DATELINE: September 14, 2009, Chicago
The California Attorney General has brought suit against individuals associated with the L.B. Research and Education Foundation (Foundation). Raja Abdulrahim, UCLA Surgeon Sued for Benefiting From His Own Charity, L.A. Times (Sept. 10, 2009). Given the allegations in the AG's complaint and the newspaper coverage, we are willing to bet that the IRS will join the fray, if it hasn't already.
The suit names Dr. Gerald D. Buckberg,five others who are or were Foundation officers or directors, and 50 unnamed individuals. At the heart of the suit are allegations over self-dealing, but the AG has thrown just about everything imaginable at the defendants. If the facts are anywhere close to the alleged ones, we’d recommend that the defendants...
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settle as soon as possible.
According to the L.A. Times, the AG’s action has its genesis in a lawsuit by the Foundation brought against UCLA following a donation of $1 million to UCLA by the Foundation to fund a faculty chair. The suit allegedly was commenced by the Foundation after UCLA failed to appoint Buckberg to the chair. According to the AG’s complaint, the foundation “has spent over $400,000 litigating the action against UCLA." In its press release, the AG uses $300,000 rather than $400,000 as the number. UCLA notified the AG about the Foundation, resulting in a 2007 investigation of the Foundation.
According to the AG’s complaints, the Foundation engaged in a number of self-dealing transaction involving Buckberg and others, including:
(i) “[F]unding over $60,000 to UCLA Foundation…to support Buckberg’s research and laboratory;"
(ii) “[F]unding various grants…totaling over $120,000 to produce an educational DVD called the Helical Heart. All rights to the DVD are owned by The Helical Heart Co., LLC, a for-profit Ohio limited liability company formed and owned by Buckberg and his cousin, Herb Urell;”
(iii) "[F]unding over $140,000 to the California Institute of Technology…for research requested by Buckberg to be conducted by Dr. Morteza Gharib, Ph.D. On information and belief, Buckberg collaborated with and directed Dr. Gharib’s research. On information and belief, Buckberg collaborated with and directed Dr. Gharib’s research;"
(iv) "[F]unding over $50,000 to support conferences, travel, and hotel expenses for Buckberg, Athanasuleas and other individual physicians who were members of the Restore group that performed an operation called Surgial Ventricular Restoration (“SVR”), a surgical treatment for patients with certain types of congestive hear failure. The SVR research supported a medical device known as the CorRestore System patch that is licensed and presented for a for-profit corporation controlled b Buckberg and Athanasuleas. In fact, Samonetics cited research supported by LB as a basis for marketing the CorRestore patch to the public at large."
Many of the allegations assert failures to follow corporate formalities, something that is common whenever a corporation is controlled by a close group of individuals. Of particular note are the allegations that some individuals were unaware that they had been appointed officers and directors.
Is Dr. Buckberg’s behavior as troubling as the complaint suggests? We leave that question to the AG and the courts, but the situation warrants some reflection. Had Dr. Buckberg done much of what is alleged to have done without interposing a corporation between himself and the activities, there would be no basis for the AG’s action. We don’t know whether Buckberg claimed a charitable contribution deduction when he contributed money to the Foundation, but we would be surprised if he didn’t. What is important to keep in mind is that Dr. Buckberg didn’t necessarily need a charity to obtain tax benefits for many of the dollars that the Foundation spent. Some dollars would have undoubtedly been subject to capitalization requirements if Buckberg had expended them himself, but depending on the facts, the expenditures may have generated cost recovery deductions in subsequent years We suspect that the $1.0 million donation to UCLA would not have given rise to a charitable contribution had Buckberg donated the money himself given the allegation that Buckberg applied for the chair. But we suspect that some of the other expenses incurred by the Foundation in the form of grants might have given rise to business deductions had Buckberg made them himself.
