Fundraising and Private Inurement
by Rich Johnson
Table of Contents
I. Introduction
A. Charities
B. Contingent Payment Agreement
C. Nonprofit Organizations, Charities and Fundraising
D. Private Inurement
E. Issue
II. Analysis
A. Private Inurement and Compensation
B. Structuring the Agreement
C. Oklahoma Fundraising Law
D. Association of Fundraising Professionals
E. Commission Based Pay
F. Summary
III. Conclusion
A. The Agreement
B. Future of the Law
C. Final Remarks
I.Introduction
The issue addressed in this paper is the problem that can arise when fundraisers are paid on a contingent basis. The central issue is be the appearance of private inurement. Private inurement may be found where it appears that part of the net earnings of the organization are coming into the use of a person having a personal and private interest in the organization. Charities need to plan and take precautionary measures to ensure that contingent payment agreements with fundraisers are not viewed as private inurement by the Internal Revenue Service. A contingent payment agreement is one where a fundraiser is paid based on the amount of money he or she raises. The appearance of private inurement could jeopardize the organization's tax-exempt standing. The objective of this paper is to explain the correct way for charitiesto structure commission based payment agreements to avoid the appearance of private inurement, and to suggest ways in which the law in this area may be improved.
A.Charities
The primary focus of this paper is on Internal Revenue Code Section 501(c)(3) charities. Section 501(c)(3) of the Internal Revenue Code exempts corporations and any community chest, fund, or foundation organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary or educational purposes, or to foster national or international amateur sports competition or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda or otherwise attempting, to influence legislation, and which does not participate in, or intervene in, any political campaign on behalf of any candidate for public office[1].
B.Contingent Payment Agreement
Many charities wish to pay their fundraisers based on a contingent agreement where the fundraiser is compensated partially or wholly based on the amount of money he or she raises. For example a fundraiser may be allowed to keep 20% of funds raised as payment for his or her services. One of the main reasons that many charities prefer this type of compensation agreement is that they can ill afford to pay up front for fundraising services that may or may not result in donations to the organizations[2] and they may lack fundraising expertise.
C.Nonprofit Organizations, Charities and Fundraising
Nonprofit organizations are, as the name indicates, organizations that do not make a profit. In order to remain operative over the years, nonprofit organizations have an excess of revenues over expenses. In any other organization this excess would be called a profit, but nonprofit organizations do not speak of the word profit.[3]
Charitable organizations are a subset of nonprofit tax-exempt organizations. While section 501(c)(3) lists other organizations they are commonly all referred to as charities with the exception of public safety testing organizations. A definition for the term charitable has not been fixed and is a hotly debated topic.[4] The Regulations note that the term charitable should be broadly applied in its generally accepted legal sense.[5]
Fundraising is defined as the organized activity of soliciting money or pledges for charitable organizations.[6] Contingent fundraising is the practice of fundraising where the fundraisers are compensated based on how much they raise. The payment agreement could be structured as a percentage of funds raised or as a base compensation plus a percent of funds raised over a set amount.
D.Private Inurement
One of the requirements to qualify as a section 501(c)(3) charity is that no part of the net earnings may inure to the benefit of any private shareholder or individual. Black's Law Dictionary defines inure as to take effect or to come into use.[7] The phrase any private shareholder or individual refers to persons having a personal and private interest in the activities of an organization, including founders, trustees, officers, directors, and donors, but not members of the beneficiary class contemplated by the organization’s governing instrument and exempt purposes.[8]
E.Issue
The goal for charities is to enter into contingent payment agreements, as described above, while avoiding the appearance of private as defined above. In the course of my research, I have found several tools non profit organizations can use to avoid private inurement including setting an upper limit on compensation and negotiating at arm's length.
II.Analysis
A.Private Inurement and Compensation
The disallowance of private inurement means that no benefit may come into the use of a private individual or shareholder. However nonprofit organizations must compensate their employees. Compensating employees does not create a private inurement problem unless the employee has a private interest in the organization. If the employee does have a private interest in the organization, the benefit which flows to him must be incidental. In most cases fundraisers are not employees of the organization, but if they have control over the organization may be considered to have a private interest.
Traditionally the Internal Revenue Service has not treated employees of charities as having a private interest unless they have control over the activities of the organization.[9] However in the early to mid 1980s the IRS began to expand its views on which persons may have a private interest.
