The Florida Bar

Florida Bar Journal

Recent Developments Affecting 501(c)(3) Organizations


Section 501(c)(3) organizations face ever increasing scrutiny from the government when entering into transactions with private individuals and entities. There have been three significant changes in the law which substantially affect how these types of transactions may be structured. First, the Tax Court has ruled in United Cancer Council, Inc. v. Commissioner, 109 T.C. No. 17 (1997), that the use of a professional fundraiser merited revocation of United Cancer Council’s tax-exempt status. Second, in a ruling that should have implications beyond the health care arena, the Service issued Revenue Ruling 98-151 which changes the Service’s position with regard to transactions in which tax-exempt hospitals contribute their entire facility(ies) to joint ventures with for-profit partners. Finally, on July 30, 1996, Congress enacted “intermediate sanctions” legislation which became effective September 13, 1995, and penalizes individuals who benefit from private inurement violations. This article analyzes each of these developments and explains how they impact 501(c)(3) organizations.2

Private Inurement —Definition of “Insider”

A recent Tax Court case has expanded the types of situations in which a tax-exempt organization may lose its exemption. In United Cancer Council, the Tax Court agreed with the IRS that an “insider” is anyone who has the opportunity to influence or manipulate an organization’s activities for the benefit of a private party. As a result of this decision, tax-exempt organizations may risk their exempt status when they transfer control of revenue-generating operations to an independent third party. In order to understand the significance of whether someone is an insider, a brief discussion of private inurement is necessary.

Section 501(c)(3) of the Internal Revenue Code3 provides that in order for an organization to qualify as a tax-exempt charity, no part of its net earnings or assets may inure to the benefit of any private shareholder or individual. This is the basis of the so-called private inurement doctrine. Any private inurement, regardless of the amount of benefit conferred, results in revocation of an organization’s exempt status.4

There are two critical elements of private inurement: 1) “inurement” of earnings or assets which 2) benefit a “private shareholder or individual.” Whether “inurement” of earnings or assets occurs is a broad question of fact. The issue usually arises when the organization’s financial resources are transferred to an individual solely as a result of the individual’s relationship with the organization and without regard to accomplishing exempt purposes.5

“Private shareholders or individuals” are often referred to as “insiders.” The Treasury Regulations define insiders as persons who have a “personal and private interest” in the tax-exempt organization.6 Founders or controlling members of an exempt organization (i.e., officers or directors) are generally viewed as insiders because they have the potential to benefit from an organization’s receipts and assets. In addition to individuals such as officers and directors, the Service has held that the term “insiders” also includes anyone able to exert influence on the organization to engage in a private inurement transaction.

The IRS historically has not interpreted the term insiders to include independent third parties.7 However, in United Cancer Council, which was decided on December 2, 1997, the Tax Court expanded the definition of insiders when it revoked the 501(c)(3) status of United Cancer Council, Inc. (UCC). In that ruling the Tax Court held that a third party, a contingent-fee advertising company, was an insider for purposes of the private inurement doctrine.8

Membership dues. Due to financial hardship in 1984, UCC entered into a five-year fund-raising contract with Watson & Huey Co., a professional fund-raiser (W&H). During the contract period, UCC received a total of about $2.25 million in net fund raising revenue. Over the same period, W&H received in excess of $4 million in fees directly from UCC and another $4 million indirectly through a division of W&H for use of mailing lists.

The IRS revoked UCC’s exempt status in 1990, asserting that the organization’s net earnings inured to the benefit of a private shareholder or individual, W&H. UCC contested the revocation by filing a petition with the Tax Court claiming there was no private inurement because W&H was not an insider. In support of its claim, UCC argued that W&H was not an officer or director of UCC, and, by virtue of the fact that W&H was an independent third party, W&H had no direct control over UCC’s operations.

