“IT’S ALIVE, IT’S ALIVE”: THE SERVICE RESURECTS THE COMMENSURATE-IN-SCOPE TEST
Hit me with your best shot!
Why don't you hit me with your best shot!
Hit me with your best shot!
Fire away!
Pat Benatar, Hit Me With Your Best Shot on Crimes of Passion (August 1980)
DATELINE: May 14, 2008, Chicago
You know something is up when our friends at the Chronicle of Philanthropy feature the release of an IRS determination letter in their News Update column, but Chronicle reporter Grant Williams and his editors know a big story when they see one. IRS Revokes Tax-Exempt Status of Charity That Spends Too Little Money on Charitable Programs, May 13, 2008. Williams reported yesterday that the Service issued Determination Letter 20080818023 (May 2, 2008), which concluded that a Section 501(c)(3) organization did not qualify for tax-exempt status. "Big whoop," you say, but it is because the Service invoked the much heralded...
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commensurate-in-scope test in denying tax-exempt status that this adverse determination letter will receive much attention.
"The commensurate-in-scope test. What's that?" you say. We and most of the tax professionals working in the tax-exempt arena are asking the same question. By and large, this is a non-existent doctrine that the Service is trying to breathe life into. The Service's willingness to invoke the doctrine on the facts presented in DL 200818023 demonstrates just how much the Service wants to begin using it. Had the Service been presented with the same facts even two years ago, it would have disposed of the matter by invoking the private benefit and private inurement doctrines. Or, it would have pointed out that the organization didn't satisfy the operational or primary purpose test. But we are living in a time when politicians are worried that colleges and universities are hoarding assets instead of spending those assets to reduce the tuition costs borne by today's cash-strapped college students. Those same individuals who have iPods strapped to themselves.
If the Service wanted to play this game, it should have chosen a better candidate. Harvard University comes to mind. Yes, if you are going to do something, do it big. The Service should have revoked Harvard University's tax-exempt status. After all, Harvard is sitting on close to $35 billion in endowment assets that it could be spending to cut tuition costs. It certainly would be a fair fight given Harvard's world-renowned law faculty.
But the Service chose an organization that described a number of clearly exempt activities in its request to be recognized as a Section 501(c)(3) charitable organization, but which appears to have been anything but charitable in terms of how it was operated. The organization told the Service in its Form 1023 application for exempt status that it:
plans to coordinate and conduct, through its staff, evangelistic campaigns in a number of countries wherein the people are receptive to the Gospel of Jesus Christ. In addition, the organization may co-sponsor evangelistic campaigns with other organizations that have a track record of proven evangelistic results, such as D (a religious organization) . . . B may also underwrite the costs of operating orphanages that teach children the Gospel. The organization may also distribute Bibles, build churches and install fresh water wells, particularly in third world communities where such opportunities are unavailable.
Sounds good to us, but the Service took a closer look, concluding that the organization's:
primary focus is the "Asset Exchange Programs" rather than the charitable programs described in its Articles and application. B's website promotes the three programs. These asset exchange programs allow individuals to exchange Real Estate, Securities and Annuities for the "B Tax Deductible Installment Plan" product. The website also affirmed that when a person exchanges an asset for a B Tax Deductible Installment Plan, they receive the following:
- A generous income tax deduction
- A tax-favored income
- Elimination of a portion of any capital gains
- A guaranteed income that grows every year, and
- An estate tax reduction
The Service then examined the relationship between revenue and program service expenditures. Although there is a lot more discussion in the letter, the Service obviously decided to deny tax-exempt status because:
The z dollars amounts reported for charitable programs in the four quarterly financial reports for the tax year * * * is less than one half of one percent of the total revenues (or contributions to B) reported.
The other facts that most likely contributed to the Service's decision include:
- The charity was operated by a husband and wife team (based on experience, you always have to be wary of husband and wife teams who work together).
- The organization was operated out of a home office (although a business office was subsequently established, with the home office also continuing to be used).
- The husband and wife each had access to a leased car.
- A state agency filed a court petition to place the organization under court-supervised receivership.
- The state agency alleged that the organization was an unauthorized insurance entity marketing a term annuity product.
- Five other states reportedly issued cease and desist orders prohibiting the organization from conducting business in the their states.
