American Bar Endowment v. The United States, Frederic D. Turner, Et Ux., Arthur Sherwood, Et Ux. v. The United States

Citations: 761 F.2d 1573; 56 A.F.T.R.2d (RIA) 5005; 1985 U.S. App. LEXIS 14792Docket: 84-988

Court: Court of Appeals for the Federal Circuit; May 10, 1985; Federal Appellate Court

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Consolidated appeals were filed in the case of American Bar Endowment v. United States, concerning two main issues stemming from a ruling by the United States Claims Court. In appeal No. 84-988, the Government contests the court's determination that the American Bar Endowment (the Endowment) does not generate unrelated business taxable income from a fundraising initiative involving group insurance policies for its members, where the Endowment retains refunded dividends. In appeal No. 84-1000, individual taxpayers associated with the Endowment challenge the court's decision that they cannot deduct the assigned premium dividends as charitable contributions. The appellate court affirmed the ruling in No. 84-988 and reversed in No. 84-1000, remanding the latter for further proceedings.

The Endowment is a charitable organization focused on supporting legal education and research, exempt from taxation under 26 U.S.C. Sec. 501(c)(3). Established in the 1950s, its insurance program requires members to assign dividends from their insurance policies to the Endowment, which reflect the difference between premiums paid and actual insurance costs. Members who do not assign their dividend rights are ineligible to participate. During the relevant tax years (1979-1981), the Endowment acquired policies from New York Life Insurance Co. and Mutual of Omaha Insurance Co., using broker James Group Service, Inc., which received a commission from the insurers.

The Endowment is solely responsible for managing its insurance terms, including premiums and coverage, aiming to maximize dividends. It strategically set premiums competitively while maintaining participant engagement, resulting in significant growth from 12,000 to 55,000 participants over twenty-eight years and recouping $81.9 million in dividends, with $63 million allocated to educational projects. The Endowment notifies participants annually about the percentage of premiums recouped as dividends, which can be as high as 30-50%, and claims this portion is a tax-deductible charitable contribution, though it includes a caveat regarding IRS views amid potential litigation.

Two main legal issues arise: the taxability of dividends received by the Endowment and the deductibility of the dividend portion of insurance payments by participants. Tax laws, particularly sections 170 and 501, provide favorable treatment for charitable contributions, allowing deductions for donors and exempting charities from taxation on received donations. However, to prevent tax-exempt organizations from engaging in unrelated commercial enterprises, Congress established an unrelated business income tax on income from activities not substantially linked to a charity's purpose, defined under sections 511 and 512. The Tax Reform Act of 1969 further clarified the definition of 'trade or business' to include income-generating activities from sales or services.

Section 513(c) establishes a three-part test for determining whether a charitable organization's income is subject to unrelated business tax under section 511. The income is taxable if: (1) it comes from trade or business, (2) the organization regularly conducts this trade or business, and (3) the trade or business is not substantially related to the organization’s exempt functions, aside from generating funds. In the case concerning the Endowment’s tax liability, only the first part of this test is contested—whether the Endowment's insurance plan constitutes a trade or business. 

The IRS, in a technical advice memorandum dated July 3, 1980, classified the insurance plan as an ‘unrelated trade or business’ and deemed the dividends taxable. The IRS's rationale was that the Endowment acts as a group policyholder, which enables its members to access group rates. Following an audit, the IRS assessed a tax deficiency for 1979 and 1980, which the Endowment paid, along with taxes on dividends for 1981. The Endowment later filed a claim for a refund, which the IRS disallowed.

In the subsequent refund suit, the Claims Court evaluated whether the Endowment operates in a competitive, commercial manner. The court referenced a precedent case and concluded that if the insurance plan resembled a profit-making enterprise, it would qualify as a trade or business under section 513(c). However, the court ultimately determined that the Endowment did not operate commercially, citing its significant success, the fundraising intent of the program, and the members' informed consent. The court also noted that the income from the Endowment far exceeded the value of any services provided, concluding that it did not meet the statutory definition of income from a trade or business.

