United Cancer Council, Inc. v. Commissioner of Internal Revenue
1999 U.S. App. LEXIS 1931, 83 A.F.T.R.2d (RIA) 812, 165 F.3d 1173 (1999)
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Rule of Law:
An outside party that provides services to a charity under an arm's-length contract does not become an 'insider' for purposes of the private inurement prohibition merely because the contract's terms are highly favorable to the outside party, particularly when the charity's desperate financial situation necessitated such terms.
Facts:
- In 1984, the United Cancer Council (UCC), a small charity, was nearly bankrupt.
- UCC's board negotiated and entered into an arm's-length, five-year exclusive fundraising contract with Watson & Hughey (W&H), a professional fundraising firm.
- Due to UCC's precarious financial position, W&H agreed to front all initial expenses for a direct-mail fundraising campaign.
- In exchange for fronting the costs, the contract gave W&H co-ownership of the donor list generated by the campaign and prohibited UCC from ever selling or leasing that list, while W&H faced no such restriction.
- Over the five-year term, the campaign raised $28.8 million in donations.
- From the donations, UCC reimbursed W&H $26.5 million for expenses, leaving UCC with net proceeds of $2.3 million for its charitable programs.
- UCC's board reviewed and approved the text of all fundraising letters, which included cancer prevention advice.
- At the conclusion of the five-year term, UCC chose not to renew its contract with W&H.
Procedural Posture:
- The Internal Revenue Service (IRS) revoked the charitable tax exemption of the United Cancer Council (UCC), retroactive to 1984.
- UCC petitioned the U.S. Tax Court to contest the revocation.
- The Tax Court ruled in favor of the IRS, upholding the revocation on the grounds that UCC's net earnings had inured to the private benefit of its fundraiser, Watson & Hughey (W&H).
- UCC, as the appellant, appealed the Tax Court's decision to the U.S. Court of Appeals for the Seventh Circuit.
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Issue:
Does a charity's arm's-length fundraising contract with an outside company, which is highly advantageous to the company, cause that company to become an 'insider' to whom the charity's net earnings have impermissibly inured under 26 U.S.C. § 501(c)(3)?
Opinions:
Majority - Posner, Chief Judge
No. A charity's arm's-length contract with an outside company does not make that company an insider for private inurement purposes, even if the terms are highly favorable to the company. The private inurement prohibition is designed to prevent the siphoning of charitable earnings to insiders, such as founders or board members, through self-dealing or breaches of fiduciary duty, not to empower the IRS to regulate the terms of contracts with outside suppliers. W&H was not an insider because it did not found or control UCC; its board members were independent, and the contract was a result of UCC's desperate bargaining position, not W&H's seizure of control. The high ratio of expenses to net proceeds is a matter of prudent management, which falls under the separate 'private benefit' analysis, not the 'private inurement' doctrine.
Analysis:
This decision significantly clarifies the distinction between the 'private inurement' and 'private benefit' doctrines under § 501(c)(3). It narrows the definition of an 'insider' for inurement purposes, establishing that control, not merely contractual advantage, is the key factor. This provides crucial protection for new or financially struggling charities that may need to enter into unfavorable but necessary contracts with third-party vendors. The ruling prevents the IRS from revoking a charity's tax exemption based solely on the perceived unfairness of an arm's-length agreement, forcing the agency to instead analyze such situations under the broader, and distinct, private benefit doctrine which questions whether the charity is being operated for a substantial non-charitable purpose.
