior section, however, we've seen that the Court may have assumed too much. The private benefit doctrine as presently articulated would most likely have provided redress for the distribution of profit in UCC. But many more instances of improper distributions would be unaffected by the presently articulated private benefit doctrine. Thus, if the Service intends to finalize the regulations containing the first bite rule, it should also restate the private benefit doctrine to avoid a result surely not contemplated by the Seventh Circuit or good tax policy.

[27] So that my thesis goes beyond offering mere hypothetical solutions to real problems, I now provide an annotated version of a proposed restatement of the private benefit doctrine. ³⁴ Each asserted provision or related group of provisions is followed by a brief comment describing the source and/or purpose of the assertion.

1.501(c)(3)-1(d): PRIVATE BENEFIT

(i) To be entitled to tax exemption, an organization must benefit the public exclusively. Thus, to be tax exempt, an organization must not convey a priority right of beneficial interaction to a select and identifiable person or group. Except as provided in subparagraph (ii), conveyance of such priority right results in and constitutes private benefit.

(a) A priority right of beneficial interaction results whenever

(a) The public benefit to be achieved thereby is within the

COMMENT: Present law is inappropriately skewed towards leaving

[28] Undoubtedly, the bigger interests in the charitable community -- hospitals, universities, and international disaster relief organizations -- will object to the proposal in this article. The objection will be that organizations that spend millions in pursuit of their charitable goal should not be at risk of revocation because of a relatively small diversion. The objection is legitimate, but relates to a separate issue. Whether an expenditure or activity offends the theory upon which tax exemption is granted -- that tax exemption assists in the accomplishment of a public good -- is a separate issue from the sanction that should be imposed upon a violation of that theory. Of course, the sanction should be tailored to prevent unnecessary harm, just as the intermediate sanctions provision is designed to redress a distribution of profit to insiders without harming beneficiaries. But the harm itself must first be correctly defined and articulated separately from the determination of the proper sanction. We should not ignore a real affront to tax exemption simply because we don't like the sole available sanction. Obviously, we should correctly define and articulate the harm, as this article attempts to do, and then define a proper sanction.

² IRC 501(c)(3).

³ See Darryll K. Jones, The Scintilla of Individual Profit: In Search of Private Inurement and Excess Benefit, 19 Va. Tax Rev. 575 (2000) (providing a history and extensive analysis of the prohibition against profit taking).

⁴ Id.

⁵ See IRC 4958.

⁶ IRC 4958(a)-(b).

⁷ 165 F.3d 1173 (7th Cir. 1999).

⁸ 165 F.3d at 1176.

⁹ Prop. Treas. Reg. 53.4958-0 - 53.4958-7, 63 Fed. Reg. 41486 (1998).

¹⁰ 66 Fed. Reg. 2150 (Jan. 10, 2001) ("Several comments received during the regular comment period requested that a person having no prior relationship with an organization not be considered a disqualified person [i.e., an insider and therefore subject to sanction] with respect to the first contractual arrangement with the organization.").

¹¹ Temp. Treas. Reg. 53.4958-4T(a)(3) (2001).

¹² 165 F.3d 1179-80.

¹³ See Darryll K. Jones, Private Benefit and The Unanswered Questions From Redlands, 89 Tax NOTES 121 (2000).

¹⁴ 165 F.3d at 1174.

¹⁵ Id.

¹⁶ 165 F.3d at 1175.

¹⁷ Id.

¹⁸ 165 F.3d at 1176.

¹⁹ United Cancer Council, Inc. v. Commissioner, 109 T.C. 326, 388 (1997) rev'd 165 F.3d 1173 (7th Cir. 1999).

²⁰ 109 T.C. 390 92, rev'd 165 F.3d 1173 (7th Cir. 1999).

²¹ 165 F.3d 1176.

²² 165 F.3d 1179.

²³ I.R.S. Notice 96-46, 1996-2 C.B. 112.

²⁴ Supra note 9.

²⁵ Prop. Treas. Reg. 53.4958-3(f), Example 3, 63 Fed. Reg. 41499 (1998).

²⁶ See Temp.Treas. Reg. 53.4958-4T(a)(3) (2001).

²⁷ 66 Fed.Reg.2150 (Jan. 10, 2001).

²⁸ Temp. Treas. Reg. 53-4958-4T(a)(3)(ii)(A).

²⁹ id.

³⁰ 92 T.C. 1053 (1989).

³¹ 92 T.C. at 1066 [emphasis added].

³² Gen. Couns. Mem. 39862 (Nov. 21, 1991). General Counsel Memoranda do not constitute binding legal authority.

³³ Id. In the quoted provision, I add the labels "Prologue" and "Epilogue," and I also divide and number the two parts of the Service's informal rule.

³⁴ I first proposed the following articulation in Darryll K. Jones, Private Benefit and the Unanswered Questions From Redlands, 89 TAX NOTES 1211, 138 (2000).

³⁵ For a more in-depth discussion of this point, see Darryll K. Jones, supra note 34, at 131-32. 20