Congress enacted the unrelated business income tax to address the competitive advantage that tax-exempt organizations have over commercial enterprises. The Claims Court determined that the Endowment, which utilizes commercial underwriters and aims to increase insurance prices rather than undercut competitors, does not compete effectively with taxable insurance businesses. Consequently, the Endowment does not fall under the scope of the unrelated business income tax provisions. The court affirmed Chief Judge Kozinski's ruling that the administration of the insurance plan does not constitute an unrelated trade or business. The court correctly applied the standard for determining whether the plan qualifies as a 'trade or business' under section 513(c) and found that the Endowment did not meet the competitive and commercial criteria outlined in previous rulings.

The Government argued that this case was similar to other court cases involving unrelated business provisions for group insurance plans, referencing cases such as Professional Insurance Agents of Michigan v. Commissioner and others. However, Chief Judge Kozinski distinguished these cases, noting they involved business leagues that received business deductions rather than charitable contributions, with income derived from services rendered to insurance companies. Unlike the Endowment, these leagues directly competed with commercial enterprises, which is where Congress intended the unrelated business tax to be applied.

The Government also contended that the Endowment's practice of setting rates based on market rates demonstrated competitive behavior characteristic of commercial enterprises. However, the court clarified that the determination of whether the unrelated business tax applies does not solely depend on profit maximization or revenue generation but also on the nature and source of the funds received by the charitable organization.

The Claims Court rejected the Government's argument that dividends from the Endowment were payments for services, determining that the funds were not obtained through a commercial exchange and thus do not qualify as 'profits' under section 513(c). It asserted that charities should not be taxed solely based on successful solicitations, countering the IRS's reasoning. The taxpayers' appeal addressed whether the assignment of dividends to the Endowment constituted deductible charitable contributions under section 170, which allows deductions for contributions made without expectation of financial return. 

A letter from the Endowment informed members that starting in 1980, the IRS would disallow the deduction of dividend portions of insurance premiums as charitable contributions. The individual taxpayers, who did not deduct these amounts in 1981, sought a refund after receiving no response from the IRS and subsequently filed a complaint in the Claims Court, which consolidated their cases. 

The Claims Court acknowledged that a transaction could be both commercial and charitable, focusing on the significance of each aspect. It indicated that taxpayers must show they paid more for goods or services than their economic value, intending the excess to benefit the charity. If the charity provides compensation equal to the payment's value, no charitable contribution exists. Moreover, taxpayers must demonstrate an intention to contribute charitably.

To assess the value of the compensation received by the Endowment's participants, the court compared it to similar insurance plans. Three taxpayers could not prove eligibility for cheaper alternatives, undermining their claims of a charitable contribution. One taxpayer showed eligibility but lacked awareness of it during the relevant years, failing to establish the intent to contribute. Consequently, all individual claims were denied.

The taxpayers' case is unique, with no precedent found regarding the deductibility of insurance dividends assigned to a charitable organization holding the group insurance policy under section 170. The Government claims that the Claims Court properly placed the burden of proving a charitable motive on the taxpayers, asserting this motive is essential for deduction eligibility. However, the court rejects the Claims Court's unitary approach and remands the case for reevaluation based on established tax principles, particularly since the tax code does not clearly define 'charitable contribution.' 

A charitable contribution cannot be an exchange; significant economic benefits expected by the donor negate deductibility. Citing Singer Co. v. United States, the court emphasizes that substantial benefits expected by the donor exclude the transaction from deductibility. Similar rulings in Ottawa Silica Co. v. United States reinforce this principle, where both cases involved donations made with the anticipation of future financial gains. Conversely, transactions with charitable organizations can allow for deductions if the quid pro quo is minor relative to the gift's value, as seen in examples like purchasing tickets for charity events. The IRS has acknowledged this by allowing deductions for contributions that exceed the fair market value of the benefits received.

