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contemporary efforts to craft a private benefit doctrine that can carry the burden of providing the rationale for exemption.

The UCC, an organization formed for the exempt purpose of educating the public with respect to approaches to treating cancer, encountered severed financial difficulties when several of its affiliates left to join a competing cancer organization, thereby depriving the UCC of dues on which it relied. In the face of this financial crisis, the board decided to engage the services of a professional fundraiser. A committee of the board investigated fundraising options and recommended that the organization engage a firm specializing in direct mail fundraising. A separate committee of the board negotiated a contract with the direct mail fundraiser Watson and Hughey ("W & H").

The contract provided that W & H would advance the initial money required for the fundraising as well as money for continued operation of the UCC. Both of these provisions were critically important to the UCC, which was insolvent when it entered into the contract. W & H became the UCC's exclusive fundraiser for a five-year period. The contract gave W & H the exclusive right to unrestricted use of the mailing list generated under the contract even after the contract terminated. The UCC, which paid W & H for all the costs of generating the mailing list, would never have the right to sell, lease, or exchange the mailing list, even after its contract with W & H terminated. Gross receipts from the mailings were placed in an escrow account, and W & H was paid before any money went to the UCC. Over the term of the contract, the direct mail solicitations produced $28.8 million in gross receipts. UCC received $2.3 million, and W & H received the remaining $26.5 million. The Tax Court was never able determine during its protracted consideration of this case how much of this amount was profit for W & H.'

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The Service revoked the UCC's exemption in 1990.12 Thus began a saga that is important not so much for its length as for the way it highlighted the overlapping application of private benefit and inurement, the uncertainty in the interpretation of each doctrine, and the possibility that neither private benefit nor inurement is the true issue in the case. Above all, the UCC case illustrates the difficulty of examining the absence of a public benefit by attempting to show the presence of private benefit or inurement.

The Service revoked the UCC's exemption on grounds that it was operated primarily for a commercial purpose, not an exempt purpose, and that the fundraising contract was so favorable to W & H that it resulted in a more than insubstantial private benefit to the fundraising firm. The Service presented this public benefit argument in terms of a “commensurate in scope"

11 United Cancer Council, Inc. v. Commissioner, 109 T.C. 326 (1997). The Tax Court expressed its frustration with the parties' failure to provide all of the information that the court considered relevant.

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Final Notice Revocation (Nov. 2, 1990, retroactive to June 11, 1984). The Tech. Adv. Mem. in which Service presented its reasoning is available at 91 TNT 144-5.

claim.

The service rejected any fixed percentage of an organization's assets which must be used for exempt purposes, but it took the position:

The "commensurate test" requires that organizations have a charitable program
that is both real and, taking the organization's circumstances and financial
resources into account, substantial. Therefore, an organization that raises funds.
for charitable purposes but consistently uses virtually all of its income for
administrative and promotional expenses with little or no direct charitable
accomplishments cannot reasonably argue that its charitable program is
commensurate with its financial resources and capabilities. The Service did not
add the inurement claim only in its second amended filing in the Tax Court and it
treated this claim only perfunctorily in its reply brief in the Tax Court.

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After it had considered the case for four years, the Tax Court held that the Service had properly revoked the UCC's exemption, but it based its decision solely on the inurement claim. This claim was widely regarded among the private bar as the most innovative and the most dangerous element of the UCC case. The idea that a contract negotiated between unrelated parties negotiating at arms length could make a party to the contract an insider for inurement purposes threatened to disrupt the joint ventures and royalty agreements that were becoming increasingly important to a growing number of exempt organizations. Neither the parties nor the amici nor the Tax Court considered the Service's claim that the UCC was not operating for an exempt purpose, that it was not providing a public benefit. The Service itself failed to develop this claim in the Tax Court, even though it had been one of the grounds for revoking the UCC's exempt status.

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The Seventh Circuit, in an opinion by Chief Judge Richard Posner, reversed the Tax Court on inurement. 18 Judge Posner found that anyone could be an insider with the requisite control over the organization even if the person had no formal role in the organization, but he did

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Id. both amicus brief presented vigorous arguments opposing this approach.

