The International Journal
of Not-for-Profit Law

Volume 1, Issue 3, March 1999

The United States Court of Appeals for the Seventh Circuit recently rejected an IRS claim that an arms-length contract between a nonprofit organization and a professional fundraiser that resulted in a high ratio of fundraising expenses to net fundraising proceeds constituted private inurement to the fundraiser, justifying revocation of the nonprofit’s charitable tax exemption under 26 U.S.C. § 501(c)(3). In United Cancer Council v. Commissioner, (7th Cir., Feb. 10, 1999), the Seventh Circuit held that the Internal Revenue Service improperly revoked an organization’s charitable tax exemption on the grounds that the organization’s net earnings had inured to the benefit of a professional fund raising company it hired. The Seventh Circuit’s decision overturned a ruling of the United States Tax Court.

United Cancer Council (“UCC”), a small, nearly bankrupt charity supporting preventive approaches to cancer with an annual operating budget of $35,000, contracted with Watson and Hughey Company (“W&H”), a professional fundraising firm, to organize a fundraising campaign. Under the terms of the contract, W&H served as UCC’s exclusive fundraiser for a five-year term, and obtained co-ownership of UCC’s prospective donor list. UCC agreed to refrain from selling or leasing the list, while W&H ‘s use was subject to no restrictions. W&H fronted fundraising expenses until the campaign yielded sufficient proceeds to allow UCC to reimburse W&H. W&H conducted a mail solicitation that included educational materials about cancer prevention as well as a request for donations and a sweepstakes entry form. The campaign yielded $28.8 million in net proceeds, of which $26.5 million, over 90%, was paid to W&H as fundraising expenses.

The IRS claimed that UCC did not qualify for the section 501(c)(3) exemption from federal income tax. Section 501(c)(3) exempts from taxation organizations that are “organized and operated exclusively for [charitable] purposes . . .” where “no part of the net earnings of the charity may inure [ ] to the benefit of any private shareholder or individual.” 26 U.S.C. § 501(c)(3). The purpose of the restriction of private inurement is intended to prevent “siphoning of charitable receipts to insiders of the charity.” United Cancer Council.

The Court rejected the IRS’ contention that the arrangement was so advantageous to W&H that it effectively rendered W&H in control of UCC and an insider of the charity, triggering the private inurement provision of the code. The Court found, inter alia, that the high ratio of fundraising expenses to net charitable receipts was unrelated to the issue of private inurement.

The IRS’s alternative ground for revoking UCC’s exemption, which was not ruled upon by the Tax Court and therefore not presented by the appeal, was that UCC was operated for the private benefit of W&H, as opposed to charitable purposes, as a result of the disproportionate fundraising expenditures. The Tax Court did not consider this ground, and the Seventh Circuit remanded the case to the Tax Court for further proceedings to consider this argument.

In Re Bishop Estate

The more than two year saga surrounding the mishandling of the Bishop Estate’s trust continues both in and outside of the courtroom. On Monday, March 29, 1999, Hawaii’s Attorney General, Margery S. Bronster, petitioned the court to remove four of the estate’s five trustees. These trustees have been the focus of an investigation into alleged mismanagement of the trust’s $10 billion assets, as well as various alleged criminal exploitations.

The investigation began in 1997 shortly after Lokelani Lindsey, one of the estate’s trustees, became involved in a dispute between Michael Chun, the principal of the Kamehameha Schools, and Kamani Kuala’au, the school’s student body president. The investigation led to the indictment of Henry Peters, another trustee, and the discovery of an independent inquiry by the IRS. Furthermore, it has recently been determined by a court-appointed master that between fiscal years 1993 and 1996, the trust lost $242 million and that the trust would have been better off investing its money in a simple savings account rather than with the investments made by the trustees.

On Mach 3, 1999, just prior to the March 29th proceedings, the chief legal counsel for the Kamehameha Investment Corporation, Rene Ojiri Kitaoka, was discovered in the men’s bathroom of the Hawaii Price Hotel having sex with Gerard Jervis, a trustee of the estate and chairman of the corporation. The next day, Ms. Kitaoka was found in her garage, dead from carbon monoxide poisoning and one week later, Mr. Jervis made an attempt on his life. Further discussion of the legal issues presented in this case is found in IJNL, vol. 1, Iss. 2.