In General Counsel Memorandum 39498, the IRS said that employees or other individuals with a close professional working relationship were considered to be persons with a personal and private interest.[10] The IRS concluded that a physician recruitment program, where a hospital guaranteed a minimum salary for two years, could adversely affect the hospital's exempt status because the payments may result in an inurement of the hospital's net earnings to the physicians. As employees or individuals with a close working relationship with the hospital the physicians are persons who have a personal and private interest in the activities of the hospital which may be more than incidental.
General Counsel Memorandum 39598 announced the stance that an incidental flow of private benefits to an organization's control persons would not jeopardize the organization's exempt status.[11] That memorandum also lays out a two part test for determining whether a private benefit is incidental to the organization's exempt status. The benefit must be necessarily associated with the organization's activities which benefit the public. The private benefit must also not be substantial after considering the overall public benefit generated by the activity.
In Truth Tabernacle, Inc. v. Commissioner of Internal Revenue the IRS established that where an organization establishes a relationship in which private benefits flow to a control person in negotiations that were not at arm's length, a reasonableness determination will be made by comparison to what would be provided by the same organization to someone with whom it dealt with at arm's length.[12]
B.Structuring the Agreement
The cases below are instances where contingent payment agreements entered into by 501(c)(3) organization were reviewed by United States Courts or the Internal Revenue Service. A review of these cases provides insight as to what factors the courts will consider when determining if a contingent payment agreement is private inurement. By properly taking into account these factors charities can structure contingent payment agreements to avoid private inurement.
In National Foundation, Inc. v. The United States, the United States Claims Court rejected the government’s argument that a compensation arrangement maintained by the taxpayer, that involved the payment to a charitable development officer from each application fee and of a commission percentage of the contributed amount obtained from each donor, was a benefit to a private individual. Commission based compensation arrangements are part of business, the court reasoned, and do not preclude tax-exempt status to the taxpayer if such arrangement is reasonable.[13]
In United Cancer Council, Inc. v. Commissioner of Internal Revenue the United States Court of Appeals for the 7th Circuit overturned an earlier Tax Court holding in which a fundraising company was determined to be an insider and payments to that company were deemed to be a private inurement. The term any private shareholder or individual in the inurement clause of section 501(c)(3) of the Internal Revenue Code has been interpreted to mean an insider to the charity. Orange County Agricultural Society, Inc. v. Commissioner, 893 F.2d 529, 534 (2d Cir. 1990). The court interprets this provision as being designed to prevent the siphoning of charitable receipts to insiders of the charity, not to empower the IRS to monitor the terms of arm’s length contracts made by charitable organizations with the firms that supply them with essential inputs whether premises, paper, computers, legal advice, or fundraising services.[14]
In World Family Corporation v. Commissioner of Internal Revenue the Tax Court held that World Family corporation was entitled to tax exemption under section 501(c)(3). World Family Corporation offered commissions of up to 20 percent to fundraisers who procured contributions for the organization. The court stated that the commissions program did not result in private inurement even though its president and incorporator were credited with 10 percent commissions.[15]
In People of God Community v. Commissioner of Internal Revenue, the Tax Court found that there was private inurement where a pastor who also set on the board of directors of a church was compensated based on percentage of gross receipts, subject to no upper limit. The court reasoned that a portion of the organization’s earnings were being passed on to the pastor who, as a member of the board directors, was vested with control of the organization. The court stated that it did not mean to imply that all contingent compensation arrangements made by charitable organizations will preclude tax-exempt status and that such arrangements are a part of business life and must occasionally be paid by a charity to salesmen, publishers, support groups, and even fund raisers. The court also defined the term private shareholder or individual as referring to persons who have a personal and private interest in the payor organization (Sec. 1.501(a)-1(c), Income Tax Regs.), but not to include unrelated third parties (Broadway Theatre League of Lynchburg, VA. V. United States).[16]
In Broadway Theatre League of Lynchburg, Virginia v. United States of America the United States District Court for the Western District of Virginia held that an organization which paid 15 percent of its membership dues to a booking agent was not precluded from tax exempt status.[17]
In an Action on Decision RE: Plumstead Theatre Society, Inc. the Internal Revenue Service found that a Corporation was operated for the private benefit of investors where 63.5 percent of the net profits were paid to limited partners whom performed no services for which reasonable compensation on a percentage basis is paid.[18]
In Science and Research Foundation, Inc. v. United States of America the United States District Court for the Southern District of Illinois held that a company which used royalties from sales to pay expenses and then deposited further royalties into a fund for publication of new books or further circulation of published books was entitled to income tax exemption.[19]
C.Oklahoma Fundraising Law
The Oklahoma Solicitation of Charitable Contributions Act is codified in Section 552 of Chapter 14 of Title 18 of the Oklahoma Statutes and regulates fundraising. Section 552.3 requires charitable organizations which are soliciting funds to register with the state. The registration fee is $15. Section 552.4 exempts organizations which collect less than $10,000 per year from registering and paying the fee. Section 552.5 requires all charities organized in Oklahoma which received contributions during the year to file information reports. Section 552.7 requires professional fundraisers to register with the Secretary of State and to pay a $50 fee. The applicant must also file a bond, in which the applicant shall be the principal obligor, in the amount of $2,500. Section 552.14 allows an action for violation of the act to be prosecuted by any district attorney or by the Attorney General.[20]
D.Association of Fundraising Professionals
The Association of Fundraising Professionals (AFP) is the largest association of philanthropic fundraisers and has been the standard-bearer for professionalism in fundraising for more than 40 years. The AFP has more than 30,000 members in 200 chapters spread across the world. The association works to promote high ethical standards in fundraising. One of the main functions of the association is to keep its members up to date on fundraising concerns throughout the world. In order to maintain public trust the AFP has laid out ethical standards, guidelines, and principles for not only its members but for donors as well.