At this point, we aren’t willing to excuse Buckberg’s alleged misbehavior, but we think the problems he now faces offer an important lesson to entrepreneurs who are considering conducting their entrepreneurial activities through a charity. By imposing a charitable entity, an entrepreneur is subjecting those activities to a layer of state regulation that is designed to prevent the entrepreneur from profiting from those activities. Moreover, if the entrepreneur is the sole funder (or close to it), he most likely is creating a private foundation under the federal tax law, which subjects the entrepreneur to onerous restrictions on self-dealing, expenditure responsibility for certain grants, and limitations on grants to individuals for study. Finally, to the extent that the activities produce intellectual property, that property and the right to exploit it belong to the charity, not to the entrepreneur. In short, if the entrepreneur stands to reap significant benefits from the entity’s activity, he is asking for trouble from both state regulators and the IRS by conducting the activity through a charity. Given the IRS's focus these days on private benefit, the entrepreneur is unlikely to obtain tax-exempt status for the charity if he discloses his intentions when completing the Form 1023.
Let’s now consider some interesting points raised by the AG’s complaint. First, there has been a lot of controversy as to whether the IRS should be asking about the corporation's recordkeeping and meeting minutes in Part VI of the Core Form 990. We can debate whether that is appropriate, but the AG’s complaint couldn’t be clearer. Section 6320 of the California Corporations Code requires that the corporation maintain adequate and correct books and records of accounts and minutes of the proceedings of its members, the board, and committees of board. In the complaint, the AG alleges that the Foundation failed to produce records and minutes as requested, with the implication that those records and minutes did not exist. The AG asserts that failure to prepare and maintain records constitutes gross mismanagement and abuse of authority. We don’t necessarily disagree with that conclusion, but we suspect most lawyers who advise nonprofits will be startled when they see “gross mismanagement” attached to the failure to maintain minutes.
Many will note that nonprofit directors and officers are shielded from liability under state liability shields. That may be true for damages, although the AG’s reference to gross mismanagement might prevent reliance on the shield if the AG can establish gross mismanagement. But of even greater interest is the AG’s demand that California be reimbursed for the all reasonable attorney’ fees and actual costs incurred in bringing the action, citing California Government Code Section 12598, which provides:
(b) The Attorney General shall be entitled to recover from defendants named in a charitable trust enforcement action all reasonable attorney's fees and actual costs incurred in conducting that action, including, but not limited to, the costs of auditors, consultants, and experts employed or retained to assist with the investigation, preparation, and presentation in court of the charitable trust enforcement action.
(c) Attorney's fees and costs shall be recovered by the Attorney General pursuant to court order. When awarding attorneys' fees and costs, the court shall order that the attorney's fees and costs be paid by the charitable organization and the individuals named as defendants in or otherwise subject to the action, in a manner that the court finds to be equitable and fair.
These costs could be high.
Also worth noting is how the AG uses the tax code as the basis to allege wrongdoing under state law. Establishing that someone has violated the state fiduciary law is difficult because that determination often requires a judgment based on an assessment of the facts. The AG essentially asserts that alleged violations of the Internal Revenue Code’s restrictions on private foundations is a per se violation various legal standards. Given the fact that the tax code’s restrictions are both broad and clear (at least some of the time), the linkage between state law and the tax code, if honored by the California courts, makes the AG’s burden a much more manageable one, particularly when there are multiple allegations.
Notice that we referred to violations of various legal standards. The complaint does refer to fiduciary duties (see Paragraphs 13, 20, and 24, for example). But the complaint alleges that the defendants abused their authority, committed fraud, diverted funds, and engaged in unlawful business practices or acts, among other allegations. These later allegations seem to be tied to the handling of charitable assets rather than duties owed to the Foundation.
Finally, the AG alleges that the defendants filed and distributed false and incomplete reports. Of note are allegations that extend to the Form 990, not just to reports required to be filed with the AG’s office. This case indicates that filing an incomplete or false Form 990 or Form 990-PF may provide state regulators with a basis for seeking redress against those filing the false return. At least that is what the allegations suggest.
In addition to repeatedly seeking the cost of the investigation and attorney’ fees from the defendants, the AG also seeks an accounting from the defendants as well as an involuntary dissolution of the Foundation. The AG also is seeking to recover over $500,000 in allegedly misappropriated funds and assess over $100,000 in civil penalties.
We may never know whether the IRS has or eventually intervenes in this matter. As we noted at the outset, the publicity surrounding the case may make such intervention inevitable. We would be interested to know how the AG and the IRS interact, particularly in terms of how monetary damages, penalties, and excise tax payments are imposed, if they are. If there is a settlement, we hope the AG requires these details to be disclosed.
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