United Cancer Council, Inc. v. Commissioner, 109 T.C. 326 (1997).

16 Amended brief for American Heart Association, American Lung Association, American Cancer Society, and Independent Secter as Amici Curiae (Jan. 5, 1994) (9400 TNT 18-37). (arguing that the fundraising contract provided an impermissible private benefit to W&H but rejecting the Service's public benefit test as an abridgement of First Amendment freedom of speech). But see, brief Amicus Curiae of Non-Profit Mailers Federation (Jan. 5, 1994) (94 TNT 9-58) (arguing that the fundraising contract furthered the UCC's exempt purposes.

240-30).

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See, Brief for Respondent in United Cancer Council Case (Nov. 1, 1993) (93 TNT

18 United Cancer Council v. Commissioner, 165 F. 3d 1173 (7th Cir. 1999).

not find the requisite control in this case. A one-side contract does not in itself establish control over the party that agreed to a bad bargain.

The Seventh Circuit remanded the case to the Tax Court on the private benefit issue and on the issue of whether the UCC was operating for an exempt purpose by providing a public benefit. The apparently disproportionate share of the gross revenues received by the fundraising firm was, in the court's view, relevant to this analysis. The issue was whether the UCC had made the equivalent of a gift to the fundraiser by paying it an excessive amount. If the UCC had failed to preserve its assets for its exempt purpose, it was not operating for an exempt purpose and was not providing a public benefit.

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The UCC case thus addressed both private benefit and inurement and did so from two different perspectives. The Tax Court opinion was a conventional doctrinal analysis that, despite its prodigious length, did not provide an adequate factual basis for fully considering the issues. The Seventh Circuit opinion, while noting the lacunae in the record below, applied a market analysis that focused on the UCC's limited choices for contracting with a fundraiser when it was already insolvent. Judge Posner looked at the fundraising contract as a standard risk allocation between parties with asymmetrical bargaining power and seemed to express impatience with the more regulatory analytical framework presented by the Tax Court.

The UCC case did not involve section 4958 excess benefit transaction issues because that provision had not been enacted during the years at issue. Yet, the case had a significant impact on the regulations issued under section 4958. The proposed regulations followed the Tax Court opinion,20 and the temporary regulations took account of the Seventh Circuit opinion.2

Gainsharing is terms for an incentive compensation strategy that the Service was prepared to rule was consistent with exempt status until the Department of Health and Human Services ("HHS”) ruled that it violated the Medicare laws. The differences between the two agencies illustrate the limits on the Service's approach of defining a public benefit as the absence of a private benefit.

Gainsharing based compensation on net profits of the exempt organization, not on gross revenues generated by the particular employee. The concept arose in the health care industry, but it could have been applied in universities or other fee for service organizations. The particular gainsharing arrangement on which the Service was prepared to rule favorably arose in a teaching hospital. The physicians in a particular practice group contracted with the hospital

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19 See, Frances R. Hill, Deregulating the Exempt Sector? CA-7 Reverses Tax Court in United Cancer Council, J. TAX'N.303 (1999).

1998).

20

The proposed regulations were issued in 1998. See 63 Fed. Reg. 41486 (Aug. 4,

21 The temporary regulations were issued in 2001.

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The following discussion is based on the text of a private letter ruling that was never released. This unreleased ruling is available at 1999 TNT 128-39.

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to maintain or improve patient service while reducing the cost of the services they provide. Once
the group as a whole met a threshold level of patient satisfaction, then the group would be
awarded points based on their success in meeting cost management targets. The physician group
would be required to show that no member of the group based decisions on admissions to the
hospital on the patient's race, creed, color, religion, sex, sexual preference, national origin,
health status, age, handicap, income level, or ability to pay, and that coverage or lack of coverage
under any government health care program, or any financial incentives under the contract with
the hospital.23 The incentive compensation was limited to a fair market value equivalent as
determined by an independent committee relying on market comparables. The ruling also
recounted that the arrangement was negotiated between the hospital and the physicians group at
arms length.