The IRS in Rev.Rul. 68-432 established that significant discrepancies between membership contributions and potential benefits may indicate a dual nature of payments, allowing for the separation of amounts treated as charitable contributions under section 170 of the Code. Courts have similarly applied this principle. In *Marshall v. Welch*, a donation to a nursing home was deductible beyond the cost of a wheelchair provided to the donor's son. In *Arceneaux v. Commissioner*, petitioners had to demonstrate that their payment exceeded the value of services from an adoption agency and was intended as a gift. Conversely, in *DeJong v. Commissioner*, a contribution was disallowed to the extent it equaled the market value of the education received by the taxpayer's children.

Rev.Rul. 67-246 outlined two conditions to establish a charitable component in transactions: proof that the claimed gift represents the excess payment over the value received, and evidence that the excess was intended as a gift. This intention, although not always essential, is significant in distinguishing gifts from mere purchases. The Court of Claims in *Singer* denied deductions for transactions with schools that were seen as business-oriented rather than charitable. Similarly, in *Rusoff v. Commissioner*, the Tax Court determined that an assignment of patent rights to Columbia University was a business transaction, not a charitable contribution, based on the circumstances and legal documentation surrounding the transfer.

The Claims Court determined that taxpayers must compare the cost of the Endowment's insurance plan with other options and demonstrate that the Endowment’s plan is more expensive for their participation to be deemed economically motivated. This position implies that if the Endowment's plan is the lowest cost, participation is driven by economic incentives rather than charitable intent. The critique of this approach highlights several flaws: 

1. The requirement for taxpayers to prove a motivation of disinterested generosity is excessively burdensome, contradicting the precedent established in Singer, which rejected a strict motivational requirement.
2. The cost comparison disregards that other plans may offer dividends, effectively lowering participants' net costs and indicating a voluntary sacrifice of those dividends for participation in the Endowment's plan.
3. The Claims Court's assumption that participants act purely based on economic calculations overlooks the reality that motivations for charitable transactions are often mixed, including non-charitable factors.

The appropriate inquiry should focus on whether the transaction was business-related or charitable, requiring a comprehensive examination of all relevant circumstances rather than a singular criterion. Evidence suggests some participants attempted to negotiate the assignment of dividends, implying a belief that the Endowment offered the best insurance despite the assignment requirement. This could lead a trial court to conclude that the transaction was business-oriented. Conversely, other participants may have engaged with the plan motivated by a desire to support a charitable cause while fulfilling their insurance needs, potentially justifying their eligibility for a tax deduction. This variability indicates that distinct conclusions could be drawn based on individual participant motivations.

Participants in the Endowment's charitable plan may assert their intent to support the Endowment's charitable goals, which, until challenged, suffices as justification for their involvement. The Government has the burden to demonstrate that the transactions were primarily business-oriented. The case record reveals limited information regarding the taxpayers' interactions with the Endowment, aside from their participation and awareness of the dividend assignment requirement. The court has decided to reverse and remand the case for further examination of whether the relationship was predominantly business-related or if it contained significant charitable elements. The ruling affirms case No. 84-988 and reverses and remands case No. 84-1000. The document references statutory provisions and IRS positions relating to the taxation of unrelated business income, emphasizing the need for tax-exempt organizations to compete on equal footing with non-exempt businesses. The Claims Court's finding that dividend assignments were not payment for services but rather support for the Endowment's charitable mission aligns with IRS guidelines. The case is consistent with IRS memoranda indicating that such arrangements do not subject charitable organizations to taxation, particularly when dividends are offered as rebates. The distinction between the plans in terms of competition with commercial insurance is minimal, if it exists at all. Additionally, contributions exceeding certain limits are not deductible as business expenses under Section 162(b).

To qualify for a tax deduction, an insurance plan must be disadvantageous for the taxpayer, who must recognize that better options are available. This requirement emphasizes the need for disinterested generosity, which the taxpayer must demonstrate. Taxpayers argue that the sole criterion for deductibility is whether the charity's services equal or exceed the claimed donation value, asserting that in the current case, the Endowment's services were significantly undervalued. However, this simplistic view contradicts the comprehensive analysis prescribed by the Singer-Ottawa Silica case, which assesses the entire transaction, including relative values, overall purpose, and donative intent. Furthermore, the nature of negotiations may suggest a business rather than charitable intent, and the level of economic benefit provided to the charity is a strong indicator of donative intent.