Although the Tax Court acknowledged that W&H was not a director or officer of UCC and had no “formal voice in the selection of any director or officer,” it nevertheless rejected UCC’s claim that the private inurement doctrine could not apply to an independent third party. The Court pointed out that W&H had exclusive control over UCC’s fund-raising activities, had substantial control over UCC’s finances, and received excessive and unreasonable compensation from UCC.

broadening the definition of an insider, United Cancer Council signals an expansion of the private inurement doctrine. Pursuant to this holding, if a 501(c)(3) organization enters into an arrangement with an independent third party, the organization must determine whether the arrangement cedes control of integral parts of the organization’s activities. If so, the exempt organization risks its tax exemption if the third party receives any impermissible benefit.9

Hospital Joint Ventures

In addition to the Tax Court’s holding in United Cancer Council, the IRS has issued guidance on joint venture arrangements between not-for-profit and for-profit parties. In Revenue Ruling 98-15, the Service considered two different factual scenarios in which an exempt organization formed a limited liability company with a private entity. Although this ruling involves exempt health care organizations, it has implications for other 501(c)(3) organizations engaging in joint ventures.

The ruling considers two contrasting factual scenarios, designated “Situation 1” and “Situation 2.” In both situations, the exempt organization contributed a “whole” hospital to the venture and the for-profit corporation contributed working capital. Ownership in the venture was divided in proportion to the value of the respective contributions. Despite these basic similarities, the Service concluded that the exempt organization in Situation 1 maintained its exempt status while the organization in Situation 2 lost its exempt status. Therefore, the impact of the ruling is embedded in the factual distinctions between the two scenarios.

The Service focused on control of the venture’s governing board as the first distinguishing factor. In both situations, certain enumerated decisions, including the selection of key executives, approval of material contracts, and changes in the types of hospital services provided, were reserved for the vote of a majority of the governing board. In Situation 1, the board consisted of five members, three of whom were appointed by the exempt organization out of a pool of “community leaders.” The for-profit entity had authority to appoint the remaining two board members. Thus, the exempt organization in Situation 1 maintained control of the board after the joint venture was formed.

In Situation 2, however, the venture was governed by a six-member board, with each venturer appointing three board members. Further, the ex-empt organi-zation in Situation 2 appointed two former employees of the for-profit corporation to serve as the CEO and CFO of the venture. The Service believed that the exempt organization’s control over the venture’s board in Situation 2 was diluted because: 1) it could not initiate programs without the agreement of at least one for-profit board member; and 2) the venture’s officers (who were closely aligned with the for-profit venturer) were the board’s primary source of information in evaluating key decisions.

The second factor considered by the Service was the priority of the charitable purpose in the organizational documents of each of the ventures. The documents in Situation 1 required the hospital be oper-ated for the charitable purpose of “promoting health for a broad cross section of the community.” They also provided that the governing board’s duty to implement this purpose superseded any fiduciary duty to operate the hospital for the finan-cial benefit of its joint venture owners.

In contrast, the organiza-tional documents in Situation 2 contained no special provisions concerning opera-tions for charitable purposes. The venture’s organizational documents lacked an explicit directive to operate the hospital for any charitable purpose and this influenced the Service to hold that the exempt organization’s participation in the venture failed to further a charitable purpose. Because the exempt organization devoted all of its assets to the venture, it, therefore, could not establish that it qualified as a §501(c)(3) charity.

The third and final factor the Service analyzed was the day-to-day management of the hospital. In Situation 1, the hospital had a five-year management contract with an independent management company that was unrelated to either venturer. This management agreement was terminable by the governing board for cause. In Situation 2, a subsidiary of the for-profit entity provided day-to-day management under a five-year manage-ment contract which was renewable in the sole discretion of the subsidiary.

The Service held that the exempt organization in Situation 1 maintained its exempt status while the exempt organization in Situation 2 lost its exempt status due to the following:

1) The lack of control of the board by the exempt organization,
2) The lack of a binding obligation to further charitable purposes, and
3) The fact that the day-to-day management may not be under the board’s direct supervision.
The impact of this ruling is significant in that it delineates three factors which must be considered whenever exempt organizations participate in joint ventures with for-profit parties. It does not, however, discuss the relative importance of each of these factors. The absence of any one factor may or may not be conclusive on the issue of tax exemption. Therefore, the ruling leaves significant grey areas of interpretation.10 Failure to comply with all three factors, however, should result in revocation of an organization’s exempt status.

Although Rev. Rul. 98-15 only addresses whole hospital joint ventures, there is nothing in the ruling restricting the application of its general principles to the health care arena. Therefore, exempt organizations which participate in joint ventures with for-profit parties would be well advised to maintain ultimate control of the governing board, adopt a binding policy to further charitable purposes, and retain direct supervision over the day-to-day management of the venture.