There was no discussion of what factors establish an arms length negotiation at a teaching hospital. For example, it is not clear whether the teaching hospital was a part of a university and whether some or all of the members of the physicians group were members of the university faculty. It is not clear how the incentive compensation arrangement related to any other relationships the physicians had with the hospital and/or the university. The Service seemed to lack a certain curiosity in its presentation of the facts.

The Service also seemed to lack curiosity about what cost containment meant in the context of a teaching hospital and what element of cost could be controlled by physicians' decisions. Presumably, the costs of supplies and the choice of suppliers of all of the materials and equipment required by a teaching hospital, as well as the cost of employees, were the responsibility of the hospital management. It would appear that only element of hospital costs which the physicians control is hospital admissions and the nature and extent of the care provided to various types of patients. The critical question is whether gainsharing means rationing care in ways based in some part on the ability to pay.

The Service ruled that the program was not inconsistent with the hospital's exempt status. As the Service saw it, the issue was whether the gainsharing program resulted in compensation that was reasonable in amount. There was no analysis at all of the exempt purpose of the teaching hospital and the relation of the gainsharing arrangement to the exempt purpose.

It was left to HHS to point out that rationing patient care was inconsistent with federal funding programs because gainsharing involved rationing of health care. HHS took the

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The draft ruling described the review process but gave no information on the criteria for excluding a physician from the program, an action that would render the entire group of physicians ineligible for participation in the incentive compensation program.

24 Much of the language of the factual narrative was marked by conclusory language that seemed like a barrier to understanding the facts.

25 Department of Health and Human Services, Office of Inspector General, Special Advisory Bulletin on Gainsharing Arrangements and Civil Money Penalties for Hospital Payments to Physicians to Reduce or Limit Services to Beneficiaries, 64 Fed. Reg. 37598 (July 14, 1999).

position that the method used to determine cost savings permitted limiting the amount and quality of care available to patients. This method thus, in the view of HHS, violated the Social Security Act. In effect, HHS reminded the Service and the Treasury that exempt organizations have a duty to operate for a public benefit. Gainsharing has come to stand for the idea that exemption does not depend on providing a public benefit but on avoiding the technical definitions of private benefit.

Proponents of gainsharing arrangements made a creative effort to establish the view that exemption means the absence of a private benefit during the comment period for the proposed regulations under section 4958. The claim was that gainsharing arrangements are not revenuebased compensation arrangements because they are based on lower costs, not on revenue earned. Treasury and the Service refused to adopt this approach, pointing to the HHS position on gainsharing and announced that no private letter rulings would be issued with respect to gainsharing arrangements.

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The gainsharing case illustrates the conceptual bankruptcy of separating private benefit from public benefit. The implicit premise that the absence of private benefit establishes the presence of public benefit was rejected by HHS and, in less dramatic fashion, was questioned by Judge Posner in the UCC case. These two cases have shaped the Service's position on private benefit, inurement and excess benefit transactions. The conceptual gap at the heart of these two cases have become increasingly central to the three private benefit doctrines discussed below.

3. Private Benefit

Private benefit has been developed and applied as a separate doctrine primarily in the case of section 501(c)(3) organizations. In the case of most other exempt organizations, the concept of inurement includes at least certain instances of private benefit. Inurement, in turn, is a general anti-abuse provision that does not always lead to revocation of exemption.

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Private benefit is most important as a separate element in the case of section 501(c)(3) organizations. These public charities are exempt only if they are organized and operated "exclusively" for an exempt purpose. An organization will be treated as organized for an exclusively for an exempt purpose based on the statements of purpose in its organizing documents. An organization will be treated as "operated exclusively' for one or more exempt purposes only if it engages primarily in activities which accomplish one or more such exempt purposes. By engaging in activities that accomplish one or more exempt purposes, an organization "serves a public rather than a private interest.' A section 501(c)(3) organization will not be treated as operating exclusively for an exempt purpose "if more than an insubstantial

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26 'T.D. 8920, 66 Fed. Reg. 2144, 2155-56 (Jan. 10, 2001).

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Section 501(c)(3). For this purpose, “exclusively" is defined as "primarily." Treas. Reg. § 1.501(c)(3)-1(c)(1).

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