Despite obvious alternative grounds for denying tax-exempt status, the Service concluded the ruling by stating:
Based on the information submitted and the programs promoted on your website it appears that you are primarily involved in the sale of annuity plans associated with their asset exchange programs. The sale of annuity plans would constitute a trade or business and without a charitable program commensurate in scope with the business of selling these plans, you do not qualify for exemption under IRC § 501(c)(3).
In our view, this determination letter is nothing less than a shot across the bow—an announcement that tax advisors and charities should take the commensurate-in-scope talk seriously.
Let Us Count the Ways. The Service didn't need to resurrect the commensurate-in-scope test to deny the organization tax-exempt status. We strongly suspect if the facts had been further developed (or more facts were reported in the determination letter), that the Service could have easily denied exempt status on the basis of private benefit. In other words, the primary beneficiaries of the organization's activities were the individuals who entered into the annuity contracts and received tax and financial benefits. Alternatively, the Service might have denied exemption on private inurement grounds. We don't have enough facts, but the home office and leased cars at least raise the possibility that the husband and wife were operating the charity for their own benefit. We sure wish the Service had given more information about their salaries and fringe benefits. Finally, the Service could have pointed to the alleged violations of state insurance law, concluding that an organization that conducts illegal activities is not charitable. See Revenue Ruling 75-384, 1975-2 C.B. 204.
Validity of the Doctrine. It is open to serious question whether the commensurate-in- scope test even exists. We strongly suspect that a court would rule that there is no statutory basis for the commensurate-in-scope test if the court were required to rely solely on the test to reach a decision. There is certainly no reference to the test in the statute, nor is there one in the regulations. With the exception of one published ruling, the reference to the test has been limited to administrative pronouncements having extremely low precedential value—TAM 9636001, GCM 34682, and FAS 19919007. This opens the test up to two constitutional challenges. A taxpayer faced with an adverse application of the test could argue that the Service has exceeded its administrative authority. It also could argue that the test is unconstitutionally vague. As presently unformulated, nobody even knows what the test is or how to satisfy it. In one instance, the Service initially invoked the test to argue that not enough of the money contributed to a charity found its way to the charity after the collected money was diverted to pay fundraising fees (United Cancer Council, 109 TC 326 (1997), rev'd and rem'd 165 F.3d 1173 (7th Cir. 1999)). In reviewing the dispute, the 7th Circuit ignored the commensurate-in-scope line of analysis. As of late, the Service and Senator Grassley have suggested that the test should be invoked when too much money ends up in the charity, but is not immediately spent. These two uses of the test address entirely different issues. Something so elastic and unbounded is a dangerously vague.
Congress Has Pre-empted the Test. The Service relies principally on Revenue Ruling 64-182, 1964-1 C.B. 186, in DL 200818023. In its entirety, this revenue ruling states:
A corporation organized exclusively for charitable purposes derives its income principally from the rental of space in a large commercial office building which it owns, maintains and operates. The charitable purposes of the corporation are carried out by aiding other charitable organizations, selected in the discretion of its governing body, through contributions and grants to such organizations for charitable purposes. Held, the corporation is deemed to meet the primary purpose test of section 1.501(c)(3)-1(e)(1) of the Income Tax Regulations, and to be entitled to exemption from Federal income tax as a corporation organized and operated exclusively for charitable purposes within the meaning of section 501(c)(3) of the Internal Revenue Code of 1954, where it is shown to be carrying on through such contributions and grants a charitable program commensurate in scope with its financial resources.
An organization may not consider itself exempt from tax merely because it falls within the scope of this Revenue Ruling. In order to establish its status, an organization claiming exemption under section 501(c)(3) of the Code should file its application on Form 1023, Exemption Application, with the District Director of Internal Revenue for the internal revenue district in which is located the principal office of the organization. See section 1.501(a)-1 of the Income Tax Regulations.
To us, the reference to "commensurate in scope" looks more like a throwaway line rather than a clearly articulated test. Basically the ruling says that a foundation that uses investment income to make grants qualifies as a charity, as distinguished from a Section 502 feeder organization carrying on a trade or business. Nothing exciting here. The organization in question was a private foundation.