Intermediate Sanctions

Individuals, as well as exempt organizations, may now be penalized for engaging in private inurement transactions. In addition to the loss of exempt status for organizations that engage in private inurement, “intermediate sanctions” legislation enacted by the 1996 Taxpayer Bill of Rights 2 imposes excise taxes on individuals receiving private inurement.

Intermediate sanctions are imposed on “excess benefit transac-tions.”11 An excess benefit transaction is any transac-tion in which the value of the con-sidera-tion given by an exempt organ-i-zation exceeds the value of the consider-ation received by it.12 The statute permits the Treasury to expand the definition to include other types of private inurement transactions.13 Presumably, this is targeted at trans-actions that consti-tute inurement per se — for example, transactions in which the benefit conferred is “reasonable” but nevertheless involves the transfer of an organization’s net earnings.

When an excess benefit transaction occurs, intermediate sanctions are imposed in the form of two excise taxes. The first excise tax is imposed upon “disqualified persons.”14 Generally, disqualified persons are defined as individuals who receive an excess benefit and are in a position to exer-cise substantial influence over the affairs of the exempt organization.15 The initial tax imposed upon a disqualified person is equal to 25 percent of the excess benefit.16 If the disqualified person does not correct the transaction by returning the excess benefit and paying the 25 percent tax before the IRS assesses a tax or sends a notice of deficiency, the disqualified person will become subject to an additional tax of 200 percent of the excess benefit.17

The second type of excise tax is imposed upon “organization managers” equal to 10 percent of the excess benefit.18 Organizational managers are defined as officers, directors, trustees, or similar persons who approve or otherwise participate in the transaction.19 Unlike the tax on disqualified persons, no additional tax is levied upon an organizational manager for failure to correct the transaction. Further, the total tax imposed on all organizational managers cannot exceed $10,000.20

The House Ways and Means Committee report on the legislation outlines three procedural steps that exempt organizations may take to signifi-cantly reduce their exposure to these excise taxes.21 If these procedural standards are observed, there is a rebuttable presumption that any benefit conferred is reasonable.22 The first requirement is that the transaction must be approved by a board or committee that is composed entirely of individuals unrelated to and not sub-ject to the control of any dis-qualified person involved in the transaction. Second, the board must have reasonable sup-port for its decision, in the nature of compensation surveys, compet-ing offers, expert opinion, etc. Finally, the board must document its decision-making process, including the factual basis for its decision.

If the presumption of reasonableness applies to a transaction, it is unlikely that organization managers will be subject to intermediate sanctions. The statute provides that organization managers will not be held responsible if their participation is not willful and was due to reasonable cause.23 However, there is no such “good faith” defense with respect to disqualified persons. Therefore, the IRS could impose excise taxes on a disqualified person, for example, by ruling that the organization failed to reasonably support its decision with accurate data.24

The IRS is instructed to issue regulations which would clarify the application of the presumption of reasonableness.25 In the meantime, organizations should implement the procedures outlined in the House Committee report to ensure that they qualify for the presumption in future transactions. Exempt organizations should also review all prior transactions occurring after September 13, 1995, to see if any corrective action is necessary.


With regard to maintaining tax-exempt status when entering into any transaction with private parties, 501(c)(3) organizations should avoid ceding control over operations, to the extent possible. In particular, after Rev. Rul. 98-15 these organizations should: 1) retain control of the governing board; 2) establish a clear directive to perform charitable activities; 3) maintain ultimate discretion over day-to-day management. Additionally, United Cancer Council indicates that 501(c)(3) organizations should reserve supervision and control over the organization’s revenue- generating functions.

With regard to avoiding the imposition of intermediate sanctions, exempt organizations should implement procedural guidelines which comply with those described in the House report. If these guidelines are followed, organizational managers should be able to avoid substantially all personal liability for intermediate sanctions. Disqualified persons may also avoid personal liability, although the final determination of whether these sanctions apply is a question of fact.