AFP members must agree to abide by the ethical standards developed by the organization. The failure to do so can result in disciplinary measures including expulsion. Five of the AFP standards address compensation specifically. Members shall not accept compensation or enter into a contract that is based on a percentage of contributions; nor shall members accept finder’s fees or contingent fees. Business members must refrain from receiving compensation from third parties derived from products or services for a client without disclosing that third-party compensation to the client (for example, volume rebates from vendors to business members). Members may accept performance-based compensation, such as bonuses, provided such bonuses are in accord with prevailing practices within the members’ own organizations and are not based on a percentage of contributions. Members shall neither offer nor accept payments or special considerations for the purpose of influencing the selection of products or services. Members shall not pay finder’s fees, commissions or percentage compensation based on contributions, and shall take care to discourage their organizations from making such payments. Any member receiving funds on behalf of a donor or client must meet the legal requirements for the disbursement of those funds. Any interest or income earned on the funds should be fully disclosed.[21][22]
E.Commission Based Pay
As expressed above the AFP disallows commission based pay. The AFP explained its reasoning in a 2001 position paper prepared by the AFP Ethics Committee. The AFP bases its view on the fact that private benefits cannot inure to individual's with an interest in the charity thus private benefits should not be allowed to inure to the fundraiser. The AFP believes that compensation based on skill, effort, and time does not result in private inurement, but that commission based compensation does constitute private inurement. The position paper goes on to list six specific reasons as to why commission based compensation violates their ethical standards. First, commission based compensation puts the interest of the fundraiser ahead of the interest of the donor and the public. Second, such compensation compromises the trust of the donors on which the charity relies. Third, a commission based compensation arrangement may foster inappropriate behavior by fundraisers. Fourth, tying compensation to the amount of funds raised may discourage the volunteer work which charities rely on. Fifth, commission based compensation may provide rewards without merit. Finally, such compensation arrangements may cause the donor's interest to no longer be paramount.[23]
It is important to distinguish between ethical obligations and legality. The AFP does not contend that commission-based fundraising is illegal, only that it is unethical. In a legal sense commission-based compensation is fine as long as the fundraiser discloses that a percentage of the donation is going towards compensation. Many people in the fundraising industry do not adhere to the AFP's view that commission based compensation is unethical. Proponents of commission based compensation see it as a way for individuals to achieve the American dream and point to the positive aspects of these agreements such as excitement, motivation, and rewarding hard work. Doug Tieman, President and CEO of the Caron Foundation, is baffled as to why national fundraising organizations, such as AFP, take such a strong stance against commission based compensation. Tieman continues to say that it builds longevity and makes people feel good about what they are doing. Tieman goes on to say that there have been countless studies showing that people who have some financial stake in what they are doing perform better than when they have no financial interest. Tieman also points to the burden the high turnover rate of fundraisers creates for non-profit organizations. Commission based compensation would allow these organizations to pay their fundraisers more and would cause the fundraisers to stay longer, alleviating the burden caused by high turnover.[24]
F.Summary
Paying fundraisers based on a commission can potentially create problems for not for profit organizations regarding their tax exempt status. Many non-profit organizations wish to pay their fundraisers this way because it is the only way they can afford to pay for the fund raising services. In order for an organization to keep its exempt statues, none of its earning may come into the use of any person having a personal and private interest in the activities of the organization. Nonprofit organizations have to enter into commission based agreements with fundraisers while avoiding the appearance of private inurement.