Then along came the Tax Reform Act of 1969, which added Section 4942 to the Code. Roughly speaking, that provision requires private foundations to annually distribute 5% of the value of their investment assets. So when Congress wanted to make sure that a charity was currently using its resources for charitable purposes, it knew exactly how to do so. The fact that Congress did not extend Section 4942 to public charities speaks volumes. Congress chose to defer to the judgment of a public charity's board as to when a charity should spend its resources. This is keeping with the centuries old recognition of the validity of charitable endowments. Charitable funds can be maintained in perpetuity. So to the extent the Service intends to apply the commensurate-in-scope test to accumulated endowments, it seems to be acting contrary to what strikes us as clearly articulated congressional intent. Before Senator Grassley asks the Service to change the rules, he first needs to ask his colleagues to change the statute. In any event, it would seem that any charitable organization that spends at least 5% of its endowment for charitable purposes each year has a pretty good argument that the commensurate-in-scope test doesn't apply to its endowment.
Clear Guidance. As should be apparent, we seriously question the authority of the Service to continue to develop or rely on the commensurate-in-scope test. Our views, however, are unlikely to deter the Service. We therefore believe the Service should avoid continued efforts along the lines of DL 200818023. The Service should utilize more formal tools, like a comprehensive revenue ruling with examples, or better yet, a set of proposed regulations. That way it can receive input from its stakeholders.
The Coming Accumulated Earnings Test. Not so long ago, many businesses were conducted through taxable closely-held corporations. The then existing rate structure and incentives caused the owners of these businesses to accumulate earnings inside the corporation rather than pay them out as dividends, which were subject to high-levels of tax. To combat taxpayer efforts to escape the double tax on corporate earnings, Congress enacted the accumulated earnings tax, which is located in Sections 531 through 537 of the Internal Revenue Code. This tax applies when a corporation unreasonably accumulates earnings rather than paying them out as dividends. The widespread use of LLCs, S-corporations, and partnerships has largely relegated the tax to the trash heap of tax history. Yet, if the Service persists in developing the commensurate-in-scope test, we are likely to see the concepts that developed under Section 531 being incorporated into the law of tax-exempt organizations. In the old days, the way to escape the tax on accumulated earnings was to demonstrate that the accumulations were reasonable and served business purposes. This led to elaborate studies and high fees paid to consultants to develop theories and rationales demonstrating that corporate accumulations were reasonable. Those who took ACTP (Advanced Corporate Tax Problems) at NYU recall the Bardahl formula for determining how much of the accumulated earnings were required for the reasonable working capital needs of the business. Now, you can even buy a computer program for $199 to help with the application of the formula. But taxpayers didn't stop with Bardhal. Taxpayers successfully argued that they could accumulate earnings to (i) prepare for strikes—Dielectric Materials Co., 57 T.C. 587, Acq., 1972-1 C.B. 2; (ii) expand facilities—Newman Machine Co., 26 T.C. 1030, Acq., 1957-1 C.B. 4; and (iii) acquire competing businesses—The Crawford County Printing and Publishing Co., 17 T.C. 1404, Acq., 1955–1 C.B. 4; Gazette Telegraph Co., 19 T.C. 692, Acq., 1954-2 C.B. 4—to name just a few of the justifications for accumulating earnings—there are hundreds of cases.
Assuming the courts are willing to go along with the Service's belief that the commensurate-in-scope test exists, exempt organizations likely will make similar arguments that their endowments represent reasonable accumulations of charitable assets. Colleges will argue that some of the funds will be used to finance future capital projects, annual scholarships, and research that can't be completed in just one year. The end result: High-priced consultants will make a fortune and large endowments will remain largely intact. Canada legislatively tried to reach the result that Senator Grassley and the IRS are trying to reach with the commensurate-in-scope test. As University of Western Ontario Professor Adam Parchin pointed out at last week's ABA Tax Section meeting, the Canadian effort has turned out to be a disaster that the regulators are now trying to undo.
Conclusion. Why can't Congress and the Service leave it to the business judgment of boards and donors? If donors continue to give to those charities that are accumulating wealth, the donors must see value in such accumulations. Anyone who heard Princeton University's Lorraine A. Sciarra, who spoke at same meeting as Professor Parchin, now knows that university boards devote much thought and judgment in deciding how much of endowment to spend annually. At the end of the day, the IRS and Senator Grassley are creating a monster that will wreak havoc once it escapes from the lab. Unfortunately, this Frankenstein will produce few benefits that couldn't have been achieved through more conventional doctrines. The charitable sector looks like the sweet little girl playing on the shore just before Dr. Frankenstein's monster threw her into the lake. The villagers weren't happy following that incident.
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