The government’s increased scrutiny of 501(c)(3) organizations applies to both the organizations and the individuals who influence them. Rev. Rul. 98-15 and United Cancer Council seek to restrict the ability of 501(c)(3) organizations to enter into transactions which may benefit private parties. The intermediate sanctions legislation permits the government to penalize the parties benefitting from these transactions. Although these developments lack precise guidelines, they nevertheless present certain parameters within which 501(c)(3) organizations should be able to operate in furtherance of their charitable objectives. q

1 1998-12 I.R.B. 6.
2 Some of these developments impact tax-exempt organizations other than 501(c)(3) organizations.
3 All section references are to the Internal Revenue Code of 1986, as amended, unless otherwise indicated.
4 I.R.C. §501(c)(3).
5 Gen. Couns. Mem. 38,459 (July 31, 1980).
6 Treas. Reg. §1.501(a)-1(c) (1982).
7 But cf. Gen. Couns. Mem. 39,670 (October 14, 1987).
8 Although the Tax Court considered both elements of the private inurement doctrine, the most important aspect of the opinion was its focus on the definition of an insider. Therefore, this article will not discuss the “inurement” portion of the case.
9 Prior to this case, when entering into third party arrangements, 501(c)(3) organizations only had to consider whether the arrangement constituted more than an insubstantial private benefit to the third party. Now that there is authority which applies the private inurement doctrine to independent third party contracts, any private benefit (regardless of how insubstantial) could result in the loss of exempt status.
10 Rev. Rul. 98-15 comes in the wake of a 1997 ruling by the IRS revoking the tax exemption of Redlands Surgical Services. In revoking the tax exemption, the Service departed somewhat from its earlier rulings permitting whole hospital joint ventures where the exempt organization relinquished control over the joint venture operations. The Redlands matter is currently before the Tax Court. A decision by the Tax Court on this issue may solidify the position of the IRS in Rev. Rul. 98-15 or may severely limit its application.
11 I.R.C. §4958(a).
12 I.R.C. §4958(c)(1).
13 I.R.C. §4958(c)(2).
14 I.R.C. §4958(a)(1).
15 I.R.C. §4958(a)(1). The report of the House Ways and Means Commit-tee on this legis-lation provides some help-ful guidance with the definition of disqualified persons, indicating that the officers and directors of an organization (and persons holding similar posi-tions) typically, although not invariably, will be found to possess such influ-ence. H. Rep. 104-506, 104th Cong. 2d Sess. (1996).
16 I.R.C. §4958(a)(1).
17 I.R.C. §4958(b).
18 I.R.C. §4958(a)(2).
19 I.R.C. §4958(a)(2). An organizational manager does not have to receive an excess benefit in order to become subject to the excise tax. Rather, the organizational manager may be subject to the tax simply by approving of or participating in the transaction.
20 I.R.C. §4958(d)(2).
21 H. Rep. 104-506 at 57.
22 The House report states the “intent” of the committee that “the parties to a transaction are entitled to rely on a rebuttable presumption of reason-ableness with respect to a compen-sa-tion arrangement with a disquali-fied person.” H. Rep. 104-506 at 56-57.
23 I.R.C. §4958(a)(2).
24 H. Rep. 104-506 at 57.
25 Id. at 57.

J. Andrew Hagan is an associate in the tax/individual planning group of Foley & Lardner, Orlando. He graduated from the University of Florida with both a law degree and master’s degree in accounting and holds a master of laws degree in tax law from the University of Florida and is a certified public accountant. His practice involves planning for business formations, reorganizations, and acquisitions. Mr. Hagan also concentrates in the areas of corporate and individual income tax planning, tax controversies, and estate, gift and generation skipping tax planning.

T. Kevin Taylor is an attorney in the tax and individual planning department of Foley & Lardner, Orlando. His practice concentrates in tax and estate planning, including the use of life insurance to plan for estate liquidity; the use of revocable and irrevocable trusts, family limited partnerships and S corporations to minimize estate taxes; use of buy-sell, split-dollar and other agreements for business owners and executives; the determination of the value of entities; formation and operation of nonprofit entities and charitable tax planning; tax controversies involving succession and income taxes; and various forms of probate and trust litigation.

This column is submitted on behalf of the Tax Section, Lauren Y. Detzel, chair, and Michael D. Miller and Lester B. Law, editors.