A federal appeals court has reversed the Internal Revenue Service’s revocation of a charity’s tax-exempt status because of the arrangement it had with its direct-mail fundraiser.
On Feb. 10, the U.S. Court of Appeals for the Seventh Circuit reversed the U.S. Tax Court’s decision in United Cancer Council Inc. v. Commissioner, which had upheld the IRS’ ruling. The IRS had said that United Cancer’s outside fundraiser had benefited improperly from running the non-profit’s donor activities.
Near insolvency in 1984, United Cancer signed an exclusive, five-year contract with Watson & Hughey Co., now called Direct Response Consulting Services and based in McLean, VA. In addition to paying the charity’s expenses upfront, the fundraising agency had co-ownership of the donor list. United Cancer was forbidden to rent it but there was no restriction on Watson & Hughey’s use of it.
Between 1984 and 1989, Watson & Hughey raised $28.8 million in donations, but only $2.3 million went to the charity. According to the court decision, its expenses for postage, printing and mailing were $26.5 million.
After the contract, United Cancer hired another fundraiser and went bankrupt. The IRS in 1990 revoked its tax-exempt status retroactive to the date the Watson & Hughey contract was signed.
In its proceeding, the IRS said United Cancer’s deal with Watson & Hughey violated federal law against “inurement,” which pertains to the improper benefit of parties inside a charity. The tax agency argued that the contract was so beneficial to Watson & Hughey that it was an insider.
The appeals court admitted the arrangement was more favorable to Watson & Hughey than are most fundraising contracts, but did not make Watson & Hughey an insider.
The appeals panel said that the IRS’ argument in the case made “the tax status of charitable organizations and their donors a matter of the whim of the IRS.”
“There’s a myth that whatever a charity doesn’t get goes to the fundraiser but a lot of it goes to expenses,” said Richard O. Wolf, general counsel for Direct Response Consulting Services, which is not a party to the case. “United Cancer had $35,000 before the contract, and at the end of it had $2 million in cash and a list of donors. The idea that Watson & Hughey drove them to bankruptcy is wrong.”
A spokeswoman for the IRS said that the agency does not comment on tax-court cases.
The court sent the case back to the tax court to consider a ground separate from inurement–that the charity was run for the “private benefit” of Watson & Hughey. The court suggested that the large fundraising expenses, which were irrelevant to the inurement question, might play a larger role in the “private benefit” accusation.
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